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On Wednesday, Germany-based Deutsche Telekom's (OTCQX:DTEGY) U.S. unit, T-Mobile, and MetroPCS Communications Inc. (PCS) confirmed that they have entered into a merger agreement. The deal brings together the fourth and fifth largest U.S. wireless carriers. MetroPCS is a dominant player in the pre-paid wireless market.

Under the terms of the merger agreement, PCS will declare a 1 for 2 reverse stock split, make a cash payment of $1.5 billion to its shareholders and acquire the entire capital stock of T-Mobile by issuing Deutsche Telekom 74% of its common stock on a pro-forma basis. The new company will retain the T-Mobile name. Deutsche Telekom will hold a 74% stake in the new company, while PCS shareholders will hold the remaining 26% stake.

The new company, which will be publicly traded, will be led by John Legere, T-Mobile's Chairman and CEO. T-Mobile and MetroPCS will operate as separate brands.

Last year, regulators had blocked AT&T's (T) takeover of T-Mobile on antitrust grounds. Through the transaction, Deutsche Telekom was looking to exit the U.S. market, where it has not had much success. By merging T-Mobile with MetroPCS, Deutsche Telekom has re-committed itself to the U.S. market even though the merger has been structured in a way that would allow Deutsche Telekom to easily exit in the future, if it chooses to.

The big question is what would this merger, if completed, do to the U.S. wireless market. The other big question is what does a deal between MetroPCS and T-Mobile mean for Sprint Nextel Corp. (S), the No.3 wireless carrier in the U.S.

The U.S. wireless market is dominated by AT&T and Verizon (VZ). Both companies have more than 100 million subscribers. Sprint has around 56 million subscribers, while T-Mobile has some 33 million subscribers. In fact, the distance between T-Mobile and Sprint has been increasing. However, the deal with PCS makes T-Mobile a much stronger player. The combination of MetroPCS and T-Mobile will have 42.5 million subscribers. This narrows the gap with Sprint. However, it doesn't change the dynamics of the wireless market significantly. AT&T and Verizon still remain the dominant players.

While the combination of MetroPCS and T-Mobile does not pose any significant challenge to AT&T and Verizon, it does create some problems for Sprint.

Sprint has had an excellent year so far. The company has finally been able to put behind the disastrous merger with Nextel, which was completed in 2005. YTD, Sprint shares have gained more than 113%, reflecting the strong operating performance. The availability of Apple Inc.'s (AAPL) iPhone on Sprint network has also given a boost to the company.

However, the T-Mobile/MetroPCS deal has taken an attractive target for Sprint off the table.

Sprint itself was close to acquiring MetroPCS earlier this year. However, Sprint's Board scrapped the deal at the last moment. This was a lost opportunity for Sprint. Given the difficulties Sprint faced in integrating with Nextel, it is understandable that the company has been reluctant to go for another merger. However, MetroPCS and Sprint employ the same network technology, therefore integration would have been smooth if the transaction was completed. The deal would have also created a significant gap between Sprint and T-Mobile.

So what are the options left for Sprint now? The company does have the option to acquire Leap Wireless International Inc. (LEAP), another player in the pre-paid universe. However, Leap Wireless is not an attractive takeover target. The company has been losing money and analysts don't expect it to a post a profit until 2016, according to data compiled by Bloomberg.

That leaves Sprint with two options. Either come up with a counter offer for MetroPCS or continue on its own.

Having rejected the PCS's takeover earlier this year, I don't expect Sprint's Board to approve a takeover of MetroPCS now if the company decides to come up with a counteroffer, which will have to be higher than the previous offer. Also, it may not be a good idea for Sprint to get into a bidding war. By bringing on iPhone subscribers, Sprint has already spent billions of dollars. The company has also spent a lot of money on upgrading its network. I don't think the company is in a position to get into a bidding war now.

I think the best option for Sprint now is to continue on its own. The company has already seen a significant improvement in its operating performance this year. Although the T-Mobile/MetroPCS merger will narrow the gap between the third and fourth largest carrier, Sprint still has a comfortable lead. In addition, T-Mobile and MetroPCS may struggle to integrate, and this would in fact help Sprint in grabbing some of their subscribers.

If the merger is successful then Sprint also has the option to merge with the new T-Mobile in the future. Such a transaction may be rejected on antitrust grounds. However, if such a deal goes through, it would create a credible third national carrier that can challenge the AT&T and Verizon duopoly.

Recently, Dan Hesse, Sprint Nextel's CEO, said that he expects mergers in the U.S. wireless industry. Hesse also predicted that Sprint would participate in future deals in the wireless industry. Although Sprint missed out on an attractive takeover target, I think the company still has an opportunity to participate in a larger deal that will give it greater scale to compete against AT&T and Verizon.

Source: T-Mobile/MetroPCS Merger And What Sprint Nextel Must Do Now