Sanford Bernstein's downgrade of Sprint (S), based in part on what it perceives as a rising risk of bankruptcy, has generated quite a bit of controversy. On March 19, Sanford Bernstein downgraded Sprint to underperform, from neutral, and cut its price target on the stock from $2.50 to $1.75. Analyst Craig Moffet sees numerous risks for Sprint, including its debt, the costs of completing its Network Vision renovation, and the impact an LTE iPhone would have on the company.
In essence, Moffet says that:
Sprint's stock price may be best thought of as the awkward probability-weighted expected value of two distinctly different outcomes. In the first, the company successfully navigates its complicated Network Vision upgrade, stabilizes Clearwire's financial position, and delivers a compelling 4G product. In the second, some combination of its gargantuan take-or-pay contract with Apple, a hobbled 4G offering, and a stupendous debt burden bring the company to its knees.
Moffet says that the risk of Sprint filing for bankruptcy is currently 50%. Sprint shares fell 5% on news of the downgrade, as the market fretted over the likelihood of this doomsday scenario coming to pass. As of this writing, shares of Sprint have outperformed the S&P 500 year-to-date, rising over 17%, compared to the S&P 500's advance of nearly 11%.
However, this outperformance cannot mask the fall in Sprint shares over the past year, as concerns about the iPhone, Network Vision, and Clearwire (CLWR) have all weighed on Sprint.
We have written extensively about Sprint before, for we believe that for long-term investors, Sprint is an outstanding value play. This article will focus on the Sanford Bernstein downgrade, which we delve into below.
The Debt & Finances
One of the central tenets of Bernstein's downgrade of Sprint is its debt and financial profile. Admittedly, it is weaker that of AT&T (T) and Verizon (VZ). But, we do not think that the downgrade presented anything new. Sprint's debt load is not a secret, and while it is certainly large, it is being managed. For all the worries over Sprint's finances in 2011, it actually decreased its net debt.
In addition, the $2 billion of debt Sprint recently raised was a necessary step. It improved Sprint's liquidity position by allowing it to retire and/or service existing debt, fund its capital expenditures, and possibly fund Clearwire (CLWR). The incrimental addition to Sprint's debt load (transaction costs, etc.) is well worth the increase in liquidity. And Sprint cannot delay its capital investments, for they are the essence of the telecom industry.
Furthermore, Sprint is free cash flow positive, and finally achieved positive operating income in 2011, something that you do not usually see from companies in true financial distress.
|Revenue||$33.679 Billion||$32.563 Billion|
|Operating Income (Loss)||$108 Million||($595 Million)|
|Free Cash Flow||$429 Million||$2,512 Billion|
Sprint's free cash flow was depressed in 2011 by expenses related to Network Vision and iPhone subsidies. We believe that in the years to come, Sprint's free cash flow will improve from 2011 levels as Network Vision expenditures come to a close. Sprint expects $6 billion in capital expenditures in 2012, adjusted OIBDA of $3.7 to $3.9 billion, and for all Nextel customers to switch to the Sprint platform by mid-2013.
Much has been made of Sprint's GAAP losses. While we cannot deny that on a GAAP basis, Sprint is losing money, we do not feel that GAAP is the most appropriate way to measure Sprint's financial performance. Of Sprint's $2.89 billion net loss in 2011, $1.733 billion was due to losses in "unconsolidated investments," which means Clearwire.
We do not think that this figure should be used in calculating Sprint's true performance. Sprint did not invest in Clearwire to simply invest in it. Sprint's 4G network runs on Clearwire, and the Sprint needs it to be a viable competitor in the 4G race. If Clearwire stock jumped to $10, Sprint's GAAP income would shoot higher, yet the company's underlying performance would not change. Sprint would never realize the benefit of having Clearwire stock at $10 per share. Nor will Sprint ever realize the losses of having Clearwire at $2.37 per share (as of this writing). Clearwire should be viewed more as an asset.
Here, critics may pounce, and say that the losses on Clearwire equity could be viewed as depreciation. We disagree. Clearwire's primary asset is its spectrum, which does not depreciate on a straight-line basis like tangible assets do. Under GAAP, it is subject to impairment tests.
