Unless you’ve been living under a rock, you are probably aware that
T-Mobile (NASDAQ: TMUS) and
Sprint (NYSE: S) are attempting to merge. I say attempting to merge, because the deal was announced near the end of April last year and the deal isn’t done yet. Investors should realize we’ve been down this road a few times before. In 2011
AT&T wanted to acquire T-Mobile and that didn’t happen for fear of eliminating competition. In 2014, Sprint and T-Mobile wanted to get together, and once again anti-competitive issues caused the deal to be abandoned. The wireless landscape has changed dramatically, and this deal seems to have a chance to be completed. With that in mind, there only seems one reasonable way to play this trade: own T-Mobile.
John Legere should be exhausted
Investors can tell John Legere (T-Mobile) has been rehearsing his lines. The number of video spots, articles, and analysis about the merger has increased, due to Legere and Marcelo Claure (Sprint) meeting with Congress to discuss their plans. While Claure looks every bit the businessman in a standard suit and tie, Legere is living up to his maverick roots wearing a T-Mobile shirt underneath a suit jacket.
There are several punch lines that Legere is using repeatedly to remind everyone why he believes this merger is beneficial.
“New T-Mobile will make available the same or better rate plans for our services as those offered today by T-Mobile or Sprint”
“Broader services, faster speeds, and lower prices”
“The country can look forward from day one to more jobs”
When asked the obvious question about the wireless industry going from 4 carriers down to 3, he quickly responds that “It’s expected that
Charter Communications will take five million wireless customers in the next two years.” He points to offering 5G both mobile and home broadband service as a key reason for the tie-up. In addition, he is touting that the combined company will bring competition to broadband where, “48% of American households have no choice when it comes to home broadband.” Legere is bound and determined to convince anyone who will listen that this merger is good for the economy and for consumers.
When it comes to the process itself, the merger has already received approval from the Committee on Foreign Investment in the United States. While the FCC and Department of Justice still need to approve the merger, T-Mobile says it expects to receive regulatory approval in the first half of 2019.
Of course, with any merger there are going to be doubts and questions. One of the holes in the wireless competition theory is Comcast’s ambitions ride on the back of the
Verizon network. Since Comcast doesn’t own its own network it must rely on Verizon to provide the service and compliment this with thousands of its Wi-Fi sites. Charter also has an agreement with Verizon to use its network. While it’s true that Comcast and Charter represent competitive threats, ultimately Verizon is still involved. In addition, unlike the traditional wireless carriers, Comcast and Charter only offer wireless service to existing customers. Though each company has millions of customers, this isn’t a true nationwide threat like Sprint and T-Mobile.
Even with these caveats, regulators may have to deal with having three very large wireless competitors in order to gain real competition in the broadband industry. A merger that creates competition in one industry and evens the playing field in another, is likely a story that regulators can ultimately accept.
A clear picture of the haves and the have nots
It’s not unusual when companies merge to see one as stronger than the other. In the T-Mobile and Sprint merger, this dichotomy is clearly presented. T-Mobile is firing on all cylinders, whereas Sprint seems to be treading water hoping for this merger to go through.
In T-Mobile’s most recent quarter, several items stood out. First, the company’s postpaid churn was lower than AT&T at 0.99%. This is quite an accomplishment as many would perceive Verizon and AT&T as the standard for the industry. John Legere has been vehemently disagreeing with this stance for a while, but a lower churn rate than AT&T speaks volumes about customer satisfaction.
Second, T-mobile’s service revenue increased once again. Third, the company grew its postpaid total customers by nearly 10% year-over-year, which is no small feat in an industry widely believed to be mature. Last, T-Mobile generated about $1.2 billion in core free cash flow, while investing to expand its network and dealing with the noise around the merger.
If T-Mobile is the “haves” then Sprint is the “have nots.” Sprint’s last quarter had a few highlights, but even these pale compared to its merger partner. “Postpaid service revenue grew year-over-year for the first time in five years” Sprint said on its conference call. Unfortunately, prepaid challenges caused overall service revenue to decline by 4% year-over-year. Sprint’s postpaid churn was nearly double T-Mobile at 1.85%. Though Sprint’s other challenges are bad enough, the company’s cash flow is potentially the biggest issue. Between capital spending on network and capital expenditures for leased devices, Sprint’s core free cash flow was negative $2.3 billion during the last quarter.
In short, what investors are looking at is a company that is thriving and growing (T-Mobile) and a company that is struggling to stay relevant (Sprint). Investors who are hoping this merger goes through also need to look at the several challenges facing the “new T-Mobile.”
When two companies want to merge, management will make promises to try and improve its case for the merger. Some promises come in the form of veiled threats about what could happen if the merger isn’t approved. Often, the most repeated promises surround job creation, better prices, and increased competition. What investors need to pay attention to is how some of these promises could affect the new company’s prospects in the future.
