On a comparative basis, I believe that Sprint's (S) current valuation is very attractive, when compared to that of AT&T (T). While this may seem counter-intuitive - considering Sprint's historic losses and AT&T's historic strength and profitability - the goal is, obviously, to invest in the future and not the past. With that in mind, let's take a comparative look at the two companies.
Revenue growth trends favor Sprint
Sprint's recent revenue growth trends have been much better than those of AT&T (Sprint grew revenues by 3.4% in 2011 versus revenue growth of 2.0% for AT&T). Furthermore, the rate of change is also favoring Sprint, which improved their year-over-year growth rate from 3.4% in FY 2011 to 4.8% in Q1 2012. AT&T's y-o-y revenue growth, on the other hand, slightly declined (to 1.8% in Q1 2012 from 2.0% for FY 2011).
AT&T suffers from a disproportionately large percentage of wireline/other revenues which have been declining and negatively impacting total revenues (wireless comprised only 46% of AT&T's revenue in Q1 2012 versus 91% for Sprint). While a lower percentage of wireline revenues is a positive differentiator for Sprint, the company's recent wireless revenue growth is also substantially better than that of AT&T (7.2% growth in Q1 2012 versus 4.3% for AT&T).
Also bear in mind that Sprint's revenue growth numbers reflect the shutdown of the company's Nextel business, which is negatively impacting revenues. This is a temporary issue and the Sprint platform, itself, grew revenues by a whopping 16.1%, year-over-year.
|2010||2011||Q1 '11||Q1 '12||% of rev.|
With respect to the highly scrutinized iPhone sales, the trends also favor Sprint. Sprint increased its share of iPhone sales, amongst the three carriers, by 360 basis points, from Q4 2011 to Q1 2012, and reported a sequential decline from the seasonally high/product launch 4th quarter of only 17% (versus 43% for AT&T). The recent addition of a pre-paid iPhone to Sprint's Virgin Mobile USA subsidiary, on June 29th of this year, should further boost iPhone sales for Sprint.
|Q4 2011||Share||Q1 2012||Share|
Margins favor AT&T, but should converge over time
AT&T's margins are currently substantially higher than those of Sprint and this is one of the main reasons for the valuation difference between the two companies. For FY 2011, AT&T reported an adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) margin of 32.3% -- effectively double Sprint's comparable margin of 15.1%. While Sprint's operating margins are currently very low, there are two ways to look at a company with low margins, as I have discussed before.
The negative view is that the company is at a long-term competitive and/or other structural disadvantage, such that it will never be meaningfully profitable. Conversely, the positive take on Sprint's situation is a view that the company has no long-term structural disadvantage and is, therefore, a great turnaround story. As a result, substantial profitability upside is likely to come from margin expansion as the company improves its operations and brings profitability metrics more in line with that of its competitors.
I still find it difficult to believe the negative of the two potential views of Sprint (i.e. that Sprint is at a long-term structural disadvantage), as the company now has the same product offerings as AT&T and Verizon (VZ) (e.g. Apples (AAPL) iPhone, RIM's (RIMM) Blackberry, Google's (GOOG) Android phones, etc.). Furthermore, Sprint will have a similar 4G LTE network (once it has completed its upgrades), and the company, arguably, has better pricing plans and a better customer service reputation and brand image.
Granted, Sprint is substantially behind in the 4G LTE upgrade race and this will be a competitive disadvantage, in certain markets, over the near to medium-term. Longer-term, 4G LTE coverage will be more equal and Sprint does benefit from an offsetting competitive sales advantage in the meantime (with unlimited data plans). It should also be noted that sales of existing 4G devices have shown that customers are often more interested in the product type (i.e. phone model) than the network.
Overall, I still believe that the more positive of the two views on Sprint's low margins seems more plausible and Sprint is a great turnaround story. The company has a detailed plan in place to improve its margins and I see no logical reason why Sprint's margins won't migrate towards the levels of its competitors over time. By 2014, Sprint's management expects a 400 to 600 basis point margin improvement from "network vision" initiatives and a further 400 to 600bps improvement from other operational improvements, which would give Sprint 800 to 1,200bps in total margin expansion. Over this period, I would also expect healthy revenue growth from Sprint's strong product offering, attractive price plans, and good service reputation.
