Sprint: Spectrum Deal Does Not Threaten Upside

| About: Sprint Corporation (S)

Summary

Sprint has risen 40% from its Leap Day price when I recommended to buy it.

My $16 price target is solely a spectrum play, and ignores any further upside from Enterprise Value.

Sprint's plan to sell spectrum is seen by some as a threat, as it may alter Softbank's incentives to keep the company afloat.

American bankruptcy laws ensure that Softbank actually has little incentive to attempt to game the deal against other equity holders.

Sprint is not a risk-free trade, but the potential rewards substantially outweigh the risks.

Introduction

On Leap Day, I wrote an article describing my argument that Sprint (NYSE:S) was substantially undervalued by the market. At the time, the stock was trading for just over $3 a share. With the stock rocketing higher the past two days, finishing well over $4 today, the gains for Sprint since Leap Day come to over 40%. If you bought at the very bottom, $2.18 a share, you have now officially doubled your money. At one point today the stock touched as high as $4.44 a share, before falling back to settle at $4.38.

Has Sprint reached a new peak? Should investors pocket their nice gains and leave the table? Or is there more to come?

The Driver

The impetus for the gains seems to have been the declaration by Masayoshi Son, CEO of Softbank (OTCPK:SFTBY) and Sprint's principal shareholder, that he was continuing to stand fully behind Sprint and would be postponing his retirement to make sure Sprint survives the ongoing mobile price wars in the American wireless industry. Lately, Son has been putting his money where his mouth is, liquidating various other Softbank holdings including Alibaba and selling his Supercell shares to Tencent. But he is holding tight to his Sprint investment.

The only other news about Sprint was that PC Magazine ran a piece declaring that Sprint was "back," after conducting its regular network test. That sounds important, but the truth is it is just the latest in a long line of publications to make that same statement, and not even really the most authoritative of them. It was news to no one. Nevertheless, network quality is obviously a major factor in valuing any wireless operator, so that news too could conceivably have been a catalyst.

Regardless, the network news has been good for Sprint lately. Not up in Verizon's (NYSE:VZ) class, by any means, but pulling close enough to the Big Three of Verizon, AT&T (NYSE:T) and T-Mobile (NASDAQ:TMUS) to be considered once again a worthy adversary, not an also-ran. As I explained, however, in Sprint's case network news is almost purely a bonus to what was already a very compelling investment, thanks to Sprint's holdings of massive amounts of high-band spectrum almost perfectly suited for densifying wireless networks in high-traffic urban areas.

One Little Wrinkle

But while Son's support is certainly good news, the way he has been supporting Sprint has raised a few eyebrows. When Sprint found itself shut out of traditional borrowing networks, Son declined to offer more equity. Instead he created several new Softbank subsidiaries for the sole purpose of entering into buy-and-lease arrangements with Sprint. Essentially, Sprint "sells" pieces of itself - its network radios, its receivables on phone sales installment plans, etc. - to the new subsidiaries, and then leases them back. The resulting cash flows - one lump sum to Sprint, regular, smaller payments back to Softbank and other investors in the new companies - are indistinguishable from secured debt, and the debt holder has a claim on the assets just as secured lenders do.

Selling assets in this way has raised a few hackles with Sprint's unsecured bondholders, who are already into the company for $34 billion. Each sale of assets, whose cash proceeds promptly disappear into Sprint's sea of red ink, reduces their potential recoveries if Sprint ultimately does fall into bankruptcy.

I have not written of this before, because while it may be of concern to Sprint's bondholders, it has little import for Sprint's equity. In fact, it has been a positive. With two separate $1.1 billion transactions for phone receivables, and a $2.2 billion transaction just completed for network equipment, Sprint has raised enough cash along with a $2 billion line of credit to keep itself afloat for the foreseeable future. For shareholders, the encumbrance of assets like towers and phone receivables is a small matter. Shareholders already can expect to recoup little in a bankruptcy filing, thanks to Sprint's heavy debt load, so by the time the encumbrance of the assets matters it is game over for the equity anyway. What's more, Sprint apparently got something close to full value for them.

One More Deal?

Of more concern are the recent reports that Sprint may culminate this lease-debt phase with a deal to sell spectrum to a new Softbank subsidiary. As I explained, it is Sprint's unparalleled position in high-band spectrum that makes the stock such a buy. Sprint's high-band spectrum alone is worth, by my estimates, close to $100 billion at least, and it also holds low- and mid-band spectrum licenses I didn't even include. Even assigning a value of $0 to Sprint as an enterprise, just liquidating the spectrum at full value would pay the debt off and leave $16 a share for stockholders.

But it is likely that Sprint would have to wait until the 2020-2021 timeframe to achieve full price on any spectrum sales, at least in the high-band. So Sprint needs to stay out of bankruptcy until then, or risk being forced into a spectrum fire sale. This is part of why I have been skeptical of CEO Marcelo Claure's cash-burning strategy.