On the negative side, Sprint is being very clear about what it believes happens if the merger isn’t approved. Marcelo Claure said, “Sprint would need as much as $25 billion to build a 5G network as a standalone company.” Given that Sprint is forecasting negative free cash flow for 2019, the company wouldn’t be able to generate this from operations. What regulators may pay more attention to was his statement that, “the company’s total debt of $40 billion and no free cash flow would lead to higher prices for consumers if it’s not allowed to combine with T-Mobile.” The bottom line for Sprint, is without the merger it won’t be able to compete and stay price competitive. Keep in mind, those are Claure’s words not my opinion.
On the positive side, we’ve already covered some of the promises Legere has made about more jobs, but what could that mean for the “new T-Mobile?” The company says, “we plan to open 600 new retail stores and up to five new customer care centers… making this merger job positive from day one.” Though some don’t like to think about it this way, new jobs means new expenses, and it begs the question, what have the two companies been doing up until now?
T-Mobile has been on a streak of adding more than 1 million postpaid subscribers quarter after quarter. Sprint just saw postpaid connections grow just over 2% annually in its last report. If the theory is that each company is trying to win customers, why the need to open 600 new stores? What this doesn’t address is two big issues. First, what about the situations where a Sprint and T-Mobile store are within spitting distance of each other. In my hometown for instance, there is a T-Mobile store in a shopping plaza and a few doors down there is a Sprint store. There is zero chance the new T-Mobile keeps them both, so are these 600 new stores, net new or just replacing other sites that will close?
A second consideration is five new customer care centers means a significant investment in what I refer to as non-revenue generating jobs. I’ve personally worked in customer care and sales in multiple industries. Unless these representatives are very good at cross-selling or up-selling customers, this could be a net expense to the new T-Mobile. This begs the question, why does the new company need these new centers? If T-Mobile has enough service representatives for its customer base, and Sprint has enough for its base, why would a merger necessitate five new centers? As we can see, there are multiple questions here without easy answers.
With new stores and call centers comes more expenses. Some of these expenses will show up in the SG&A line item, some in capital expenditures and elsewhere. It’s a simplistic comparison, but in the last quarter T-Mobile generated $1.2 billion in core free cash flow, while Sprint reported a negative $2.3 billion (if we include capex for network and leased devices as we should). If we combine the companies to just hit a breakeven for free cash flow, the new T-Mobile would need to find about $1.1 billion in costs to take out on a quarterly basis. Obviously, the new company would target efficiency and there are certainly overlapping jobs, but keeping this merger job positive while cutting billions in expenses per year isn’t guaranteed.
$7.5 billion reasons to bet on magenta
To be blunt, the only way to play this potential merger in my opinion is through T-Mobile stock. There are several reasons I believe this is the case. First, using Sprint stock to play the risk arbitrage game doesn’t seem to make sense. On the positive side, for every Sprint share you get 0.10256 shares of T-Mobile. At present, T-Mobile shares trade for $72.05, while Sprint is priced at $6.30. The exchange at these prices would value Sprint at $7.39, or a premium of about 17%. While this might sound like easy money, the risk versus reward just isn’t great enough.
As mentioned before, Sprint’s own Claure essentially said the company has tons of debt and no free cash flow. If the merger isn’t approved, he also said that the company will have to raise prices. Let’s assume for a moment this plays out and Sprint must raise prices to compete. The carrier is already struggling with postpaid churn relative to its peers and at aggressive prices. If Sprint raises prices in light of a failed T-Mobile deal, there is little question this churn rate will increase. Another buyer may come to the table, but after Claure’s comments before Congress, there is little reason to expect a substantially better offer for the shares.
A second reason to own T-Mobile is the stock’s growth profile. The company has, “19 consecutive quarters leading the industry in year-over-year service revenue percentage growth.” This last quarter was the “23rd straight quarter of more than 1 million total net customer additions”. T-Mobile’s operating margin is 9.6% versus Sprint at 5.6%. T-Mobile is free cash flow positive to the tune of more than $1 billion as of the last quarter. Maybe most importantly, there is a huge share buyback if T-Mobile does not complete the merger with Sprint.
An overlooked portion of T-Mobile’s first quarter 2018 earnings, explained how the company would proceed if the Sprint merger did not go through. When talking about share repurchases, T-Mobile said:
“The additional $7.5 billion repurchase authorization is contingent upon the termination of the Business Combination Agreement with Sprint.”
The bottom line is T-Mobile is a fundamentally stronger company than its partner. If the merger doesn’t go through, shareholders will be theoretically rewarded with billions in share repurchases. If the merger does go through the new T-Mobile has a chance to compete in the 5G world against Verizon and AT&T. In the game of roulette, there is an old school line that says always bet on black. In the case of the T-Mobile and Sprint merger, I would only bet on magenta.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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