The telecommunications industry is experiencing some serious M&A activity since past two years. AT&T (T) tried to merge with T-Mobile USA, which is owned by Germany's Deutsche Telekom (DTEGY.PK), but was blocked by the government. Then in 2012, there were some reports about a merger between Sprint (S) and MetroPCS (PCS), and this time, Sprint's board blocked the deal.
On September 19 2012, during the Goldman Sachs investment conference in New York, Sprint's white knight Dan Hesse predicted that the telecommunications industry is likely to undergo a "wave of mergers and acquisitions." Obviously, Wall Street was quick to predict a Sprint-MetroPCS deal. Instead, Deutsche Telekom unexpectedly stepped forward recently to merge T-Mobile USA with MetroPCS.
The Synergy Question
If the Sprint-Nextel deal years ago taught us something, it is that mergers should be made keeping technological as well as cultural synergies in mind, and with the goal of a larger market share, better product diversification and shared R&D efforts to lower costs. Sans any one of these factors, the deal would cause a leak in the customer base as well as the stock's equity value, like it did for the Sprint-Nextel Corporation.
Permutations and Combinations
Let us review some scenarios regarding the players involved in the telecommunications space.
- The MetroPCS/T-Mobile merger is a weird deal. The merged company will be called T-Mobile, and yet, it is MetroPCS who will be swallowing T-Mobile, considering that the latter's parent will leave its US operations, and yet again, it is MetroPCS's network that gets shut down in 2015 if the deal gets approved. The clear winner is Deutsche Telekom who gets to raise the money and get out of the US market at the same time.
The biggest challenge in the T-Mobile/MetroPCS deal is that their network technologies are incompatible - MetroPCS uses CDMA while T-Mobile largely depends on GSM and HSPA technologies. Also both these companies have declining revenues. Exactly how can these two companies with a leaking customer base suddenly join and show increased revenues, especially amidst potential chaos in the network infrastructure due to incompatible technologies?
On the positive side, if the integration does work and works more efficiently, Sprint would face a little more competition which could potentially result in increased marketing spend and customer acquisition costs - surely a concern for Sprint's shareholders.
- Now in theory, a Sprint/MetroPCS merger is comparatively a better deal for the shareholders. According to some reports, the deal would result in savings of $8-$9 billion on an NPV basis, and both companies use the CDMA network technology.
But Sprint will have to pay more than $11.28 per share that T-Mobile is willing to pay, and analysts estimate it to be even more than $12.50 per share. Sprint has already embarked on a costly network upgrade project that will last for a couple years, and the company is already running on a tight budget. I bet the shareholders are nervous about Sprint paying an exorbitant amount of money for yet another deal.
T-Mobile has 33.2 million subscribers, MetroPCS has 9.3 million customers and Sprint has 56.4 million customers. In my opinion, Sprint should continue the wait-and-watch game until this deal gets finalized and does not need to spend more money than it is already spending, just to get 9.3 million customers (that too only Prepaid segment).
- In theory, T-Mobile/Leap or MetroPCS/Leap mergers are also possible if the MetroPCS/T-Mobile deal fails. Remember that in 2007, MetroPCS had offered to merge with Leap and then withdrew the offer, and then the next year they settled their lawsuits and agreed upon a roaming agreement and spectrum swap. Any of these mergers could cost Sprint, because neither MetroPCS nor T-Mobile has the Apple (AAPL) iPhone product suite or a substantial LTE network, while Leap does.
The Sprint/Leap deal on the other hand could cost Sprint simply in terms of more money - and the benefit is mainly the Prepaid segment.
- I discounted any deals involving AT&T and Verizon here, lazily assuming that the regulators will simply not allow them.
Sprint and Leap can sprint and leap
If you don't like the wireless carriers space right now, go for the tower providers like Crown Castle International Corp. (CCI) - they are going to benefit no matter what from any industry consolidation.
Among the wireless carriers, weigh individual companies and rate them in terms of valuation, growth prospects and product offerings.
- Obviously, AT&T and Verizon are the top quality market leaders here, also offering healthy dividend yields - they are good lower risk income prospects.
MetroPCS though is caught in this M&A mess and for the time being should trade in a range of $11-$13.50 (upper end of what Sprint could pay to merge with it if its deal fails).
Of all the wireless carriers, my opinion is that regardless of M&A activity, both Sprint and Leap could provide higher returns (with increased risks compared to AT&T and Verizon).
Sprint is in a solid turnaround mode that is expected to continue next year and beyond, and both Sprint as well as Leap have worked hard to develop a decent product suite consisting of LTE smartphones, including the Apple iPhone 4S and iPhone 5. Both companies have shown focus on cost savings and cash flows, their EPS (albeit negative) has shown improvements in the past quarters, and the earnings estimates are trending upwards as well. Most importantly, both companies provide generous data plans and target the rapidly growing low income and young market segments.
Whether more spectrum is freed or not, these companies will have to scamper around to consolidate, and it could take months or even couple of years. There is no need for knee-jerk reactions based on consolidation news. The success of MetroPCS/T-Mobile deal has its own risks and it will take time (e.g. LTE factor) before Sprint starts getting impacted. During this time, Sprint will continue its network improvements. Sprint need not chase the MetroPCS deal right now or shoot for a deal with Leap for that matter. If Sprint does go for either deal, we will have to carefully look at its balance sheet, and pray for a better integration than it has done in the past.