Why Sprint Will Disappoint Tomorrow, But Remains A Buy

| About: Sprint Corporation (S)

Summary

Sprint is about to become a more volatile stock, but remains on course to hit $20 in 2 years' time. Investors with less risk appetite, however, should take profits now.

The results of the spectrum auction do not diminish my assessment of Sprint's spectrum - its most valuable resource, and sufficient to warrant a $16 price on its own.

Sprint's acquisition of Tidal may also be beneficial, although more details are needed to make a firm projection.

The nature of the old Sprint contract system leaves my view unchanged that abolishing upgrades substantially diminishes the appeal of Sprint for iPhone owners.

Sprint's strong promotional activity during the quarter does not alter this conclusion.

Introduction

Sprint (NYSE:S) is due to report earnings tomorrow morning. It may have already done so by the time you read this. I have been bullish on Sprint and remain so, however, earlier today, I noted that there was one new factor that might give some investors pause. The article generated some pushback, and was also rather narrowly focused on one aspect of Sprint's performance. The purpose of this article is to respond to some of the points that were made, and to examine Sprint more broadly to suggest an appropriate investment strategy.

Short And Sweet Stuff First

Sprint's future is basically dependent on the three S's: spectrum, subscribers, and stakes, as in the stake it just purchased in music service Tidal.

Sprint's purchase of a stake in Tidal is potentially a very significant event, though obviously it has no impact on fourth-quarter earnings. Despite the increasing emphasis put on video, music remains one of the most compelling use cases for mobile phones, as well as a considerable portion of the bandwidth burden for carriers. The continuing success of paid music subscription services also shows that customers are willing to pay for this service. A common owner of network and music therefore has an opportunity to find synergies and hopefully reduce customer churn at the same time.

Without knowing more about exactly how Sprint intends to deploy it, however, anything I said at this point would be more conjecture than analysis. I would like to hear what CEO Marcelo Claure has to say about it on the earnings call before opining further, as I am sure he will be asked about it. So for now, I am going to put Tidal to one side, although I think it has the potential to be very significant in future quarters, if it is managed correctly. More on this next week, after we've heard from CEO Claure.

Spectrum Values

Sprint's spectrum remains, far and away, its most valuable asset. I have written about it at length on several previous occasions, so I will only briefly summarize here. In a nutshell, Sprint's high-band spectrum is worth $16 a share alone, even if it didn't have a single wireless subscriber. That is after paying off all of the company's $38 billion debt load, and it does not include any of Sprint's mid-band (1900 MHz) or low-band (850 MHz) spectrum.

The argument was put forward that Sprint's spectrum is not as valuable as expected following the results of the FCC spectrum auction. For the broadcasters, it certainly has been disappointing. From a hoped for $86.4 billion, its payout will now go no higher than $10 billion for all licenses sold. The price per MHz didn't fall quite as much since the size of the auction also fell, but at 70 MHz in total, prices are likely to be far below the $2.50/MHz-POP that I based my calculations on. Prices below $1/MHz-POP are very possible.

However, I do not believe this alters my assessment of Sprint's spectrum at all. As my initial article on Sprint explained, the company's spectrum is so valuable because it is high-band spectrum, perfect for providing large amounts of data capacity in crowded urban areas. The spectrum being auctioned now is some of the lowest-band spectrum the FCC has ever offered in competitive bidding, at 600 MHz. It has very low data capacity.

While that means it also offers strong signal strength, a boon to a network suffering from reliability issues, wireless providers today are looking for capacity, not coverage. Hence the low valuations. I believe the value case for high-band spectrum remains intact, especially with carriers continuing to zero-rate more and more high-bandwidth video streaming and even returning to outright unlimited data offerings. I re-iterate my $100 billion valuation of Sprint's spectrum pile.

The Fly In The Ointment?

On spectrum alone, then, Sprint should be well-positioned, and its spectrum is why I have been and remain bullish on the stock. That confidence has been richly rewarded. The stock was at $3 when I made my initial buy recommendation and now trades at $9.10 as of this writing. It has been on a steady upward march for months and, because of spectrum, should still have a ways to go.

I expect it to be higher a year from now than it is today, but there is a factor that might make the trip a little bumpier this time around: subscribers.

