How A Bizarre Ownership Structure Creates A Compelling Opportunity In Clearwire

| About: Sprint Corporation (S)
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Clearwire (CLWR) has been in the news quite a bit these past few weeks. The company raised hundreds of millions in equity, renewed its agreement with Sprint (NYSE:S), and has been the subject of rampant speculation now that the deal between AT&T (NYSE:T) and T-Mobile has collapsed. In our opinion, all of these events serve to highlight just how compelling an investment Clearwire is.

We first profiled Clearwire at the start of December, noting that the company's share price in no way reflects the true value of the company. But, we felt our first article did not adequately describe how Clearwire is structured, and we believe investors in Clearwire, both current and potential, should know about this company's structure. A close look at the company's ownership structure, reveals that it is one of the most bizarre we have ever seen in corporate America.

First, some history. Clearwire as we know it today was created in 2008, when Sprint merged its Xohm broadband division with the old Clearwire, taking a majority stake in the company. Investors including Comcast (NASDAQ:CMCSA), Intel (NASDAQ:INTC), Google (NASDAQ:GOOG), and Time Warner Cable (TWC) invested $3.2 billion into the company, taking a stake as well. At the time, giving up billions in spectrum to Clearwire seemed like a good idea, for Sprint had no idea just how much data demand would soar, thanks to rapid smartphone adoption. That decision has now come back to haunt Sprint.

In June, Sprint announced that it is cutting its majority stake in Clearwire to around 49.7%. Sprint did so because of worries about a Cearwire bankruptcy and default. Some of Sprint's debt is structured in such a way that if Clearwire defaults on its debt, then Sprint is deemed to be in default on its own debt. We think this move was a mistake on the part of Sprint, and recent events have proven this to be true.

When Sprint effectively outsourced its 4G network to Clearwire, it seemed like a good idea to solidify its lead in the 4G race. But now that lead is gone and Sprint's 4G network has little to differentiate itself from its competitors. Furthermore, Sprint must still service Clearwire's debt. Why? Because Clearwire's debt is backed by its spectrum. And should it default, the spectrum would go to creditors, along with Sprint's 4G network. This is why the agreements announced with Sprint on December 1 specifically state that as part of the deal, Clearwire will make its $237 million interest payment on schedule. This bizzare relationship can be summed up in one chart, outlined in Clearwire's latest 10-K.

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This chart shows just how entangled Sprint is with Clearwire, and how little leverage it truly has. Clearwire's spectrum and assets are housed in a subsidiary called Clearwire Communications. Clearwire has two classes of stock, the publicly-traded Class A stock, and Class B stock. Each share of Class B stock gives the owner a share of Clearwire Communications Class B stock. Sprint controls about 68% of Clearwire's Class B common stock, giving it the majority interest in Clearwire Communications. Clearwire itself holds 100% of the voting power at Clearwire Communications via its Clearwire Communications Voting units, but controls only around 24.7% of the economic interest with its holdings of Clearwire Communications Class A Common Units. Such an arrangement is mostly unheard of in corporate America. Clearwire does control only around a fourth of the equity in its assets, despite having all of the voting power. As a result, Clearwire's true "book value" is somewhat unclear, with a variety of financial organizations stating a variety of book values.

Clearwire Book Value per Share
Firm Book Value per Share Price-to-Book
Morningstar $0.93 2.1x
YCharts $3.94 0.5x
Merrill Lynch $3.82 0.51x
Credit Suisse $14.80 0.13x

As you can see, different firms value Clearwire differently, most notably Credit Suisse. We believe its outlier valuation derives from the fact that the firm values Clearwire's spectrum at market rates, not its value as carried on Clearwire's balance sheet. Our own analysis of Clearwire derives a book value per share of $3.42, based on the most recent 10-Q, as well as the recent equity raise.

Clearwire seems to be in a bind here. It does not hold a majority interest in its assets (spectrum), and Sprint has a right of first refusal over Clearwire, essentially being able to block anyone from being able to takeover the company. Clearwire may seem as being subservient to Sprint, but it has a major trump card: Billions in debt.

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Clearwire has just over $4 billion in debt, which is backed by its spectrum holdings. And that is what holds Sprint hostage. In giving up voting control of Clearwire due to fears of a Clearwire default, Sprint allowed Clearwire to regain leverage with the threat of a default. Clearwire's board of directors, which Sprint no longer has control over, can choose to default and file for bankruptcy. Should that happen, creditors will seize Clearwire Communications, taking all of its spectrum, and Sprint's 4G network with it. This is basic corporate finance. Bondholders take control of a company's assets should it enter default. Sprint's majority control of Clearwire Communications will mean nothing should this happen.

In our previous article on Clearwire, we noted that in a bankruptcy liquidation, holders of Clearwire stock should receive around $10/share. In a bankruptcy auction, bondholders will receive only the $4 billion that they are owed, with shareholders receiving everything else. It is here that critics of Clearwire will pounce, arguing how holders of Clearwire stock can receive anything close to $10/share, when Clearwire itself owns so little of its operating assets. Once again, Clearwire's bizarre ownership structure provides the answer, and once again, it benefits Clearwire investors enormously.

As a reminder, Clearwire has two classes of stock, the publicly-traded Class A stock, and Class B stock, which also gives holders one equivalent share of Clearwire Communication Class B Common Units. However, Clearwire's by laws give no rights to Class B stockholders in liquidation. Should Clearwire default, and the company's spectrum be sold off to pay the bondholders, only Class A stockholders would be entitled to the remainder of the proceeds. The Class B stock, as well as their associated Clearwire Communication Units, would be worthless, with each investor receiving only the par value of their stock, which is $0.0001 per share. This means that should Clearwire's spectrum be liquidated, Class B stockholders would receive a grand total of $83,970.30, based on Clearwire's 839.703 million Class B shares.

Here, critics will argue that Class B stockholders can simply convert their shares into Class A stock, as is their right in accordance with Clearwire bylaws, and receive proceeds from a liquidation. It is true that this could happen, but any investor who elects to convert their Clearwire Class B stock into Class A stock gives up their Clearwire Communications Class B Common Units. Thus, any dilution in the Class A stock is offset by a rise in Clearwire's equity stake in Clearwire Communications. If every share of Clearwire Class B stock were converted into Class A common stock, Clearwire would regain a 100% equity interest in Clearwire Communications, thus offsetting the dilution resulting from such a conversion.

Below we break down the liquidation value of Clearwire, eliminating all assets except cash, including Clearwire's debt and all other liabilities, and valuing Clearwire's spectrum at 34 cents per MHz-POP, half of what Verizon paid for its spectrum from Comcast (CMCSA), Time Warner Cable (TWC), and BrightHouse Networks. This scenario includes the cash raised from the recent equity offering, as well as the dilution from those shares. Currently, Clearwire has 1,290,658,000 shares outstanding, and this assumes that all shares are converted into Class A stock.

Clearwire Liquidation Analysis
Asset/Liability Value Per Share Value
Cash $1,426,875,000 $1.11
Debt -$4,019,326,000 -$3.11
Other Liabilities -$1,138,909,000 -$0.88
Spectrum Sale $15,640,000,000 $12.12
Total Value $11,908,640,000 $9.23-$9.24 (Depending on Rounding)

While this is lower than our $10 assumption in our previous article, this valuation is much more conservative, and our initial assumption did not account for the fact that Clearwire would upsize its recent stock offering. And we believe that in liquidation, Clearwire will command more than 34 cents per MHz-POP. Critics once again can pounce here, arguing that Clearwire cannot possibly sell its spectrum for such a price. We believe it can, for Clearwire is the single largest holder of spectrum in the United States, and we think that every wireless company will be clamoring for its spectrum should the company liquidate.

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To be fair to critics, Clearwire does not hold prime 700 Mhz spectrum, which commands the highest premium. In general, the lower the frequency, the better the spectrum. For an analysis of Clearwire's spectrum relative to its peers, we defer to a great piece by SR Capital, which details the scientific and technical aspects of Clearwire's spectrum in far greater detail. In essence, while Clearwire's spectrum is not as potent as 700 MHz, it is not too far away from the spectrum Verizon recently bought in terms of quality. In addition, Clearwire's spectrum is very well suited to managing higher amounts of data more efficiently, and it is clear that the wireless market is moving towards more data intensive applicattions and uses. And given that Clearwire is one of the last remaining major sources of spectrum, we think its scarcity value more than outweighs any issues over quality, relative to 700 MHz spectrum.

In conclusion, we think that Clearwire is a very compelling opportunity. It is very rare to see a company where bankruptcy could be used to unlock tremendous amounts of value. Should Clearwire liquidate, shareholders would receive $9.23/share, representing upside of almost 371% from current levels. Clearwire will either continue to be granted financial lifelines from Sprint until it reaches profitability, which we think can in fact happen, on the back of soaring revenues, subscribers, and the eventual launch of the company's LTE network, or it can file for bankruptcy and unlock billions in value for shareholders. Either way, Clearwire shareholders will benefit. Clearwire shares have been battered in 2011 due to bankruptcy fears. Yet bankruptcy would unlock billions in value for Clearwire investors. At these price levels, the clear choice is to add to or initiate a position in Clearwire.

Disclosure: I am long CLWR, S.