After the stock market bashing that Sprint (NYSE:S) suffered last year, 2012 has been exceptionally good for the carrier so far. With uncertainty about the company’s future gradually lifting, the third-largest U.S. wireless carrier has seen its stock deliver more than 100% returns this year alone. Most of the concerns, which surfaced last year, had centered around Sprint’s ability to meet a rather aggressive commitment it made to Apple while financing its expensive Network Vision plans at the same time. This year, however, Sprint has done well to appease the market concerns with a strong iPhone showing and debt sales that have raised enough money to meet its network-upgrade capital requirements.
The Network Vision strategy seems to be also coming along well with Sprint rapidly shutting down iDEN sites and aggressively building out LTE in order to catch up with industry leaders, Verizon (NYSE:VZ) and AT&T (NYSE:T). We expect the iDEN shutdown and a growing adoption of LTE to help Sprint derive a lot of savings in network expenses and increase operational efficiency. However, risks surrounding its high debt levels and burgeoning capital expenses still exist, which could have an adverse impact on cash flows in the coming quarters. Keeping these factors in mind, we have revised our price estimate for Sprint to about $5.30. We note that this revision is based on fundamental factors and is unrelated to the rumors about Softbank potentially buying a controlling stake in Sprint, which we discuss separately in a note How Would Sprint Benefit From A Softbank Deal?.
iPhone strategy paying off
Sprint has been incurring heavy annual postpaid subscriber losses for a long time now and its decision to carry the iPhone came as a solution to that problem. However, since Sprint was late in jumping on the iPhone bandwagon, it had to make a huge upfront commitment of nearly $15.5 billion to Apple over a four-year period. This was, and still is, a massive bet considering that the company already has a highly leveraged balance sheet with about $26 billion in debt on its books (including operating leases) compared with a market capitalization of less than $17 billion.
However, the bet seems to be paying off this year, with the company reporting three strong quarters of postpaid net adds (excluding legacy Nextel iDEN losses) on its core Sprint network since the iPhone launch. Last quarter, Sprint added a net 442,000 subscribers to the Sprint platform, almost twice as many as it did in the prior year quarter and 70% higher sequentially. While this figure was boosted by the number of iDEN subscribers Sprint was able to migrate to its core CDMA network, it also came in a highly saturated market that has caused behemoths Verizon and AT&T to add fewer postpaid subscribers this year.
The iPhone’s role in Sprint’s impressive recent postpaid net adds is readily apparent; last quarter, the iPhone accounted for about 600,000 new subscribers to Sprint, 40% of its total iPhone sales. Sprint also managed to increase its market share of iPhone sales, keeping its iPhone sales flat in a quarter both Verizon and AT&T saw sequential declines of 14% and 16% respectively.
An increasing number of iPhone postpaid subscribers is also helping to push Sprint’s postpaid ARPU (average revenue per user) up. Last quarter saw Sprint’s postpaid ARPU increase by more than $4 to $61. The transitioning of the iDEN subscribers to Sprint’s core CDMA platform will help push the overall postpaid ARPU further up in the coming quarters since iDEN postpaid ARPU is lower than that of the Sprint platform. Postpaid ARPU will also continue to be positively impacted by increasing smartphone penetration and the $10 premium add-on charge that Sprint started levying on all smartphone activations in 2011.
However, the impending shutdown of iDEN in about a year’s time will cause the remaining iDEN subscribers to jump ship and may deepen the market share loss in the short-term if Sprint is unable to transfer enough of them to its CDMA network. Going ahead as well, iDEN’s shutdown will limit Sprint’s potential to add as many subscribers to its core Sprint platform as it has this year. However, the addition of the iPhone has helped the company report strong postpaid net adds on its Sprint CDMA network since the 4S launch, which we expect to continue with the iPhone 5 as well. CDMA’s strong showing should therefore continue and help Sprint stem the overall postpaid losses as iDEN is gradually phased out.
CapEx headwinds could limit cash flow
Meanwhile, the risks from the company’s highly leveraged balance sheet and ever-growing capital expenditures due to the ongoing implementation of its Network Vision strategy still persist. So far, Sprint has only spent about $2 billion of the $6 billion it plans to spend on LTE infrastructure, 3G upgrades and iDEN shutdown this year. The remaining $4 billion spend could negatively impact free cash flow generation in the coming quarters. Sprint is highly sensitive to capital expenditures, as can be seen by moving the trend line in the forecast chart below and following the corresponding impact on its price estimate.
However, while the Network Vision plan is very expensive, a successful implementation of the strategy will reduce the company’s operating expenses substantially by eliminating the duplicate fixed costs of maintaining different networks. The carrier is phasing out iDen gradually and consolidating its network holdings into one 2G/3G/4G network using CDMA, EV-DO and LTE. In fact, Sprint has announced that it is planning to shut down the iDEN network completely by next summer. The freed up iDEN spectrum will then be used to boost its LTE network, boosting 3G/4G coverage and reducing roaming costs. (see Sprint To Build LTE Over iDEN’s Grave) Given that the cost of operating a wireless network is largely fixed, the elimination of these operating expenses – which should also include the shutdown of redundant cell sites – should substantially boost the company’s margins. Rolling out an LTE network will also help it improve its service gross margins, since it is a more efficient network to manage than the existing 3G networks.
As LTE adoption rates rise and the iPhone brings in highly lucrative postpaid subscribers, Sprint will also see its data ARPU levels rise in concert. Sprint’s unlimited LTE plans will help it maintain its niche and differentiate itself from rivals’ tiered data plans. Unlimited plans will likely be more valuable for LTE than they were for 3G since LTE is a higher-speed technology and will cause subscribers to easily overshoot their monthly quota for tiered plans.
Disclosure: No positions