A look at Sprint's financials shows that while the company may not be on as firm footing as AT&T or Verizon, the company is not in imminent danger. Sprint posted $3.961 billion in operating cash flow in 2011 (this figure declined from $4.815 billion in 2010 due to changes in working capital and depreciation and amortization).
LTE & The iPhone
Sanford Bernstein, in its downgrade, also warned of the impact an LTE iPhone could have on Sprint and its finances. Specifically, Moffet believes that an LTE iPhone, which he sees as a likely possibility, would be a catalyst that pushes Sprint over the edge. He believes that the take-or-pay agreement with Apple (AAPL), and the weakness of Sprint's 4G network (its future LTE version), will hobble sales.
There are several moving parts to this view that need to be addressed, and many of them relate to things other than financials, and deal with more nuanced issues. We do not see an LTE iPhone as being an issue of such magnitude reasons we outline below.
- The next iPhone may not even have LTE: This bearish view of Sprint is predicated on the fact that the next iPhone will have LTE support at all, which is not a guarantee. Code uncovered in the newest version of iOS refers to 4G support that could be referring to LTE, but likely refers to HSPA+, a network type that sits between 3G and 4G. Apple has a well-known history of not offering features deemed as very basic (copy & paste) until it feels they are designed just right. And it is possible that the next iPhone may not even have LTE. Not that it matters for iPhone sales; the top 3 smartphones in the United States in 2011 were all iPhones, and the iPhone 4S came in at number 3, despite being on the market for less than 3 months. If the next iPhone has no LTE support, the entire bearish thesis built around that point is invalidated. But should it come with LTE support, it can be refuted with the points that follow below.
- Sprint's customer base: Sprint's customers have spent years without the iPhone. While Sprint has certainly had postpaid subscriber losses from 2007 to 2011, there are 2 things that can be deduced from the customers who have stayed. Either they are fiercely loyal to Sprint, or they simply do not think the iPhone is the device for them. That can serve to explain why Sprint's iPhone sales represent a smaller proportion of overall smartphone sales than at AT&T and Verizon. Should an LTE iPhone be released, Sprint will not see a wave of subscriber defections. If its non-iPhone customers stayed with the company when it had no iPhone at all, they would be unlikely to leave if Verizon or AT&T were to offer an iPhone with a better network experience.
- The network is not everything: People do not buy networks, they buy smartphones. Guggenheim Securities believes that an LTE iPhone would be "just right" for Sprint, as opposed to Bernstein's bearish view. And while Sprint is behind AT&T and Verizon in its LTE buildout, it managed to add more WiMax subscribers than Verizon added LTE subscribers. If the quality of the network were so important, people would all be on Verizon's LTE network (even though Verizon has had numerous LTE outages). Verizon has only been able to convert 5% of its postpaid subscriber base to LTE, whereas Sprint has sold WiMax devices to 10% of its subscriber base. Network quality is important, but it is not the only factor people take into consideration when purchasing a smartphone. While Sprint's LTE network may be constrained initially, its "underperformance" may not be noticed by users for some time as it will likely be underutilized. Globally, LTE smartphpne shipments are expected to jump 10-fold in 2012, but even after such a rise, they will still represent just 10% of smartphones sold in 2012. True LTE adoption will be reached in the years after 2012, and by then Sprint should have its LTE network buildout completed.
We remain bullish on shares of Sprint. As Network Vision wraps up, the pressure on Sprint's free cash flow should subside, and its subscribers and operating income are heading in the right direction. We do not think that bankruptcy is in Sprint's future.
At any rate, Sprint's book value per share stands at $3.81, 38.9% above current prices. The $2 billion of debt offered after the end of the last quarter will likely not impact book value to a large degree, given that most of the debt will likely be used to repay old debt. The current Reuters average price target for shares of Sprint stands at $3.87, representing upside of 40.73% as of this writing. We believe that Sprint's long-term future is bright, and that investors who keep their faith with the company will be rewarded.