Sprint Turnaround Continues, But Risks Remain

| About: Sprint Corporation (S)
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Last week, telecom giant Sprint (NYSE:S) reported its fourth quarter and full year results. The company beat on both a revenue and earnings front, but did report a sizable loss for the period. Sprint's turnaround is progressing, and with improved results and a potential deal with Softbank coming, shares rallied more than 142 percent in 2012. Sprint's turnaround is continuing, albeit at a slow pace until the Softbank and Clearwire (CLWR) deals are completed. Sprint is certainly in better shape than many thought it would be at this point, but there still are plenty of risks with this company. Today, I'll analyze the fourth quarter report, look forward to the next part of the turnaround, and examine the risks that remain.

Fourth Quarter Results:

Sprint reported fourth quarter revenues just above $9 billion, which beat estimates for $8.92 billion. The company reported a net loss of $1.321 billion, or 44 cents per share. That beat by two cents.

Revenues rose by 3.24% in the period. The company was able to reduce the cost of services by 4.63% over the prior year period. However, the cost of products rose sharply by 13.76%. Overall, gross margins declined from 37.87% in the year ago period to 37.23% in this year's period.

On the operating side, SG&A expenses rose by 3.9% over the prior year period, slightly faster than the rise in revenues. Sprint reported a 27.17% rise in depreciation for the period. Sprint provided the following statement in terms of depreciation and Superstorm Sandy.

Sprint's fourth quarter 2012 results include accelerated depreciation of approximately $400 million, or negative $.13 per share (pre-tax), primarily related to Network Vision, including the expected shutdown of the Nextel platform, and $45 million or negative $.01 per share (pre-tax) related to impacts from Hurricane Sandy.

Due to the large depreciation expense, Sprint's operating loss widened from $438 million to $705 million. That meant that operating margins fell from -5.02% to -7.83%. Sprint also saw its interest costs rise from $287 million to $432 million. However, that was more than offset by the reduction in losses from investments. In last year's period, Sprint recorded losses of $472 million, which was reduced to a loss of just $140 million in the fourth quarter of 2012. Sprint's pre-tax loss widened by $80 million to $1.277 billion. However, the income tax expense was just $44 million, compared to $106 million in the prior year period.

Sprint's net loss widened by $18 million to $1.321 billion. The loss per share increased by a penny to $0.44. The diluted share count rose by 10 million shares to 3.007 billion.

Overall, it really was a mixed quarter for Sprint. The company was able to sell 2.2 million iPhones in the period, up from 1.8 million in the prior year period. While the unit sales number was a quarterly record, only 38% were sold to new customers, and that was a quarterly low for the company. Also, if you go back a year, the iPhone 4S didn't go on sale until mid-October. Thus, there weren't as many selling days for that phone as there were this year for the iPhone 5, which went on sale in late September. Sprint looks well on the way to fulfilling its 4-year deal with Apple (NASDAQ:AAPL) to sell the iPhone.

In terms of operating metrics, Sprint's quarter was mixed. Here are some positive numbers:

  • 4th Quarter Nextel postpaid recapture rate of 51%.
  • Best ever Nextel quarterly prepaid recapture rate of 50%.
  • 4th quarter adjusted OIBDA (operating income before depreciation and amortization) of $860 million, up 2% from last year's period.
  • Sprint prepaid and postpaid churn rates were lower than the prior year period.

However, there were some negative numbers:

  • Sprint postpaid ARPU (average revenue per user) declined from $63.21 in the third quarter to $63.04 in the fourth quarter.
  • Total end of period subscribers declined from 55.963 million at the end of the third quarter to 55.626 million at year's end.

Looking Forward:

The first part of Sprint's turnaround has to do with the company upgrading its existing network. Sprint is working to shut down the old Nextel network, as well as build out its 4G network. The company provided the following update on its Network Vision plan.

Sprint continues to make significant progress on Network Vision deployment. The number of sites that are either ready for construction or already underway has grown to more than 19,500 - approximately half the total number of sites to be upgraded. To date more than 8,000 sites are on air and meeting speed and coverage enhancement targets. Recent weekly construction starts are up 56 percent from the third quarter. Sprint continues to expect to have 12,000 sites on air by the end of the first quarter of 2013.

As part of Network Vision, Sprint has launched 4G LTE in 58 cities and expects that 4G LTE will be available in nearly 170 additional cities in the coming months. During 2012 Sprint launched 15 4G LTE devices including Apple iPad mini and iPad with Retina Display, LG Optimus G™ and Samsung Galaxy Note® II in the fourth quarter.

As part of its network improvement, Sprint is trying to acquire the rest of Clearwire that it doesn't already own. So far, Sprint's negotiations with Clearwire are not faring well, as Dish Network (NASDAQ:DISH) has come in with a higher offer. Clearwire is considering the Dish offer, and has held off on accepting a purchase of $80 million of exchangeable notes. That payment is part of a total package of $800 million in monthly payments Sprint agreed to give Clearwire as part of its offer to buy the company. It originally looked like Dish's offer was an attempt to get some kind of deal done between Dish and Sprint, but now I'm not so sure. Sprint's offer (backed by Softbank) remains at $2.97 a share for Clearwire, with Dish coming in at $3.30.

