We got a fright when we saw T-Mobile announce a conference call for Monday morning with no mention of what it would focus on. We worried that they may announce that they were abandoning the deal. I am not sure why it didn’t occur to us that Legere might be stepping down to focus his energies on Slow Cooker Sundays.
As we broke open the models in preparation for the call and started running through scenarios around what might come next for each of T-Mobile and Sprint, we realized that the world had changed quite materially since we first set out our thesis for the deal. We have some work to do mapping out the no-deal scenarios in more rigorous detail, but in the meantime, we have some thoughts on what the options for both companies are, and the pros and cons of each.
T-Mobile is starting from a good place
T-Mobile’s business has strong momentum. There are some challenges ahead, with industry growth likely to slow, AT&T set to recover, and Cable gaining pace. Offsetting these headwinds, T-Mobile’s churn is still falling, and they aren’t claiming their fair share of consumer decisions yet. Their network is on par with AT&T and Verizon on most objective metrics, and yet it is priced at a 20% discount.
Expectations aren’t challenging. The market seems to expect slowing subscriber growth and may be underestimating the opportunity for margin expansion as growth slows. Finally, the stock isn’t expensive, particularly in light of the FCF growth they should post over the next few years, even with slower subscriber growth.
T-Mobile needs more capacity to feed their share gains, even if subscriber growth slows a little. We can think of four places where they might get it. All four are solid choices, and the fact that there are five should ensure they have negotiating leverage with each.
#1: Sprint sells spectrum
If the deal is blocked, Sprint may be forced to sell spectrum to fund their turnaround. We think they would have to sell 40 MHz to 60MHz of the 2.5GHz to draw real interest (more on this in the Sprint section below). T-Mobile would have to beat off competing bids from Verizon and others to win. Even if they pay a high price, it may be a better value than buying all of Sprint. They will be getting a portion of the asset they most want from the deal without a lot of the headaches. It would be better to get the full ~160MHz, but they were going to have to pay close to $80BN to get that (Sprint’s transaction enterprise value). This isn’t a bad consolation price.
#2: Partnering with Dish
We have argued for the merits of a network sharing deal between T-Mobile and Dish (LINK). In our recent meeting with Mr. Ergen he was adamant that he doesn’t want to share T-Mobile’s network. Part of Dish’s advantage stems from building a greenfield network that isn’t anchored to network architecture decisions that were made a decade or more ago. Circumstances will have changed, if the deal is blocked. Ergen may reconsider.
If network sharing doesn’t make sense, there is nothing stopping T-Mobile from becoming the anchor tenant on Dish’s new network. It wouldn’t be easy for T-Mobile to get comfortable with relying on Dish for the wireless equivalent of oxygen, but they are the un-carrier, and they have figured out how to get deals done with Ergen before.
This deal could make a ton of sense for both sides. With T-Mobile as an anchor tenant, Dish should have no difficulty finding the network partners and capital they need to complete the network. We have argued that Dish will manufacture units of capacity at well below T-Mobile’s current cost ( see our big report on this theme: LINK). Buying capacity from Dish could even be good for T-Mobile’s margins, if this proves true.
T-Mobile and Dish could also merge, but we think that is unlikely. Dish isn’t an eager seller, and T-Mobile would be unlikely to pay a price that Dish would accept. A partnership could make more sense.
#3: Partnering with Cable
Altice’s deal with Sprint demonstrates a new model for a Cable-Wireless partnership in the US. The wireless carrier gets low-cost access to the Cable company’s infrastructure to deploy small cells. This allows the wireless carrier to create a very dense network, unleashing oodles of capacity. The wireless company then sells some of that capacity to the cable company at a very low cost.
We have shown how the impact on the cable company could be profound, paving the way for disruptive pricing that should drive rapid share gains in the wireless market while also driving faster broadband growth (see detailed thoughts here: LINK). Our analysis shows that Sprint may not be the best partner for this kind of network sharing, given the poor state of their network, but a similar arrangement with T-Mobile could work much better.
The challenge for T-Mobile would stem from the threat to industry pricing that would arise from arming cable with cheap wireless capacity. Cable will likely get this from one of the other carriers, or from deploying their own small cells with their own spectrum. T-Mobile may be giving up very little. Moreover, access to the Cable plant would make different spectrum bands more useful to T-Mobile, like CBRS and even millimeter wave.
#4: Partnering with Sprint
We have also argued that, if regulators won’t allow a merger, T-Mobile and Sprint should share a network (LINK). They would still book $26BN of the $43BN in merger synergies from combining the networks. More importantly, by piling 300MHz of spectrum on a single network, they would drive down their unit costs to levels well below AT&T and Verizon and well below what either company enjoys today. Both companies would be in a position to price aggressively to take share.
And that is the problem. T-Mobile would be arming a desperate Sprint with a disruptive cost structure. With just 12% market share, Sprint doesn’t have a lot to lose. Offsetting this threat, T-Mobile hasn’t had much trouble out-competing Sprint over the last five years, Sprint would still be buried beneath a monstrous debt load, and T-Mobile may still be better off with the cost advantage and lower pricing than without it. They would have to weigh the risks carefully.
The reaction of regulators isn’t 100% clear. We haven’t seen a deal like this in the US before. But there have been half a dozen in Europe, and they seem to have worked to the benefit of consumers. The two aggressive smaller carriers would see their costs lowered dramatically; in a four-carrier market those savings ought to find their way back to consumers.
#5 Spectrum auctions
Of course, there are two spectrum auctions coming up in the next twelve months. CBRS is intriguing spectrum though it is not ideal for deployment on a carriers macro cell network. This spectrum would work better in conjunction with a fixed network like Cable’s (LINK). The C-Band should be auctioned next year too, though this is less certain than it was, with the potential for a fight to erupt between the FCC and the current satellite users (LINK). Even if a deal is struck and the spectrum is auctioned early next year, it will take two to three years to clear. T-Mobile may not want to wait this long. But they will be in no worse position than Verizon while they wait.
