Sprint's Unreasonable Post-Deal Valuation

| About: Sprint Corporation (S)

On Monday, Sprint (NYSE:S) and Softbank (OTCPK:SFTBY) announced a deal in which Softbank will acquire 70% of Sprint. Under the terms of the deal, Softbank will tender for 55% of Sprint's outstanding shares at $7.30/share and will also buy newly issued shares of Sprint at $5.25/share. This deal implies a weighted average cost of $6.29/share for Softbank - approximately 25% above Sprint's closing share price on October 10 (the day before deal rumors began).

Following Monday's announcement, Sprint's shares fell 0.7% to close at $5.69. One apparent reason for the sell-off was that investors now see limited further upside for Sprint's shares, between now and when the deal closes in 6 to 8 months. I believe that this is far from the case; not least because the current valuation appears to be overly conservative.

"New Sprint's" Current Implied Valuation

While it's true that the announced deal would cap the upside of 55% of currently outstanding shares (even then, only capped at $7.30/share; 28% above Monday's close), the remaining 45% of outstanding shares have no cap and are currently being valued at a ridiculously low level of $3.72/share (26% below the pre-rumor levels of October 10).

Tendered Shares (.55 x $7.30): $4.02
New Sprint: (.45 * $3.72) $1.67
Price At Monday's Close: $5.69

The 45% of the existing shares, that will not be tendered, should continue to reflect developments at Sprint, including earnings results, competitive developments, and market sentiment. This, theoretically, provides unlimited upside potential for existing shareholders.

The $3.72/share valuation currently implied for "New Sprint" shares does seem very low, but there should be a discount for deal risks. So, let's look at current upside/downside potential for deal completion/failure to see if the magnitude of the current deal risk discount is really warranted.

Before the deal rumors began, at market close on October 10, Sprint's equity was valued at about $15.1bn or $5.04/share. Using that as a very conservative valuation for "New Sprint" - basically, assuming that a completed deal does absolutely nothing to increase the enterprise value of Sprint's business - implies a total post-deal valuation of $6.28/share.

Tendered Shares (.55 x $7.30): $4.02
New Sprint: (.45 * $5.04) $2.27
Post-Deal Value: $6.28

As we can see below, even when using that very conservative $5.04/share price for "New Sprint", the magnitude of upside/downside is very close. Simplistically, this would imply almost a 50% probability of the deal falling through, which would seem unreasonable high.

Tendered Shares (.55 x $7.30): $4.02
New Sprint: (.45 * $5.04) $2.27
Post-Deal Value: $6.28
Monday's Close: $5.69
Pre-rumor close (Oct. 10th): $5.04
Upside to Post-Deal Valuation: 10.4%
Downside to Pre-Rumor Levels: 11.4%

The reason I see such a high probability of deal failure as unlikely is because bridge financing has been secured (and there is a $600mn break-up fee payable to Sprint if financing falls through), the boards of both companies have accepted the deal, there appear to be no substantial regulatory issues, and existing Sprint shareholder's would be ill-advised to reject a tender price of $7.30 for shares that the market was valuing at $5.04 before rumors of a deal began.

Even if existing shareholders believe that $7.30/share is too cheap for Sprint's business (as I actually do believe), they can accept the premium tender price and then re-invest in the public float (at a much lower price, if current trading levels are any indication).

So What's Wrong With The Current Valuation?

If I use a higher implied valuation for "New Sprint", which I believe is justified, the implied probability of deal failure would be even higher. I use that conservative valuation of $5.04/share for "New Sprint" to show that there would be high implied deal risk even when using a conservative post-deal valuation.

All other things being equal, the higher the post-deal valuation (i.e. greater upside if/when the deal succeeds), the higher the implied risk of the deal failing. For example, if the upside for shares given successful deal completion was twice the magnitude of the downside given failure, the implied probability of deal failure would be about 66%.

I actually do see many things wrong with a valuation of $5.04/share for "New Sprint". First of all, this is an extremely conservative valuation which implies no post-deal benefits and it doesn't even give credit for the planned capital infusion at a slightly higher valuation of $5.25/share.

In reality, the transaction will immediately reduce Sprint's net debt by over half (from $14.48 to $6.48) and also provide Sprint with the support of a strategic shareholder with a strong balance sheet. Given that Sprint's leverage (and resultant credit risks) have historically weighed on the company's shares, a substantial credit improvement should provide a boost to the company's valuation and share price. Furthermore, the strengthened balance sheet and support of a strategic shareholder, should further improve Sprint's ability to compete against the giants of AT&T (NYSE:T) and Verizon (NYSE:VZ).

Secondly, the transaction will reduce Sprint's' public float by around 70%, which should provide substantial technical support for the share price. Following the proposed tender of 55% of existing shares, existing shareholders will be forced to chase after a smaller float to re-establish their positions. This dynamic should provide meaningful technical support for the shares of "New Sprint". Finally, the implied valuation of $6.20/share, as is being paid by Softbank for its 70% stake, will provide a tangible valuation point at a level substantially above current and pre-deal levels. For all of the above reasons, I believe that the enterprise value of "new Sprint" Sprint should be substantially above $5.04/share, following the completion of a deal.

So Where Should Sprint's Shares Trade Today?

For a back-of-the envelope estimate for "New Sprint", let's assume a 15% premium to the pre-rumor price of $5.04, to incorporate the deal benefits that we discussed. This gets us to $5.80/share for "New Sprint" (still below the $6.29 valuation implied from what Softbank is paying). Incorporating the 55% shares tendered at $7.30, gets us to a post-deal valuation off $6.62.

Assuming an 80% chance of deal completion (my very conservative back-of-the-envelope estimation) and 20% downside risk for existing shares to go back to $5.04, if the deal fails, gets us to a weighted-average valuation of $6.30 (11% above Monday's close). I believe this is a very conservative valuation, which still affords substantial upside potential, particularly over the longer term. All things considered, Sprint's shares are looking cheap following the deal announcement.

Disclosure: I am long S, OTCPK:SFTBF. 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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