The smallest of the national wireless carriers has aces up its sleeve and could even benefit from industry consolidation, write Stephen Ellis and Paul Larson in Morningstar StockInvestor.
Every once in a while, we find a very compelling turnaround opportunity—in short, a beaten-down company which is reaching an inflection point, and whose future returns promise to be lucrative.
Today’s dog-with-fleas stock is Sprint Nextel (S).
Sprint is the third-largest wireless carrier in the United States with nearly 50 million customers. The firm made a huge error with the Nextel acquisition a few years back, and performance issues with Nextel’s iDEN network cost it millions of subscribers and billions in profits.
Sprint’s uncertain financial position led it to complete a complex transaction with Clearwire (CLWR). This allowed Sprint to move forward with its next-generation network, or “4G” rollout, while sharing the financial burden with a group of investment partners. Today, that effort has stalled—Clearwire has run into funding issues, and Sprint is unhappy with the fact that Clearwire has decided to build out a competing retail wireless presence.
Therefore, there is considerable uncertainty around Sprint’s 4G strategy. Furthermore, investors are overly concerned about the negative impact from the pending AT&T (T) and T-Mobile merger.
While we acknowledge the tougher competition that a combined AT&T and T-Mobile would present, we also believe the Street is missing two significant positive aspects of the deal for Sprint.
Why Sprint Could Clean Up Well
First, AT&T has targeted a significant chunk of its deal synergies to come from increasing the average price per T-Mobile user, which means higher monthly prices. Sprint, as the lone major value-priced offering left in the industry, should benefit from this rising tide too.
Second, AT&T expects the regulators to take a year to approve the deal, and regulators may require customer divestitures for acceptance. Sprint should be able to capture some unhappy subscribers from T-Mobile or take advantage of some small value-enhancing deals.
Outside of merger-related issues, we think investors are missing several key points.
- First, CEO Dan Hesse has made huge strides to stem the tidal wave of customer losses and improve other key performance indicators, stabilizing the firm’s financial results.
- Second, we’re confident that Clearwire can find funding for Sprint’s 4G network, either from Sprint or elsewhere, which will remove a huge overhang.
- Third, now that its financial results are stable, Sprint is finally shutting down its woeful iDEN network (part of the Nextel deal), which costs billions to operate. The shutdown won’t start to really impact Sprint’s financials until 2013, but if successful, we think EBITDA (earnings before interest, taxes, depreciation, and amortization) margins could more than double to about 30%.
- Fourth, while the majority of our thesis rests on Sprint’s turnaround, there is compelling growth in the nascent machine-to-machine market (think about connecting Kindles, iPads, and cars wirelessly), which could be a multi-billion opportunity with 80%-plus margins.
Sprint’s accomplishments over the past few years enabled it to survive, but not thrive, in a brutally competitive industry. For the most part, Sprint is outclassed by its larger competitors.
Combined, Verizon (VZ) and AT&T have more than 180 million subscribers, and each generates more EBITDA in a single quarter than Sprint makes in a year. These profits let them outspend Sprint in terms of marketing, yet still enjoy much higher margins thanks to their large customer bases.
Little Telecom, Big Network
For all of its disadvantages, Sprint has one ace up its sleeve—a massive amount of spectrum. This could be extremely important, as mobile data traffic ramps up and the US transitions to a 4G network.
Data traffic growth is going to be huge over the next few years—the typical iPhone user uses almost 300 megabytes of data a month, more than ten times the amount of data a non-smartphone user consumes. As more and more subscribers switch to smartphones, data traffic growth is likely to be exponential.
Investing in Sprint will be an exercise in patience, as the value of its spectrum position and the anticipated savings from its network-modernization program are unlikely to fully show up for years.
At a recent $4.60 per share—equating to about five times depressed 2011 EBITDA—the potential for five or six years of improving margins, subscriber counts and growth in the machine-to-machine market is simply not priced in. Given these opportunities, we think a more appropriate valuation would be around $7 to $9 per share.
In contrast, if Sprint’s modernization plans fail, and it does not gain subscribers despite its superior spectrum position, we think the stock is worth perhaps $3.50. Therefore, we think Sprint offers a reasonable risk/reward ratio.
