Are MetroPCS Shareholders Being Short-Changed In Merger With T-Mobile?

Includes: DTEGF, S, T
by: GMI Ratings

By Greg Ruel - Senior Research Associate

On Wednesday, Reuters reported a potential combination of MetroPCS Communications Inc., the nation's leading provider of no annual contract, unlimited, flat-rate wireless communications service, and T-Mobile USA, the fourth largest U.S. cell phone provider. Deutsche Telekom AG (DT) was reportedly looking to expand wireless operations in the U.S. and a merger of its T-Mobile USA unit with MetroPCS increases its competitiveness with industry juggernauts Verizon and AT&T. While some analysts applaud the merger, MetroPCS shareholders aren't quite as enamored. The potential merger immediately sparked several investigations and class-action lawsuits charging the board of MetroPCS with a breach of fiduciary duty and other violations relating to the potential sale of the company.

In a complicated deal, MetroPCS is to declare a 1 for 2 reverse stock-split and pay its shareholders $1.5 billion, a value of $4.09 per share prior to the reverse split. The combination results in MetroPCS acquiring all of T-Mobile's capital stock by issuing Deutsche Telekom 74 percent of MetroPCS's common stock on a pro forma basis. Eventually, MetroPCS will still operate as its own entity but under the name T-Mobile. Investigations began immediately upon the announced deal and charge MetroPCS's board with failing to adequately shop for a pact of better value. Lawsuits cite one analyst in particular who set a price target for MetroPCS stock at $18 per share. Also, Kevin Smithen, an analyst at Macquarie Securities USA Inc. in New York, estimated that MetroPCS shareholders were looking for something in the neighborhood of 35 percent of the proposed new company instead of the agreed upon 26 percent.

Not only is the deal complex, but combining the entities is expected to be a huge undertaking. The two companies utilize completely different network technologies. This will prevent phones from one carrier from working on the other's network. In an integration process expected to take a few years, MetroPCS's wireless network would most likely be shut down by the end of 2015. Given that the majority of phones for the two companies run on incompatible network standards, any short-term cost savings of combining the entities becomes greatly reduced.

Shareholders certainly have a right to be suspicious of the deal which has yet to be approved by regulators or shareholders. It's no secret that Sprint, the number three cell phone provider in the U.S., was also looking to make a deal. Sprint nearly picked up T-Mobile in early 2011 before Deutsche Telekom agreed for the unit to be acquired by AT&T, a deal ultimately killed by regulators. Regulators had antitrust concerns with the deal, as AT&T, the leading wireless provider in America, would have swallowed up T-Mobile, the fourth largest provider.

It's expected that regulators would be much more likely to approve this deal, a combination of smaller providers that could ultimately help the two entities compete against larger rivals. Still, in a deal that didn't have to be made straight away, shareholders are asking why the rush when Sprint was supposedly also talking with DT about a T-Mobile merger at the same time, according to people familiar with the negotiations. In fact, Sprint passed on a deal to buy MetroPCS earlier in 2012 but was never seen as out of play. Moreover, reports over the last couple of days suggest that Sprint may yet weigh an offer to top the T-Mobile bid and acquire MetroPCS.

Still, it's important to examine the board's decision to sell MetroPCS at what some describe as a fire-sale price or shotgun wedding. Ultimately, the deal looks like a win for T-Mobile. Benefits of the merger include nine million new subscribers for T-Mobile as well as a stronger presence in the Northeast portion of the U.S. Customers of MetroPCS, who are used to low-cost, contract-free plans, could soon be pressured into signing up for two-year service agreements, which is a more lucrative arrangement at cell phone companies and more typical of what is offered by T-Mobile currently. "The prepaid business is a very difficult business," said Christopher Larsen, an analyst at Piper Jaffray & Co. in New York. "We are not fans of that. Conversion of MetroPCS subscribers to postpaid would be very difficult."

The timing of the deal is also curious. MetroPCS was struggling mightily as recently as this summer, with shares trading below six dollars through most of June. However the company had a positive earnings statement in July, with Roger Linquist, Chairman and CEO of MetroPCS declaring, "During the second quarter, we focused on generating Adjusted EBITDA and cash flow versus subscriber growth as we position for our anticipated launch of 4G LTE. I'm pleased to report that with this emphasis, we reported both the highest Adjusted EBITDA as well as the highest Adjusted EBITDA margin in Company history as a result of this focus."

Shares increased by 37 percent in overnight trading as a result of the announcement and continued to rise throughout the summer and fall, climbing to a close of $13.57 on October 2 on rumors of the deal. However, once the terms of the deal were announced, shares declined by 10 percent on October 3. Investors were left wondering why MetroPCS accepted an unfavorable deal during a period of growth. Moreover, shareholders want to know if the company vetted the market for the best deal it could get or if the board simply threw in the proverbial towel.

The board of MetroPCS is comprised of just six directors, about two-thirds the size of the average midcap company. MetroPCS combines the roles of CEO and Chair, with co-founder Roger Linquist filling the role since the company's inception 23 years ago. The next highest board authority, lead director Arthur Patterson, has also served on the board since its inception and sits on three of the board's four committees. The relationship suggests a great familiarity with each other at the very least and stands counter to the idea that a lead director should be someone willing to stand up to the board chair and CEO as a representative for the interests of its shareholders. The rest of the board includes the Vice Chairman of TA Associates (an investor in MetroPCS), the CFO of McGraw-Hill Companies, a former executive of Rockwell International, and finally James Perry, who GMI designates a flagged director for his involvement with the board of Allegiance Telecom, which filed for Chapter 11 bankruptcy protection in May, 2003. The small board of MetroPCS is light on industry experience, and with the board chairman and lead director having served together for more than two decades, it's easy to see why shareholders suspect the board of being too passive in negotiations and not performing proper due diligence in shopping for the best deal.

According to the GMI Litigation Risk Model, MetroPCS has a higher risk of class action litigation than 86% of companies in North America. Indeed, the company has been considered at High Risk of class action litigation for the majority of the past year following monthly updates with each new interim financial statement. GMI has tracked four different investigations into the company since merger terms were announced on Wednesday.

If the current deal is approved by regulators and shareholders, it would likely close in the first half of 2013. However, while regulators are expected to smile on the combination, shareholders at MetroPCS, yet to approve the deal, are reacting less enthusiastically. With analysts describing Deutsche Telekom as "desperate to rid itself" of its underperforming U.S. carrier, shareholders of MetroPCS were surely expecting more than they're getting in the deal. With approvals pending and Sprint still in play, this agreement is far from closed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.