The Market Is Too Negative On Sprint

| About: Sprint Corporation (S)
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Sprint (NYSE:S) can't seem to win, no matter what it does. Going back to mid-2011, there were great concerns about Sprint's ability to refinancing its debt and about the company's lack of an iPhone offering. Since that time, the company has refinanced its medium-term maturities and secured the iPhone in its product line-up. The investment community's response to these developments was to effectively ignore the refinancing and suddenly decide that getting the iPhone is actually a bad thing (now that Sprint offers the product).

It's puzzling that the refinancing wasn't a great relief to the market, given that the issue was a great concern, and I've seen no convincing analysis of how the iPhone economics won't work (or that the economics for Sprint and the iPhone are any worse than that of the other wireless phone operators). The investment community seems to focus almost exclusively on the near-term costs of the iPhone, without giving credit for the expected future benefits of the investment. This is also the case with Sprint's "network vision" expenditures.

While Sprint's operating margins are very low (adjusted OIBDA margins were at around 17% in 2011), there are two ways to look at a company with low margins like those of Sprint. The negative view (which the investment community seems to have passionately embraced) is that the company is at a long-term competitive and/or other structural disadvantage -- such that it will never be meaningfully profitable. Conversely, the positive take on Sprint's situation is a view that the company has no long-term structural disadvantage and is, therefore, a great turnaround story. Substantial profitability upside is likely to come from margin expansion as the company improves its operations and brings profitability metrics more in line with that of its competitors.

While the investment community seems to feel differently, I find it difficult to believe the negative of the two views of Sprint (i.e. that Sprint is at a long-term structural disadvantage), as the company now has the same product offerings as AT&T (NYSE:T) and Verizon (NYSE:VZ) (e.g. the iPhone, RIM's (RIMM) Blackberry, Google's (NASDAQ:GOOG) Android phones, etc.). Sprint will have a similar 4G LTE network (once it has completed its upgrades), and the company, arguably, has better pricing plans and a better customer service reputation and brand image.

The more positive of the two views seems more plausible (albeit, seemingly contrarian) as the company has a detailed plan in place to improve its margins and I see no logical reason why Sprint's margins won't migrate towards the levels of its competitors over time. By 2014, Sprint expect a 400bps to 500bps margin improvement from network vision initiatives and a further 400bps to 500bps improvement from other operational improvements, which would give Sprint 800 to 1000bps in total margin expansion. Over this period, I would also expect healthy revenue growth from Sprint's strong product offering, attractive price plans, and good service reputation.

Furthermore, while AT&T and Verizon also currently benefit from greater economies of scale (in addition to more efficient networks), I believe that the competitive dynamics will change over time and this advantage will be diminished. A constant level of customer churn (which is inherently high in the cell phone industry), means that the big guys (like AT&T and Verizon) have to constantly maintain a disproportionately higher number of gross adds in order to maintain their higher market shares. That's a tough task for these bigger operators when they no longer have a better product offering (and have arguably had worse service). For that reason, I expect the market share numbers for the big three operators to gradually converge over time.

Now to give you an idea of the potential upside for Sprint, let's look at the company on a revenue/enterprise value (EV) basis or subscriber/EV basis, etc. Let's consider how much potential upside the company could have if/when it turns around its operations/margins to levels even close to those of AT&T and Verizon, and thus benefit from more comparable valuation multiples.

Let's compare Sprint with Verizon, which is also more wireless focused (compared to AT&T) and thus a more apples-to-apples comparison. One metric used to compare turnaround companies with more profitable companies within the same industry is sales/enterprise value, as this metric gives you an indication of value relative to size (before considering margins, which may converge or diverge over time). To be clear, even if you believe that the margins will completely converge, Sprint should trade at a significant (multiple) discount to Verizon using this metric, because of the execution risks and the cost and cash outflow that will occur during the convergence period. That said, I believe that the discrepancy still appears overly dramatic, with Verizon valued at 1.4x revenues and Sprint at 0.7x.

Another useful valuation metric to be considered is EV/subscriber valuations. When using this valuation metric, the difference between Sprint and Verizon is even more dramatic: At around $1,422/sub for Verizon and $421/sub for Sprint. Again, Sprint should trade at a lower multiple than Verizon, based on this metric (because of its lower margins and because it has a higher percentage of lower-value, pre-paid customers; 27% versus 4% for Verizon). The difference also seems excessive to me.

If you use Verizon's revenue/EV and sub/EV valuations and apply them to Sprint, you get a market capitalization for Sprint of $32 billion (380% above Sprint's current market cap of $8.3B) and $63 billion (761% higher), respectively. Granted, as mentioned before, because of execution risks and the need to incorporate any cash burn over the transition period, that would be an overly generous valuation. But I do believe that the right valuation is somewhere between those levels and the depressed valuation of Sprint today.

In summary, I strongly believe that Sprint is currently trading at a very attractive valuation, which factors in much of the company's challenges and little of the company's upside potential. Not only do I believe that there is substantial upside from an operational improvement perspective, but I also see meaningful upside takeover potential (as I see Sprint as a very attractive candidate for an operator wanting to get its foothold into the U.S. wireless market). All things considered, from a risk/reward perspective, I view Sprint as one of the most attractive opportunities in the market today.

Disclosure: I am long S.