Sprint's Q1 Solid, But Major Problems Remain

Apr.26.12 | About: Sprint Corporation (S)

Wednesday morning, wireless carrier Sprint (NYSE:S) reported its fiscal first quarter earnings. Overall, results seemed good, as revenues came in at $8.734 billion, ahead of the $8.71 billion estimate. Also, the earnings per share loss was just 29 cents, well ahead of the 41 cent loss analysts had forecast.

However, despite the solid report, there were too many red flags for my liking, and many of my readers know I have been a Sprint bear since about $3.45 in late 2011. While the two headline numbers above were good, they weren't good enough for my liking. Apparently, they weren't good enough for the stock either Wednesday.

Early Tuesday morning, shares were rocketing higher, and I saw them in the $2.70 to $2.75 range at one point in pre-market trading. However, they only traded as high as $2.65 just after open, and headed lower throughout the day, closing down 1.62%, or 4 cents, at $2.43. Why? Well, there are still some major worries, and I'll be discussing those today.

First, let's look at the earnings per share number, a loss of 29 cents. While that did crush estimates, analysts have been known, especially in the past year or two, for taking down Sprint estimates so much, that the company almost can't miss estimates. Just three months ago, and prior to their Q4 results, the consensus estimate for Q1 was a 31 cent loss.

Had that remained, it would not have been much of a beat. Also, this was in comparison to the prior year period, where the company only lost 15 cents a share. So basically, the loss doubled. That's not exactly something to write home about. Since the start of 2008, Sprint has lost $12.5 billion, in just 17 quarters. Nothing there to really celebrate.

Now, when it comes to Sprint, everyone wants to know how they are doing with sales of Apple's (NASDAQ:AAPL) iPhone. They are doing well, but maybe not well enough to justify what they are paying for the phone. iPhone sales for the quarter were 1.5 million, down from 1.8 million in the fourth quarter. However, the percentage of sales to new customers ticked up from 40 to 44 percent.

When it comes to total additions, Sprint added nearly 1.1 million new subscribers, which was also down from 1.6 million in the fourth quarter. Postpaid additions, while still positive, were only 263k, less than half of the 539k we saw in the fourth quarter. Research firm Bernstein finds these numbers especially troubling, especially after similar down quarters for both AT&T (NYSE:T) and Verizon (NYSE:VZ).

AT&T and Verizon, which activated nearly 12 million iPhones during the 4th quarter, only activated 7.5 million in the first quarter. Is it possible that the US wireless market is saturated, the firm asks? If so, Sprint is in major trouble. The company's deal with Apple is for 7.5 million iPhones a year, and right now, it looks like they will fall short of selling that many.

Now, the cost of those iPhones is very high for Sprint, and that is something that could do them in if sales are too low. Sprint pretty much bet its future on the iPhone, and so far, you can see the impacts are mixed. Revenues have been inching higher, but costs have soared as well. Take a look at the following chart of Sprint's Q1 margin during the past few years.

Q1 Margins 2009 2010 2011 2012
Gross 50.96% 48.08% 47.12% 41.78%
Operating -5.93% -2.23% 3.12% -2.92%
Profit -7.24% -10.70% -5.28% -9.88%
Click to enlarge

Thanks to the higher cost of the iPhone, gross margins fell by more than 5 full percentage points, and that trend could continue going forward. Operating income swung back to a loss, and we already know that the net loss was nearly twice that of Q1 in 2011. The iPhone may get customers in the door, but gross margins could easily fall below 40%. Given the fact that Sprint has a myriad of other costs to worry about, the future is not looking too bright.

One main thing I've been critical about when it comes to Sprint is their balance sheet, and with good reason. Sprint has been forced to add nearly $6 billion in net new debt over the past two quarters, which has pushed their outstanding debt level above $22 billion. Given that they had plenty of debt to start with, interest rates have been going higher and higher, so interest costs have been rising too. In fact, Q1 interest expense in 2012 was $298 million, up from $249 million in the year ago period. In dollar terms it might not seem like much, but that is nearly a 20% increase.

Also, that is just a quarterly number. Stretch that out to a full year, and Sprint is paying more than $1 billion in interest costs. Given that gross margins are less than 42%, and the company is posting operating losses to begin with, those interest costs hurt. Now, let's look at the impact some of these moves have had on their key financial metrics.

Financial Ratios 12/31/10 3/31/11 6/30/11 9/30/11 12/31/11 3/31/12
Current Ratio 1.25 1.02 1.06 1.13 1.59 1.90
Working Capital $1,989 $175 $551 $968 $3,838 $5,785
Debt Ratio 71.84% 71.33% 72.83% 72.84% 76.86% 79.08%
Total Debt $20,191 $18,538 $18,534 $18,529 $20,274 $22,268
Debt/Liabilities 54.41% 52.69% 51.89% 52.98% 53.41% 55.63%
Equity $14,546 $14,140 $13,326 $13,041 $11,427 $10,591
Click to enlarge

I don't consider the improvement in the current ratio and working capital real, just because it was all through the $2 billion debt raise. In fact, if you take out the $2 billion raised, their cash pile actually decreased by $352 million, and current assets decreased by $113 million. As you can see, the debt ratio (liabilities to assets), has hit a new high. Also, debt, as a percentage of total liabilities, has hit another high, which is bad since their debt contains such high interest rates. Shareholder equity decreased again, and is not likely to rebound anytime soon.

Another major problem for Sprint is Clearwire (CLWR). Sprint has billions invested in Clearwire, which has forced them to take plenty of losses. Sprint holds a large stake in Clearwire, and Clearwire shares were actually up in the first quarter. However, Clearwire stock has taken a beating in April, dropping from $2.28 to $1.35 today. If Clearwire goes bankrupt, Sprint is in major trouble. Not only does Sprint have billions in Clearwire equity and debt, but Sprint relies on Clearwire for spectrum and the 4G and LTE networks. At this point, if Clearwire goes bankrupt, the likelihood of Sprint bankruptcy increases tremendously.

So what is the best play here? Well, I'll give you a couple of ideas to chew on. If you are looking to own a stock that benefits from the iPhone, buy Apple. Apple reported a tremendous quarter, and as the maker of the iPhone, is in the best place to benefit from its sales. Now, if you don't want to own Apple, or you already own too much of it, Verizon and AT&T are very good names to own as well. Verizon offers a more than 5% dividend, and AT&T offers more than 5.5% annually in its dividend. Oh, both of them are profitable as well. Sprint does not pay a dividend, and is unlikely to do so for at least several years to come.

I still think Sprint is a short for now, until they can start to head towards profitability. They need to do more than just selling out their iPhones, and right now, I'm not even sure they can do that. When I initially saw the earnings headline, I thought it would be a great day for Sprint. But after I looked at all of the numbers, I can definitely see why the stock fell from early morning highs, and I think that is a sign of things to come.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours.