T-Mobile: A Strong Network Could Carry It To $108

| About: T-Mobile US, (TMUS)
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Summary

Network congestion remains T-Mobile's biggest risk factor.

T-Mobile retains customer loyalty and brand strength, with little evidence recent small mishaps have damaged it.

T-Mobile has steadily earned $60 in annual net income per additional subscriber.

If network performance remains strong, a fair target price is $108.

Other non-network risk factors do not appear significant.

Introduction

T-Mobile (NASDAQ:TMUS) stock closed Wednesday at just under $59, a 52% rise since I opined that its three-year bull run was about to come to an end. An increasingly bullish consensus has emerged in the market, and I can no longer deny it. While I still don't quite know how they did it, CEO John Legere and his team seem to have created a truly "data-strong" network, capable of delivering top performance even as subscribers get to enjoy unlimited video and music streaming.

What's Left To Say?

I must confess to still having lingering doubts, which I've already explained at length, but I still wanted to write on T-Mobile for two reasons. First, I was wrong, and everyone who said so six months ago deserves to hear me say it. So here it is again: I was wrong.

The second reason, though, is more practical. It has been a while since I wrote about T-Mobile, and while my track record doesn't really inspire confidence, I wanted to take another shot at developing a framework through which investors can judge the risks and rewards of a T-Mobile investment. The core of my bear thesis was that the network couldn't handle the strain of Binge On and unlimited video streaming. If you take that out and assume somehow it can, what is left? Are there any other significant risk factors? How high can the stock go if they keep this up?

Market Leading Force

T-Mobile is due to unveil its next Un-Carrier initiative, Un-Carrier 13, tomorrow on January 5th. It may well have happened by the time you read this. The Un-Carrier remains the most disruptive force in wireless, increasingly setting the standards which other carriers must either meet or see their subscribers bolt. Some recent speed bumps have not changed this.

T-Mobile's Un-Carrier 12 initiative, the T-Mobile ONE Unlimited data plan for every subscriber, has probably come under more fire than any other initiative, even the zero-metered streaming offers of Un-Carrier 6 and 10. It was the worst-received of all the Un-Carrier moves by its own customers. They had sometimes greeted previous moves with yawns, but never with screams. Top complaints included the loss of high-speed tethering data, mandatory throttling of video content with no HD option, and the $20 hike in price of the cheapest plan.

Later, T-Mobile made tweaks to the offer to make it more consumer friendly, adding HD options and tethering. But as it did so new complaints arose that T-Mobile was sacrificing the simplicity of the offer as fine print, exceptions, qualifications and surcharges multiplied with each revision. In fact, T-Mobile's new plans now have even more terms and conditions than the old ones, which really lived up to their billing as Simple Choice plans.

T-Mobile is doubtless hoping to get a more positive reaction out of the gate this time, but there is little evidence of any permanent damage to its consumer cred. The speed with which Legere moved to address the complaints certainly helped, as did the fact that no one else in the wireless space is really innovating like T-Mobile right now. Customers didn't like the initial offering, but after Legere upgraded the new ONE plan subscriber growth actually accelerated over the old Simple Choice plans, and more than 80% of those new customers elected ONE even though T-Mobile continued to offer Simple Choice to those who wanted it.

So T-Mobile's brand strength appears intact. It continues to draw subscribers from AT&T (NYSE:T) and Verizon (NYSE:VZ) in large numbers. Sprint (NYSE:S) has fared somewhat better lately, and is even starting to peel subscribers away from the Big Two themselves. But there is no indication so far that their growth is coming at the expense of T-Mobile. Instead both of them seem to be growing at the expense of AT&T and Verizon, and I would expect that to continue.

The Value Of A Subscriber

This brings the question of how much those new subscribers are worth. It's important to remember the inherently leveraged nature of a wireless carrier. In 2015, T-Mobile tripled its annual net income while subscribers grew "only" 8.3 million, 13%, in that same year. Obviously as the base gets bigger that will tail off somewhat. But net income gains will remain far outsized proportionally to total subscribers, which are still growing in double digit percentages.

One remarkable thing about T-Mobile is how steady growth has been. Its 8.3 million net subscriber additions in 2015 were exactly identical to the 8.3 million it added in 2014, and 2016 numbers should also come in somewhere around there. Net income and free cash flow growth has been similarly steady. In its most recent quarter, 3Q2016, net income came to $366 million, $228 million higher than 2015. 2015's $138 million, in turn, was $232 million higher than 3Q2014's $94 million loss.

Full year numbers also show a similar picture. 2014 net income of $247 million rose to $733 million in 2015, and current net income is reported at $1.3 billion. 2015's $486 million improvement is a little smaller than the $567 million in the first nine months of this year, but two factors explain that. First, as I have noted before, T-Mobile reported a large one-off $636 million non-operating gain in 1Q2016 owing to a spectrum deal it consummated with Verizon. While some spectrum gains are normal, this one was abnormally large and somewhat skews the 2016 data.

T-Mobile usually reports $100-$200 million per quarter of non-operating gains. Following its outsized gain, however, it reported a very rare non-operating loss for the next quarter. I believe this may reflect a "claw-back" of some gains, so averaging the two quarters puts the skew at about $250 million. That would put 2016 beneath 2015 growth. But the second factor, obviously, is that we don't have the 4Q2016 numbers yet, which will raise it back up, by about $200 million based on past quarters. That puts the underlying growth at $517 million in 2016.

Altogether, T-Mobile has shown a consistent pattern of raising net income around $500 million on average in each of the last two years, with 8.3 million new customers each year. That means it is adding around $60 to annual net income per additional subscriber it adds.

Earnings And Share Price

On the downside, a lot of growth has already been priced into T-Mobile stock. Its P/E ratio currently stands at close to 37, down somewhat from earlier in the year but far above industry peers. AT&T's merger-augmented P/E is less than half that at 18. Verizon's P/E, which is far more comparable to T-Mobile since it lacks AT&T's new satellite and video production components, is an even lower 15.5. While T-Mobile's growth should continue, this number will presumably begin to level off moving forward.

To project T-Mobile going forward, in the absence of network saturation we can assume continued steady state growth at this $60 per year profit per customer until it reaches AT&T/Verizon levels. If T-Mobile continues to add a little over 8 million customers per year, it would hit AT&T's current level of 133 million subscribers in early 2023, and Verizon's 143 million level in mid-2024. Where the stock is at that point depends on the subscriber count and also the P/E ratio.

T-Mobile Potential Share Price
Subscribers P/E Net Income Share Price
133 million 15.5 $4.915 Billion $94
133 million 18 $4.915 Billion $109
144 million 15.5 $5.575 Billion $106
144 million 18 $5.575 Billion $123

As you can see, the stock falls somewhere within a $94-$123 range, with the blended average summing to $108. Remember, the stock is currently trading around $59. So even accounting for some diminished P/E ratio, there could be a lot of growth left.

Risk Factors Not So Risky

T-Mobile faces a number of risks, like any business, but most of the ones market analysts usually point to are, in my opinion, of little consequence. T-Mobile has only one real risk factor, as I said, network congestion. Some other commonly cited risk factors have meanwhile receded in importance.

Network Coverage

Network congestion and network coverage are often grouped together under "network quality" but they are different considerations. While T-Mobile's network congestion issues might be getting worse, network coverage problems are definitely getting better. Coverage is the ability to connect to the network from any geographic point, congestion affects how much data you can pull down once you are connected. Coverage is also important because it pertains to voice and text connections as well as data, meaning the ability to call for help in an emergency or make sure an important business note is received promptly.

The difference in coverage quality between different carriers is rapidly diminishing. Verizon remains the leader, but the gap is narrowing rapidly. AT&T's network is now almost indistinguishable from T-Mobile's in quality. While Sprint emphasizes this more in its marketing than T-Mobile does, the convergence is at least as relevant to the latter, with its stronger brand and momentum. T-Mobile is also showing real leadership in network speeds, which routinely exceed its competitors. In fact, T-Mobile CTO Neville Ray has recently begun to dangle the prospect of 1-gigabit wireless speeds in T-Mobile's near future. While he didn't give a specific target date, he insists that T-Mobile will be the first to market with this feature.

I see little danger network coverage will fail to continue to improve. T-Mobile's ownership of increasing shares of 700 MHz spectrum gives its radio towers propagation characteristics little different from those of AT&T or Verizon. T-Mobile network execution has been strong and progress should continue until the Big Three networks are virtually indistinguishable in terms of coverage.

DIRECTV Merger

DIRECTV Now is often considered a potential challenge to the broader wireless system since its data usage does not count against AT&T mobile data caps. That means that subscribers on other networks who choose to subscribe to it may want to leave their current carrier to take advantage of the zero-rating on AT&T's network.

This is potentially a real problem for Verizon, the only carrier which does not offer some form of unlimited video streaming data. T-Mobile is unlikely to be affected much, however, as it recently announced that DIRECTV Now had joined its Binge On program, exempting it from data caps on its Simple Choice plans. And of course T-Mobile ONE subscribers have no reservations about staying with T-Mobile after subscribing to DTVNow, as they all receive unlimited data anyway.

Almost no one on T-Mobile will see any degradation in their wireless experience, no matter how much data they burn on DIRECTV Now or any other video platform. So the impact of DIRECTV Now on T-Mobile is unlikely to be substantial even if uptake is high.

Conclusion

I am probably one of the last to have continued doubts about T-Mobile's ability to maintain network performance under this load. And my warnings about that have not been vindicated by events thus far. In the absence of such network problems, however, I do not see any other risk factors that pose a substantial risk to T-Mobile. If you believe the network can take it, you should be a buyer, even with the recent run up. But I re-iterate that I am still not totally convinced the network can take it.

Disclosure: I am/we are long S.

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.