Sprint's Future If The T-Mobile Deal Is Blocked

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About: Sprint Corporation (S), Includes: TMUS
by: Michael Henage
Summary

The recent price action in Sprint and T-Mobile stock suggests the market is beginning to doubt if this merger will go through.

Sprint's postpaid business is growing, too bad the same can't be said of its prepaid and wholesale business.

Looking at pricing, it's not surprising that Sprint's prepaid customers are leaving.

Sprint has told investors that 2019 won't be a good year when it comes to cash flow. Did they listen?

Let's be clear, investors are essentially left to guess whether the Sprint (NYSE:S) and T-Mobile (NASDAQ:TMUS) merger will succeed. On a day-to-day basis, articles either suggest the merger is in trouble or on shaky ground. Just minutes before starting this article, a news release announced that the FCC said it halted the informal 180-day clock on its review of the merger due to, "significant additional information on their network integration plans for 2019-2021 and other new information on the merger." With many articles suggesting the merger will go through, what if it doesn't? Does Sprint have a way forward without T-Mobile?

Charting a path

Before we can determine how Sprint would do without T-Mobile, we first should examine where the merger stands today. The opposition seems to be getting more frequent and louder. First, U. S. House lawmakers held a meeting on March 12 to review the merger and talk with the companies' CEOs. Second, Department of Justice staffers are privately raising questions about the merger, which some believe will raise the potential for more reviews and roadblocks. Third, Democratic Representatives in the House want to block the merger lead by Rashida Tlaib.

One question that may plague lawmakers is whether they can trust promises made by Marcelo Claure, as the representative for Sprint. Prior to the merger, he said:

Sprint's strong spectrum assets will enable Sprint to be the leader in the true mobile 5G."

Recently, Claure discussed Sprint's competitive position and completely reversed his earlier perspective.

He said:

Over the last decade, the company had lost over $25 billion. For all the talent and work of our employees, our path was simply not sustainable."

Most investors were already aware of Sprint's debt issues. However, his next comment suggested the company's 5G ambitions prior to the merger may have been overstatements. Claure said:

Sprint will be able to deliver 5G only in limited areas, focusing on population-dense metropolitan areas. Consequently, Sprint as a standalone company cannot fully seize the tremendous opportunity that 5G creates."

In addition, normally when companies propose a merger there is a built-in merger premium. Since investors don't know whether the combination will be completed, they leave space between the valuation of the two companies. Once it seems like the merger will go through, the premium disappears eliminating the risk arbitrage play.

If we look at a comparison of Sprint and T-Mobile's stock movement over the last few years, we can see they moved very much in tandem.

Sprint and T-Mobile stock chart

(Source: Yahoo Finance Charts TMUS and S comparison)

However, at the beginning of February, a clear separation occurred. The gap isn't huge, but it is noticeable. As a simple example, as I'm writing this, Sprint stock is down about 2.8%, whereas T-Mobile's stock is down 1.3%. If this price movement continues, it could be a sign that investors are beginning to doubt if the merger will be approved.

Sprint's future is hiding in plain sight

Despite a challenging perspective from Marcelo Claure, does Sprint have a way forward without T-Mobile? The short answer is yes and no. If the company continues its current path, attempting to turn its fortunes around will be challenging. At present, Sprint essentially operates in three different segments.

First, arguably Sprint's most profitable business is the postpaid customer base. It might surprise some, but the company's postpaid business is growing at a respectable rate. Over the last two years, the company seems to have turned a corner.

Sprint postpaid customer chart

(Source: Sprint quarterly earnings - Q4 2018 - Q3 2018 - Q2 2018 - Q1 2018 - Q4 2017 - Q3 2017 - Q2 2017 - Q1 2017 - Q4 2016)

If this were the company's only business, investors might have a different perspective on Sprint's future.

Unfortunately, the other two pieces of Sprint's business aren't a clear-cut picture of growth, in fact, quite the opposite.

Sprint Prepaid customer chart

(Source: Sprint quarterly earnings)

After flat-lining for four quarters straight, the end of 2018 saw Sprint's prepaid customers decline again. Sprint's Wholesale business seems to be following the trend of its prepaid business.

Sprint Wholesale customer chart

(Source: Sprint quarterly earnings)

Sprint's prepaid and wholesale businesses seem to be trailing off, while its postpaid business is growing. The company's future seems to lie with postpaid. If we look at the way that Sprint markets its plans, this trend isn't surprising.

The numbers don't lie

Sprint has been very aggressive with postpaid pricing to try and improve its cash flow and margins. Postpaid churn rates tend to be significantly lower than prepaid. The wholesale business can be profitable, yet Sprint can't directly control pricing or growth.

There are a significant number of options, but for this comparison, we'll look at the most prominent plans available from Sprint and Verizon (NYSE:VZ) as well as look at one of the more aggressive virtual network operators Mint Mobile.

Sprint's main postpaid offerings center around unlimited data usage, with other benefits thrown in.

Plan Name

Monthly cost per line

Additional benefits

Sprint Unlimited Basic

$20 per line

Hulu

Sprint Unlimited Plus

$30 per line

Hulu + Tidal

Sprint Unlimited Premium

$40 per line

Hulu + Prime + Tidal + Lookout

(Source: Sprint plan comparison)

If we look at Verizon's postpaid plans, the comparison seems to favor Sprint heavily.

Plan Name

Monthly cost per line

Additional benefits

Go Unlimited

$40 per line

Apple Music free for 6mo

Beyond Unlimited

$50 per line

Apple Music included + Mexico and Canada talk and text unlimited + premium data up to 22 GB

Above Unlimited

$60 per line

Apple Music included + Mexico and Canada talk and text unlimited + premium data up to 75GB

(Source: Verizon plan comparison)

Though Hulu is worth less per month than Apple Music, getting Sprint Unlimited Basic at $20 a month versus Verizon Go Unlimited at $40 a month explains why Sprint is seeing sequential growth in postpaid customers.

On the prepaid side of the house, Sprint is making it more difficult for customers to sign up for this type of service. Individuals or families must either sign up over the phone or in stores, the online option has been eliminated. What makes the prepaid situation even more challenging is unless customers are aware of the in-store option, they may get the idea that Sprint no longer offers prepaid services. On Sprint's prepaid page it says, "Sprint Forward is no longer open to new customers." Reinforcing this perception are reviews like this one:

Sprint says its prepaid plans aren't available to new customers… but if you're a long-term Sprint customer you can presumably opt for a prepaid wireless plan."

Checking with Sprint directly, an agent did confirm that prepaid plans are still available, just not online. The plan details are:

With Sprint's new Forward plan options, you will get to enjoy Unlimited Talk and Text with different data options. Sprint Forward high-speed data plans start at $40 a month for 4GB, or $60 a month for Unlimited. Please keep in mind these prices include the $5 AutoPay discount."

(Source: Sprint Online Chat on 3/12/19)

Sprint's prepaid business obviously isn't the company's primary focus. On the surface, the pricing seems challenging for anyone who could opt for a Sprint postpaid plan. In addition, other virtual network operators like Mint Mobile are going for the jugular when it comes to prepaid.

Mint has a promotion for just $15 a month for the first three months, then $25 a month thereafter. Individuals get unlimited talk and text, plus 3 GB of 4G data and then 2G data after that. Customers who need more 4G data can move up to $35 a month for 8 GB or $45 a month for 12 GB. These plans also have discounts in the first three months of $15 and $20 per month respectively. Prepaid is a game Sprint isn't pricing to win. In addition, Mint runs on the T-Mobile backbone, so Sprint doesn't even get the benefit of the wholesale revenue.

Good news and bad news

Sprint's future is in postpaid, yet prepaid and wholesale are struggling to find traction. A discussion of Sprint's future wouldn't be complete without a look at its cash flow and debt. If we look at the last several years, we can see why investors would be nervous about the future.

Year

FY Core FCF

Net LTD

FY Interest

2015

Neg. $1.9b

$31.5b

$1.6b

2016

Pos. $2.2b

$31.3b

$1.9b

2017

Neg. $1.1b

$32.2b

$1.8b

2018

Neg. $2.3b

$33b

$1.9b

(Source: Sprint quarterly earnings)

Sprint's net long-term debt has increased and the company's annual interest cost is as high as it has been over the last few years. At the same time, if we look at the 2016 to 2018 timeframe, core free cash flow has taken a steep turn south.

On Sprint's last conference call, CFO Andrew Davies said:

With regard to network cash capital expenditures, we continue to expect $5 billion to $5.5 billion for the year." He also went on to say, "we expect adjusted free cash flow to be in the range of negative $500 million to negative $1 billion for the full year."

Sprint defines adjusted free cash flow as operating cash flow minus both network capital expenditures as well as leased devices capex. There are other adjustments for FCC licenses, investing activities and more. If we use this calculation looking at 2019, we get something like the following.

Category

Low End

High End

2018 Actual

Operating Cash Flow Assumption*

$8.4b

$8.6b

$7.6b

Network capital expenditures

$5b

$5.5b

$3.8b

Leased devices capital expenditures*

$5.5b

$5.7b

$5.7b

Adjustments*

Pos. $1.6b

Pos. $1.6b

Pos. $1.6b

Adjusted FCF

Neg. $500m

Neg. $1b

Neg. $375m

(Source: Conference call information and *author's assumptions)

It seems clear that Sprint expects its operating cash flow to improve on a year-over-year basis. The bad news is Sprint plans on growing its network capex faster than operating cash flow. Sprint is already sitting on $33 billion in net long-term debt and this number seems certain to increase in 2019. In addition, Sprint has at least $2 billion in debt coming due this year that will need to be either refinanced or repaid.

What's Next?

If the T-Mobile merger is approved, some of the risks facing Sprint dissipate. The combined company should be able to leverage its greater scale, yet a new risk of increased churn over any merger hiccups may rear its ugly head. On the other hand, if the merger is struck down, Sprint's way forward is anything but clear.

The company's prepaid customer count has been increasing steadily. Unfortunately, struggles in prepaid and wholesale have caused the company's overall customer count to decline slightly over the last year. If Sprint is going to turn the corner on overall customers, its current prepaid ambitions may be getting in the way. We saw that prepaid pricing doesn't compare favorably to either its own postpaid pricing or to some competitors. On the wholesale side of things, if the merger doesn't go through, some virtual network operators may look to move their business to one of the larger carriers.

Last, the company's own predictions for cash flow in 2019 don't paint a pretty picture. With massive debt that is likely to grow, Sprint's financial profile may dim even further. Marcelo Claure said:

For all the talent and work of our employees, our path was simply not sustainable."

If the T-Mobile merger doesn't go through, it's hard to see how Sprint gets back on track. Given the risks facing the company without T-Mobile, I would recommend avoiding the shares.

Disclosure: I am/we are long VZ. 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.