Sprint's Sales Tax Blunder

May. 7.12 | About: Sprint Corporation (S)

I've recently written several bullish articles on Sprint (NYSE:S) and I remain bullish on the stock. That said, since my last article (following Sprint's recent earnings release), I've done more research into the company's New York sales tax issues and, for the sake of balance, wanted to share my thoughts and heightened concerns on this particular issue.

A couple weeks ago (on April 19th), the district attorney of New York filed a suit against Sprint for unpaid sales taxes over the past seven years and Sprint's stock fell 5% that day. While the news was concerning to me, I somewhat dismissed it as just another corporate legal dispute with meaningful, but not substantial, potential implications. After all, large corporations face litigation all of the time and it's just a cost of doing business and this suit was not for an amount that would make or break Sprint, in my opinion (a $300mn suit for a company with over $33bn in revenues and $7bn in cash).

According to the district attorney's allegations, Sprint failed to pay approximately $100 million in New York sales tax over the past seven years (and they are claiming treble damages under New York law). The New York complaint alleges that Sprint allocated up to 28.5% of the cost of certain New York fixed-price plans as intrastate calls (calls between two states; which are exempt from sales tax in New York)from July 2005 to October 2008 and a 22.5% allocation for all of its New York fixed-pricing plans from October 2008. With regard to this allocation, and the resultant sales tax reductions, the state's complaint alleges that "Under New York law, Sprint's approach was and is unequivocally illegal".

Now, I'm not a lawyer and won't go into depth about the merits of the allegations (although, I will note that all of the other major cellular operator -- each of which chose not to make the questionable sales tax reductions that Sprint did -- would seem to agree with the district attorney's allegations). I will, however, comment on the seemingly very poor judgment of Sprint's management, at the time, as I believe that the company had almost nothing to gain from this scheme and quite a bit to lose (what could now potentially be $300 million, or even more if they did the same in the other states that also have exemptions for intrastate revenues).

Now let's think about this. The New York sales tax for intrastate calls is 4.00% and Sprint withheld about a quarter of what the state claims was due -- saving their customers sales taxes of about 1% on the fixed-portion of their bills (and a lower % of the total bill). The state claims that Sprint did this to achieve a competitive advantage, but I doubt that customers are going to even notice such a marginal difference in sales taxes and it's certainly not something that Sprint could advertise and market. Can you imagine such an ad campaign?

$49 calling plans!! ... and we reduce your sale tax -- compared to the other carriers -- lowering your total bill by about 1% (almost 50 cents/month for many customers)!

While those pennies, each billing period, are probably insignificant/unnoticeable for the individual customers, they added up for Sprint over the years (apparently, they added up to about $100 million in New York, in fact). The crazy thing about all of this is that Sprint didn't even owe this money - it was an insignificant pass-through that the customers owed.

So why would Sprint take such actions when it seems clear that there were questions and grey areas in the tax law? The company didn't get any extra revenues for themselves and it really offered them no significant competitive advantages. Conversely, as a result of these actions, they are now faced with back taxes, penalties, lawsuits, headline risks, general uncertainty, etc. All things considered, it really seems like an act of very poor judgment.

Despite this sales tax issue, I remain a long and bullish Sprint shareholder (because, even with these sales tax issues and the resultant financial risks, I still see Sprint as substantially undervalued). That said, I did take some money off of the table, today, because I do believe that this issue has increased the medium-term risks of holding the name and Sprint was (and remains) a substantial position for me. Furthermore, I believe that the issue creates some questions with respect to management's decision-making. Granted, the initial sales tax decision was made under the previous leadership in 2005 (i.e. before Dan Hesse), but that doesn't excuse current management for maintaining the status quo and not remedying the issue; notwithstanding the fact that there are seemingly larger issues that have been occupying their time. Going forward, I hope (but I'm not optimistic) that the company will eventually offer a robust defense of their previous actions in this matter. Time will tell.

Disclosure: I am long S. I sold less than 20% of my Sprint exposure in pre-market trading today.