Sprint's execution risks are overstated...
Sprint's "network vision" program consists of very quantifiable infrastructure expenditures and resultant savings expectations. The company is currently having to run two networks, at great expense, so the elimination of the iDEN network by mid-2013 will have a substantial cost savings impact.
I believe that the execution risks of infrastructure programs, like "network vision", are much less than those of companies with turnaround risks relating to launching new products and turning around sales. The former is easier to predict, while the latter is exposed to the vagaries of consumer behavior (e.g. the risks facing other turnaround stories like RIM or Nokia (NOK). That's not to say that Sprint's execution risks aren't meaningful, but I do believe that they are overstated in the company's valuation.
...and debt concerns are overblown
Much is written about Sprint's high debt levels. Often, those comments are completely taken out of context and/or ignore the company's off-setting cash positions. The reality is that Sprint's absolute net debt position is substantially lower than that of AT&T ($15bn for Sprint versus $62bn for AT&T at Q1 2012). Even when adjusting for company size/revenue, Sprint's leverage ratio is actually slightly better than that of AT&T (Net Debt/Revenue of 0.44x for Sprint versus 0.50x for AT&T at Q1 2012).
Currently, because of Sprint's lower margins, adj. EBITDA leverage ratios do substantially favor AT&T. Net Debt/Adj. EBITDA for Sprint was 2.9x at YE 2011, versus 1.5x for AT&T, and this ratio will get even worse for Sprint in 2012 (as margins temporarily decline from "network vision" expenditures and expenses related to the recent launch of the iPhone). Longer-term, if margins converge as I expect, I believe that the companies' net debt/EBITDA ratio should converge, as well.
Looking out to 2014, I expect that margin improvements should substantially bring down Sprint's leverage ratios. If we assume that revenue growth continues at 5% per annum (in line with current trends) and adj. EBITDA margins expand by 900 bps, from 2011 levels, to 24.1%, we get to 2014 revenues of approximately $39bn and adjusted OIBDA of around $9.4bn. Assuming an increase in net debt from $14.8bn at YE 2011 to $17.25bn at YE 2014 (my back-of-the-envelope estimate), would leave Sprint with a net debt/adj. EBITDA ratio of 1.8x (versus 1.5x reported for AT&T at Q1 2012).
|Net Debt/Adj. EBITDA:||2.92||1.84|
It should also be noted that Sprint's leverage risks are mitigated by the company's strong liquidity position and limited re-financing risk over the next few years. Sprint ended the most recent quarter with $8.8bn in liquidity (including $7.6bn in cash), with only around $3.0bn in maturities coming due through 2014.
Valuations favor Sprint
Given my expectation for a convergence of Sprint's margins, versus those of AT&T, and Sprint's higher revenue growth rates, I believe that the valuation difference between these two companies appears to be much too great.
Looking at Enterprise Value (E.V.)/Revenue, which ignores the current margin difference, Sprint trades at around 0.72x versus 2.12x for AT&T (both taking Wednesday's closing share price). If you valued Sprint on a similar revenue multiple to that of AT&T, the share price would be approximately $19.1/share (588% above Tuesday's closing price).
To be clear, even if you believe that the margins will completely converge, Sprint should trade at a substantial (multiple) discount to AT&T using this metric, because of the execution risks and the cost and cash outflow that will occur during the convergence period (somewhat offset by Sprint's superior revenue growth trends).
All that said, I believe that the discrepancy still appears too wide and will converge over time. I do remain cautious with respect to news flow from the New York sales tax litigation, but I believe this is substantially outweighed by the additional positive catalysts that I see for the company's shares.
If Sprint continues to deliver on its turnaround strategy, I believe a valuation of around $10/share could eventually be justified, based on 2014 earnings expectations, as I estimated in a previous article. For all of these reasons, I believe that telecom investors with a higher risk tolerance, that can take a longer-term view, will ultimately be much better rewarded by investing in Sprint over AT&T.