Shares of Sprint Nextel Corp. (NYSE:S), the third largest telecom operator in the U.S., fell by more than 5% on Tuesday to close at $4.9, after an analyst, Ric Prentiss, cut his rating on the stock. He suggested that the recent rally in the stock was largely due to the consolidation speculation among smaller telecom companies, which included Sprint and other companies like T-Mobile and PCS. However, we disagree with Prentiss, as the company's stock has largely seen such tremendous gains (over 100% since the start of the year) because of investors showing confidence in the company's turnaround plans, as well as the concrete steps that it has taken.
The company has only recently started selling the iPhone (Q42011) to its customers. It is the only telecom carrier in the U.S., apart from MetroPCS Communications Inc. (PCS), to offer unlimited data on smartphones. Granted, selling smartphones like the Samsung Galaxy S3 and Apple (NASDAQ:AAPL)'s iPhone 5 comes at a cost, but in the long run these costs will be recovered due to increased smartphone usage by customers. Sprint also has the biggest market share in terms of Samsung products after T-Mobile. The recent decision to start selling iPhones is already helping the company, with its key business metrics, including average revenue per user and churn, showing consistent improvements.
Sprint's network vision program is another reason the stock has gained in value since the start of the year. For a number of years now, the company has been losing customers and posting losses, largely due to its legacy Nextel platform. However, now that the company has decided to shut the platform completely, one can expect the company to return to profitability in the coming years. If the performance of the core Sprint platform is analyzed, it is fairly obvious how the Nextel network had weighed on the company's overall profitability. Perhaps that is the reason why many fail to see the company's operational strength without the Nextel network. Of course, the switching of customers from the company's Nextel network to other carriers is a continuous threat to the company. However, the latest results filed by the company reveal that Nextel's recapture rate had improved to 60% by the end of the second quarter, as compared to 25% in the second quarter of the previous year, which is a significant improvement.
Perhaps, the main reason why the stock tumbled was due to talks about German telecom operator, Deutsche Telekom, merging its U.S.-based T-Mobile business with MetroPCS Communications Inc. That move could possibly lessen the gap between larger telecom companies, like Verizon (NYSE:VZ) and AT&T (NYSE:T), and smaller telecom operators, but it would still not give them a competitive advantage. And now reports have come in confirming that boards of both Deutsche Telekom and PCS have approved the merger to go ahead and the stock has started rallying back. There is nothing much in the merger that poses threats to Sprint's turnaround story.
Sprint CEO Dan Hesse recently commented that a consolidation of smaller telecoms would bring about healthier competition, and that his company would like to take a part in such a competitive market. Even though it is too early to confirm if the merger between T-Mobile and PCS would go ahead, considering that there will be extensive regulatory challenges to overcome, we believe that it is best for Sprint not to become part of such a merger. The company would be better off concentrating on its Nextel network shutdown and the rollout of its 4G LTE network. In an earlier report, we did mention that PCS would be a better strategic fit for Sprint than LEAP Wireless (LEAP), because of its lighter debt and network compatibility. Moreover, acquiring PCS would mean access to its nine million prepaid customers, which cannot be ignored. However, with the possible merger between T-Mobile and PCS, Sprint will be sidelined, and will face difficulties in its efforts to better compete with its bigger rivals. However, even if Sprint does not get involved in the consolidation, it stands a fairly good chance of returning to profitability from its operations, and by concentrating on its core Sprint platform.
Wireless industry is all about size, number of subscribers and currently AT&T and Verizon together hold the largest market share in the US. Interesting to note is that Sprint still would have more customers using its network (56 million) than the new T-Mobile (T-mobile: 33.2 million and PCS 9.29 million). Despite the drop in stock amid consolidation speculation, the stock has recovered ever since and is up 6% since the news of merger surfaced. The problem Sprint is facing is that it doesn't have the size to compete with rivals like Verizon and AT&T and now with PCS out of the equation it will probably look at acquiring Leap Wireless or a much bigger new T-Mobile. Having said that we believe the company will do well by concentrating on its operations through its "network vision program" and bring about organic growth rather than focusing on growth through acquisition.
Recent affirmations and upgrades for Sprint have come from Bank of America, reiterating its buy rating for the stock and FBR Capital that raised its price target for the stock to $7 from $6. Moreover, the stock is trading at cheap valuations; S trades at 0.4 times its sales, at a discount when compared to Verizon's 1.15x and AT&T's 1.7x.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by Qineqt's Telecom Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.