Sanford Bernstein, on Monday, downgraded their recommendation for Sprint (NYSE:S) to "underperform" from "marketperform" and cut their price target from $2.50 to $1.75. Shares of Sprint fell 4.5% to $2.76 on the day. While I don't have access to the full report, I would like to briefly comment on the conclusions of the downgrade and the few excerpts of the report that Sanford made public, through various media sources.
One of the main concerns expressed by Sanford seems to be the fact that they estimate that credit-default spreads are implying a 50% risk of default for Sprint over the next five years. Now to be clear, I believe that credit spreads are an important tool for equity analysis and should be considered when equity investors are evaluating shareholder risks. That said, the conclusions derived from that analysis can vary considerably and can sometimes lead to dangerous circular logic -- as companies that are overbought or oversold tend to be mispriced across both the debt and equity markets.
For that reason, when the "bears" of the debt and equity markets for unloved companies (like Sprint) point to each other, it can lead to a negative cycle of circular logic (i.e. credit spreads are wide, which indicates a greater bankruptcy risk for equity holders…so equity prices fall, which means a smaller equity cushion for debt holders…so credit spreads widen, which means a greater bankruptcy risk for equity holders, etc., etc.).
That's not to say that credit spreads should be ignored, but I do believe that an independent valuation needs to be made for both asset classes and a 50% default implied spread, in isolation, tells you nothing about the appropriate evaluation for the equity (or debt, for that matter). As a high-yield debt analyst for most of my career, I can also say that the credit markets are not always correct and spread implied default probabilities should not be taken as infallibly accurate.
To be clear, I fully agree that there's a legitimate (albeit much smaller than 50% probability, in my opinion) risk of bankruptcy for Sprint. Sprint does have a large amount of debt, they have considerable execution risks over the next several years, and the competition facing Sprint is very tough. That said, I believe that the debt is manageable and I also feel that the execution risks have reduced (not increased, as maintained by Sanford) over the past year. Among other positive developments for Sprint over the past year, the company has refinanced their medium-term maturities, progressed with their "network vision" initiatives, and secured the iPhone (which also brings additional risks, but is a considerable overall positive for the company, in my opinion).
I also see the asset value of Sprint's network, spectrum, subscriber base, and operational infrastructure, as substantially above the levels of Sprint's net debt (providing a sizable cushion with respect to asset values). As a result, I believe that if Sprint stumbles in its turnaround, and its equity value falls too far, another company will step in and acquire this valuable business (in an industry for which the barriers to entry by other means are massive). For these reasons, I see the likelihood of a Sprint bankruptcy as small and overstated by current debt and equity prices.
With respect to the specific bankruptcy concerns mentioned in the Sanford report, the analyst appears to be ringing the alarm bells about debt maturing in 2015. Now I acknowledge that Sprint has many challenges and execution risks ahead of them, but their refinancing risk three years from now is not at the top of my list of concerns. In my opinion, the success of Sprint's turnaround initiatives will be clearly evident much earlier and, by 2014, Sprint will either be i.) reaping the rewards of a successful turnaround operation and, thus, easily able to refinance their debt well in advance of the 2015 maturities, ii.) or they will have been bought out by a larger foreign operator, pay-TV company, or private equity firm, iii.) or they will be preemptively restructuring their debt, in an unlikely downside scenario. Of these three scenarios, I believe that the likelihood of one of the first two is much greater than that of the last, but all three scenarios would mean some sort of resolution and clarity for Sprint before the 2015 maturities become an issue.
With regard to the size of Sprint's debt burden, Sanford uses the provocative characterization of Sprint's debt as being a "stupendous amount". That seems to overstate the case as I certainly don't believe that Sprint's debt burden is stupendous. On an absolute basis, when compared with the other U.S. large cell operators, Sprint's debt burden is much smaller (e.g. they had $14bn in net debt at YE 2011 versus $42bn for Verizon (NYSE:VZ)). While that's not a fair comparison, as Verizon is currently a much larger company, it gives you some context and I also don't believe that Sprint's debt burden is stupendous when put into the context of the company's current leverage ratios. For example, Sprint reported 2.9x net debt/adj. OIBDA (aka EBITDA) at YE 2011 -- a level which which I believe is low enough to be manageable for a Sprint, yet large enough to allow for a substantial boost to shareholders returns over the next few years.
Granted, Sprint's debt leverage ratio will increase over the upcoming transition period -- as margins fall and the company burns cash from network vision expenditures. Furthermore, I believe that Sprint's adj. OIBDA - CAPEX differential is currently too low and will need to increase through margin expansion (particularly since I expect that CAPEX levels will also increase, going forward). That said, looking out to 2015 (when the maturities for which Sanford is concerned about come due), I expect that margins will have increased substantially. The company has stated that they project 800bps to 1000bps in margin improvements from "network vision" and other operational improvements by 2014 and I expect that debt leverage ratios will improve considerably by this time. At that point, I also expect that a lot of the uncertainties and execution risks facing the company will be removed and refinancing will be much easier and cheaper than it was for Sprint with their most recent debt finance offering (which was successfully completed during a period of heightened uncertainty and negativity surrounding the company).
In summary, I believe that the Sanford report doesn't seem to bring forward much new information, but rather reiterates many of the existing bearish arguments, while pointing to credit spreads as confirmation of their concerns. As I discussed in my March 14 article, ("The Market is Too Negative on Sprint"), I feel that this type of bearish sentiment for Sprint is overdone and I also believe that a 50% bankruptcy risk for Sprint substantially overstates the company's bankruptcy risks. For those reasons, as I have stated before, I believe that Sprint presents one of the most attractive risk/reward opportunities in the equity market today.
Disclosure: I am long S.