My thesis, just to briefly summarize, is that the end of upgrades for existing two-year customers at Sprint will put considerable pressure on subscriber levels, because iPhone owners who benefited most from those subsidies will leave and probably take their fellow family plan members, even the ones who don't own iPhones, with them. I wasn't the only one to be concerned about subscribers, either. Wells Fargo and others have also cut their projections, though without specifically referencing iPhones. Three specific rebuttals were offered to my argument in the ensuing comments.

Understanding The Importance Of Contracts

One of the most common reactions to my earlier article was that it no longer matters what anyone does with their contracts, because of what might be called "The T-Mobile Effect." T-Mobile (NASDAQ:TMUS) began a program two years ago to cover the early termination fees of defecting subscribers who joined the un-carrier, and most carriers have now followed T-Mobile's lead. This means that the hold of contracts is now much weaker, or even nonexistent, for those who want to leave a carrier.

This point is perfectly valid; however, it misunderstands my point. Yes, the "stick" of contracts is much less, since it's not the subscriber taking the hit. But my argument was not about sticks. Rather, the old system actually offered superior value to some, and heavily favored iPhones in particular. Some customers liked their contracts, for those specific subsidies on those specific devices. Sprint's abolition of upgrades for existing customers has thus eliminated the "carrot" that kept many of their subscribers tethered to Sprint. I expect this to produce a substantial headwind to subscriber growth going forward.

Will Subscribers Fall Short?

The second point made was that the subsidies were always just built into the monthly contract price, so it comes out the same either way as Sprint's current plans are cheaper. But as I said, it depends on the customer. And this actually is another reason I am so concerned.

As I explained in the last article, iPhones were more favored under the old system. Android phones do better under the current system. And this leads to a bit of a self-selection problem for Sprint. As was pointed out by the commenters, contracts have been weakening for three years. If someone was not getting a good deal with the old plans, they have had plenty of time to switch over to new ones. The ones most likely to still be on contract plans, therefore, are probably the ones who have been benefiting most from them. Family plan members are especially implicated here, as the table below shows. I have deducted the value of a contract subsidy from the Everything Data columns, $450 ($18.75/month) for iPhones ,but only $300 ($12.50) per month for Android.

Sprint Pricing Plans - ED (Contract) and UF (Contract-Free)

Plan Type

Line #

Android UF Android ED iPhone UF iPhone ED
1 $60 $67.50 $60 $61.25
2 $40 $57.50 $40 $51.25
3+ $30 $17.50 $30 $11.25

The UF columns are somewhat repetitive since they don't subsidize phones, but I wanted to visually express the impact. The two general points are iPhones vs. Android, as discussed, and also that contracts become more beneficial the more lines you add. In fact, the third line alone is enough to make up all the losses on the first two lines and then some for iPhone owners. Any additional line subsidies are pure gravy. But not for Android owners, who don't come out ahead until the fifth line. Therefore, the only people who should still have been on contracts by the time upgrades were abolished were large family plans with at least two iPhones. And that is why I see the potential for a substantial hit once those upgrades were taken away.

Promo Wars

The last argument against my position was that Sprint engaged in a lot of promotional activity, to see off whatever pressures it may have faced. That is certainly true, as Sprint offered unlimited tablet data plans and a staggering three free lines on a family plan, as well as free iPhone 7 for a limited time.

But this was simply part of a general industry theme: everyone was going all out on promos this winter. T-Mobile also offered free lines, and everyone offered free iPhones around Thanksgiving. In fact, by December, Sprint was actually falling behind on promo activity. Verizon (NYSE:VZ) was continuing to offer a free iPhone 7 with trade in, while Sprint would only offer a second iPhone SE with full-price purchase of an iPhone 7, and even then only if you got a second line.

Even AT&T's (NYSE:T) BOGO deal was more generous: they at least gave you a full iPhone 7 free once you paid for the first one. In fact, Sprint was the only carrier to not offer a free iPhone 7 at some point after Thanksgiving.

So I do not see promotional activity as saving Sprint from a shortfall.

Conclusion

I have expressed my view that Sprint stock is valuable for its spectrum, not for its subscribers. I still believe that, and for those willing to hold the stock through some turbulence I think it will reward them further. However, there is no doubt the going will get tougher from here as Sprint manages what I believe will be a very rocky transition to a truly subsidy-free business model. Investors who are not comfortable riding through the volatility should consider taking profits on Sprint at this point. However, investors with the appropriate risk profile should look to add to their positions at an $8.50 price dip. My target price remains $20 for Sprint on a 2-year time horizon.

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.

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