It is also, up till now, why I have been so confident that Softbank could not allow Sprint to fail. As the principal owner, Softbank has the same interest in Sprint's upside as all other shareholders, and therefore the same incentives to make sure Sprint did not fall into bankruptcy, as that would extinguish Softbank's equity interest and see the spectrum transferred to the company's new owners following the reorganization. That was why I thought the balance of risks favored Sprint equity owners.

Spectrum Co. And Softbank

The new deal has the potential to threaten this dynamic, because it could conceivably alter the incentives Softbank faces with regards to Sprint. Sprint has undoubtedly proven to be a bigger draw on Softbank's resources than Son expected when he purchased it. What makes it worthwhile is the spectrum. If he could somehow transfer that spectrum out of Sprint and into another subsidiary that he controls, Softbank's need to keep Sprint itself afloat would become much less. In fact, if spectrum was transferred from Sprint, which Softbank owns 80% of, into a subsidiary which was wholly-owned, it would obviate the need to share 20% of Sprint's upside and end the cash drain on Softbank at the same time.

Sprint CFO Tarek Robbiati assures that any such deal would still see Sprint continue to "own and use" any spectrum it would put up in such a deal. The "use" part is easy to see; it continues to use all the other assets it has put up as collateral as well, by leasing them back after selling them. But how would it "own" spectrum it had sold? In every other deal thus far, Sprint has clearly transferred the underlying property to the counterparty.

Robbiati declined to go into further detail. My own guess is that what Robbiati means is that the spectrum lease, like the other leases, would include a clause for nominal reversion, i.e. they would have the right to buy back the underlying asset for a nominal payment of $1 at the end of the lease. That clause has been standard in all of Sprint's deals thus far, as well.

If that is what he meant, however, it does little to allay concerns. Nominal reversion clauses do effectively reverse a sale, almost as if it had never been sold to begin with, but only if Sprint completes all of the payments to repay the cash proceeds from the counterparty, the hidden loan disguised as a sale and lease. If Sprint sells the spectrum to another entity, continues to burn cash and is forced into bankruptcy at some point, the termination of the lease payments could see the spectrum forfeited to the new entity.

And in this case, the counterparty that would profit from a Sprint bankruptcy and the company that is preventing a Sprint bankruptcy are the same company. So, some wonder, what's to prevent Son from pulling the rug out from Sprint itself as soon as the spectrum has been transferred?

My Recommendation

I do not dismiss these concerns, but I still believe shareholders should hold onto their shares. At $16 fair value there is still enormous upside. And the downside doesn't really look that different to me than before.

Set aside for the moment that any transaction of this kind, with Softbank trying to run both ends of the table, would almost certainly lead to painful litigation. I do not believe that the new spectrum deal, even if it goes through as I have described, will threaten shareholder interests as much as some think. Under U.S. bankruptcy law, executory contracts like leases are not automatically terminated. Rather, the debtor has the option to terminate them, but the counterparty is obligated to maintain the original agreement as long as the debtor continues to perform.

This means that even if Sprint was forced to file, it could preserve the lease as long as it continued to make payments. And since that spectrum is a crucial operational necessity for Sprint - no carrier can operate without spectrum - I believe a bankruptcy judge would be willing to grant Sprint prioritization of their spectrum lease payments over other obligations if necessary. And as long as Sprint's payments continued, the $1 reversion rights would continue as well.

Nor could Softbank easily prevent this from happening. While American bankruptcy law does not automatically remove management after a filing, as some jurisdictions do, nor is management completely free to do as they wish. Any attempt by one equity holder, even a majority shareholder, to facilitate a transfer that was manifestly detrimental to other equity holders would almost certainly be reversed by the court. And with the spectrum being so valuable I doubt the Sprint estate would have difficulty finding a funding source to maintain the spectrum lease payments, even in a state of bankruptcy.

So from Softbank's perspective, nothing has really changed. Right now, they own 80% of Sprint, and the upside in its spectrum. Let Sprint fall into bankruptcy, and their equity holdings will be severely diluted if not wiped out completely and the spectrum transferred to the bondholders as new ownership. In other words, I think that despite the appearance of a conflict of interest, in reality Softbank is exactly where it has always been, and Sprint's other equity holders can remain confident in its determination to keep the company afloat.

Conclusion

Sprint's unique combination of low, medium, and high-band spectrum could well make it the powerhouse of wireless for the foreseeable future if it can ever stop discounting and still grow. On the other hand, Sprint's continued cash burn remains of concern to many investors, and any attempts to stem the red ink by dialing back discounting would probably send subscribers fleeing again. For now, assigning any value to Sprint as a going concern remains very risky. But as long as its spectrum assets remain intact, the bullish cash for Sprint remains. I re-affirm my "spectrum-only" valuation of $16 a share, and remain long on Sprint.

Disclosure: I am/we are long S.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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