Who will be your wireless carrier next year? That is the question for the telecom industry. In recent years, the number of mobile phones in use in the United States has grown to exceed the population. Providers are scrapping with each other, and negotiating buy-outs and mergers, in a bid to compete for this huge market that has nearly tripled in the last decade.
The big players in the industry are AT&T Inc. (T) and Verizon Communications (VZ). Together, they control about two-thirds of the market, with over 200 million subscribers. Trailing them are Sprint Nextel Corporation (S) and T-Mobile. The gap between subscribers is huge, but both Sprint and T-Mobile are making moves to compete.
Last week, Japanese telecom company SoftBank announced plans to acquire a 70% stake in Sprint. The $20 billion deal is a big risk for the company, which is relying on its ability to build a large 4G LTE network. In addition to larger organic growth, the deal also provides Sprint with the cash to buy controlling stakes in smaller companies such as Clearwire Corporation (CLWR).
The details of the buyout imply SoftBank is valuing Sprint at $28.6 billion. Sprint is currently trading at a market capitalization of just under $17 billion. The deal represents a two-thirds premium the Japanese company is willing to pay for a shot at the growing US market.
Last year, AT&T made a bid to buy T-Mobile, which would have pushed it into the lead for market share. However, regulators blocked the deal, costing AT&T about $6 billion. This left T-Mobile floundering, looking for a way to drive up revenue.
Earlier this month, T-Mobile and MetroPCS Communications, Inc. (PCS) announced plans to join forces. The deal is subject to shareholder and regulatory approval, and its expected completion is mid-2013. While the merger will provide T-Mobile with nearly 10 million new subscribers, it will still trail Sprint, the nation's third largest provider.
Despite all of the mergers and acquisitions competitors are negotiating, AT&T and Verizon are not about to be overthrown anytime soon. In order to compete, smaller companies will need a better product. Certainly, the telecom business is a service industry, but I mean a physical product.
AT&T had outrageous success with its Apple (AAPL) iPhone exclusivity. It added millions of customers based on a single product. It is unlikely that another carrier will have a success as big as the iPhone was for AT&T in the near future.
Sprint's latest attempt to compete is to offer the iPad mini and iPad 4 with its data plans. Sprint still provides customers with unlimited data where AT&T and Verizon now enforce caps on the data usage of its customers. Savvy consumers looking for unlimited 4G LTE use will be attracted to Sprint's offers, and Sprint could convert some to mobile phone customers as well.
It seems almost inevitable that the four largest telecom companies in the U.S. will one day become three. As mentioned, AT&T has already attempted a buyout of T-Mobile. Regulators will likely block a buyout attempt by Verizon for the same anti-trust reasons. Having just invested in Sprint, SoftBank is unlikely to try to buy T-Mobile any time soon. However, T-Mobile's struggles with generating revenue may ultimately lead it to either fold on its own, or convince regulators that a buyout is what is best.
I do not believe the news surrounding Sprint, and its efforts to beef up the competition are enough to warrant buying stock in the company. The company still does not earn a profit, and pays no dividend. Despite a cash influx from the SoftBank deal, Sprint seems intent on spending that cash to buy smaller companies and increase its network. Continuing to buy stakes in smaller companies can only grow the company so much, and lead to lower profit levels overall.
Currently trading at around 41 times annual free cash flow, the market seems to expect big things for Sprint in the future. Comparatively, AT&T trades at just 13 times annual free cash flow, and Verizon trades even lower at just 6.5 times. I do not expect Sprint to increase profits enough to justify that ratio discrepancy.
The choice between AT&T and Verizon is a little more difficult. AT&T currently prices at about 47 times earnings. Couple with its P/FCF ratio, the market implies expectations of double-digit growth in the future. However, most analysts do not expect AT&T to grow profits by more than 7%. The company does have a good amount of room for growth in its TV services business, but its biggest segment is still phone service. I cannot see AT&T growing fast enough to justify its P/E ratio, despite its 5% dividend.
Verizon on the other hand sports a P/E ratio less than 41, which is cheaper than both AT&T and Sprint. Additionally, it looks more attractive on a P/FCF basis with higher free cash flow than both other companies and a smaller market cap than AT&T. The dividend is not quite as nice as AT&T's, but Verizon holds its own paying shareholders 4.6% annually.
The market expects big growth from Sprint. It might be right, but investing in the company now seems a bit risky. SoftBank is a Japanese company, and Sprint is its first venture in the United States. It is a big risk hoping that success building a network in Japan, a much smaller, more condensed country than the U.S., will lead to equal success in America. However, if the risk pays off, it could pay off very well for investors.
I, for one, would feel more comfortable putting my money in Verizon, which is the best value in telecom.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.