But it is that Softbank deal that Sprint investors really need to be concerned with. The key to Sprint's future is going to be that deal. Softbank will be paying $8 billion to acquire newly issued shares, and $12.1 billion to buy existing shares. That $8 billion in funding is crucial to Sprint's future, as it will help Sprint to continue the network upgrade as well as pay back some of its large debt pile. During the fourth quarter, Sprint received $3.1 billion from SoftBank in exchange for a newly issued 1 percent, seven-year convertible bond related to the companies' pending merger. One of the biggest risks for Sprint is this high debt load, which I'll cover in the next section.

Investors are hoping that with Sprint's network upgrade, the company can continue to add subscribers and pose some competition to industry heavyweights Verizon (NYSE:VZ) and AT&T (NYSE:T). With all of the issues Sprint is dealing with, including billions of losses, Sprint trades at a significant discount when it comes to several valuation metrics. Obviously, you cannot use price to earnings because Sprint is losing money, so I put together a few different metrics in the table below. I've valued the three companies on price to sales, for expected 2013 and 2014 sales, as well as market cap to assets (price to book assets), and market cap to equity (price to book equity). Market cap numbers are as of Friday's close, with assets and equity numbers as of each company's latest quarterly report.

Sprint trades at a significant discount on the price to sales metric for both years, as well as the market cap to asset ratio. Sprint does trade at a premium when it comes to market cap to equity. That is mostly due to two factors. First, Sprint's equity has come down tremendously in recent years with all of the losses. In just the past year alone, the book value of Sprint's equity has gone from $11.427 billion to $7.087 billion. Also, the Verizon equity balance I'm using includes the non-controlling interest, which is Vodafone's ownership stake in Verizon Wireless. If you were to subtract that out, Verizon's market cap to equity ratio would be much higher. If Sprint can eventually narrow the discount, shares could rocket higher.

Potential Risks:

Right now, the biggest risk for Sprint is the Softbank deal. Sprint is really depending on that funding to not only complete the Clearwire deal, but to upgrade the network and pay back debt. If the Softbank deal is not completed, I think Sprint shares will take a hit.

The biggest issue for Sprint right now is their huge debt pile. At the end of the fourth quarter, Sprint had about $24.3 billion in outstanding debt. Now that includes the $3.1 billion note from Softbank, so if the deal doesn't go through, that will probably be paid back right away. At the end of the quarter, Sprint had $8.2 billion in cash and short term investments on the balance sheet. That means that net debt was a little over $16.1 billion, up about $1.5 billion from a year ago. However, if we were to take away the $3.1 billion note from Softbank, you are looking at $21.2 billion in debt and $5.1 billion in cash and investments.

Sprint's interest costs have certainly risen over the past year. At the end of 2011, Sprint had slightly over $20 billion in debt with stated interest rates (Sprint provides a debt table with its results). They were paying a little more than $1.53 billion in interest, and the weighted average came out to about a 7.6% rate.

At the end of 2012, the amount of debt with stated interest rates was up to $21.46 billion. Since Sprint was able to refinance some debt during 2012, the average interest rate was down to about 7.52%. However, with the added debt, the interest cost was up to about $1.61 billion per year (all of this is before taxes). If you include the Softbank note, the annual interest cost is up to more than $1.64 billion. However, the Softbank note only carries a 1% rate, so that brings the average rate down to 6.69%. If the Softbank deal does not go through, Sprint goes back to where it was a couple of months ago. That is not a great position, which is why Sprint can really use this $8 billion Softbank is providing.

Sprint still is losing a ton of money, as their fourth quarter results show. Sprint lost more than $4.3 billion dollars in 2012, and has lost roughly $16 billion dollars over the past five years. Losses like this cannot continue forever, and analysts see another $2.5 billion in losses during 2013. However, current estimates do show Sprint coming close to break-even in 2014. Sprint will need its network upgrade to work, so the company can boost revenues. Additionally, as it shuts down the old Nextel network, the company's expenses are expected to come down. If the company can start paying back debt, interest costs will come down as well. But a lot of these are "ifs", and they all start with the Softbank deal. If the Softbank deal doesn't go through, expect these losses to continue until at least 2015.

The Clearwire deal remains a risk as well. Clearwire is an integral part of Sprint's network upgrade, and Sprint also has invested a lot of money in Clearwire. To get the Clearwire deal through, Sprint may need to pay a higher price. For every dime Sprint raises its offer by, it will cost the company another $72 million, assuming Softbank allows Sprint to raise the offer price. Additionally, the extra time and legal resources used on this deal will not only incur financial costs, but will shift Sprint's focus away from its primary mission. If Sprint is unable to acquire Clearwire and Dish Network wins, all bets are off.

Final Thoughts:

Sprint's turnaround continued with its decent fourth quarter. The company beat expectations for both revenues and an earnings loss. Results would have been even better were it not for accelerated depreciation expenses that the company took, plus a small loss from Sandy. As we look towards 2013 and beyond, Sprint's future heavily depends on the Softbank deal. A much needed injection of capital will help Sprint upgrade the network and pay back debt. Without these funds, the story reverts to a few months ago, and Sprint's future could be in question. Sprint also needs to work on winning Clearwire, a deal whose future has become cloudy in recent weeks. Sprint's turnaround continues, but at a slow pace, as large risks still remain.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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