T-Mobile has choices, even if they can’t get spectrum
We have argued that if the deal is blocked and T-Mobile can’t get more capacity quickly, they will need to slow growth on their network to maintain their network performance. The surest way to do that is to take up price (see detailed thoughts here: LINK). If they close the gap with Verizon and AT&T, which by rights they should now that their network is on par, they would create $2.4BN in additional EBITDA and FCF. FCF per share could balloon to $15. Sure, the FCF should be valued at a lower multiple because long-term growth would be lower, but even at a lowly 10x (appropriate for a low growth telco), T-Mobile stock could be worth nearly $150.
So where does that leave us with T-Mobile stock
T-Mobile’s business has momentum and is well positioned to weather rising competition. The market seems to be pricing in slower growth and a spectrum acquisition. As we kicked the tires on our estimates in the run up to the call yesterday, we weren’t worried about T-Mobile missing expectations if the deal is blocked.
If there is cause for concern, it is with the sector and the multiple that it trades at. We are comfortable owning T-Mobile at a multiple that is in-line with AT&T and Verizon a couple of years out despite strong growth at T-Mobile and little if any growth at the big guys. We feel less comfortable with sector multiples, as industry growth slows, and new entrants gain pace.
The biggest risk to owning T-Mobile absent a Sprint deal would be from multiple compression for the sector. With no market repair, slower industry growth, rising competition, the threat of pricing pressure, big outlays for spectrum on the way, and returns on invested capital that seem unsustainably high (for the two big guys), the group could easily lose a multiple point or two. T-Mobile is under-levered today, but they might not be when they have fixed their capacity shortfall and purchased a large pile of their own stock.
Investors can mitigate this risk by hedging their position with a short or underweight of one of the more affected wireless carriers though.
Sprint is starting from a bad place
Sprint is losing subscribers, ARPU is falling and has a long way to go before it is at a level that we would consider sustainable, costs and capex need to rise if they are to invest adequately in their network, they are already burning cash, and the balance sheet is already stretched.
If the deal is blocked, we believe the business needs at least $5 - $10BN in new capital to engineer a turnaround. Even with the requisite capital, a turnaround would take years and may not succeed. Softbank is adamant that they won’t invest another penny in Sprint.
If this deal fails, and if we take Softbank at their word, Sprint is in a bleak spot.
Water, water every where, nor any drop to drink
It is not hopeless. Sprint has a phenomenal spectrum portfolio with almost 160MHz of barely used 2.5GHz spectrum that would be ideal for 5G. The ingredients for an incredible business are all there; they have been there for years. Sprint has lacked the investment required to turn the raw ingredients into a great business.
The required investment is considerable. We estimate that the company would need another 30,000 sites to properly deploy their 2.5GHz spectrum. This would require $7BN in capex; however, the bigger problem might be the $2BN in additional fixed network cost that would come with the bigger network. With the company already burning cash the additional opex and maintenance capex may be unbearable.
Another deal seems unlikely
Sprint stormed out of discussions with T-Mobile early last year and went in search of an alternate deal. As far as we understand, they met with anyone remotely interested. They spent five months speaking to Comcast and Charter. They came away empty handed. They went back to T-Mobile, hat-in-hand, and accepted a lower price than the one they had walked away from months before.
We have argued that no other company is likely to acquire equity under the current capital structure (LINK). The cost of fixing the business is too high. The time required to fix it is too long. The prospects of success, even with the requisite investment and time are too low. Softbank is an astute investor in telecom assets; if they can’t see a path to a return on putting new capital into Sprint with 85% of the equity already, who else would.
T-Mobile is in a unique position to fix the problem. Sprint’s network may be beyond repair. T-Mobile would simply shut it down and move the spectrum and the customers to their own network. The $43BN in synergies make the transaction feasible. None of the other potential buyers are in this position.
A deal is more plausible post restructuring, but even then, it may pose too much risk for a credible buyer to step in.
Bankruptcy may not be the answer
Investors and regulators seem to think that Chapter 11 will be a quick fix for Sprint. They assume that if the debt is wiped out Sprint will be back in the market, competing fiercely and winning subs. We are doubtful. Sprint is burning close to $1BN a year. $2BN of additional fixed network costs would take that to $3BN. Interest expense is only $2.5BN.
But that is just the beginning. Sprint’s ARPU is patently unsustainable. They are brining subs on at prices well below their average ARPU. Sprint can’t hang onto them when those subs reprice. Postpaid phone ARPU is at least $3 too high, and perhaps more. $3 in lost ARPU would cost them another $1BN in EBITDA and FCF.
That suggests $1.5BN of FCF burn, with no debt, if the business stabilizes there. Sprint still needs the additional $7BN in new capital. And they will need time. Lots of time, particularly if they are dragged through a protracted Chapter 11 fight. Will someone be willing to make the investment once the balance sheet is cleaned up. Perhaps. Not us. It would be a speculative bet.
Burn the boat to stay afloat
Sprint may need to sell spectrum. Its their most prized possession; the one thing that confers hope of future competitive advantage; but it might be all they can do to stay afloat. They have more 2.5GHz spectrum than they can fill, particularly if they deploy it properly. They could stand to sell 40MHz or even 60MHz.
It won’t be easy. Sprint has deployed 60MHz with LTE, and they are in the process of deploying another 60MHz with 5G. And the stuff that isn’t being deployed is leased and may still have some interference challenges. We assume they could deploy it more efficiently and free up 40MHz to 60MHz of saleable spectrum if pressed, though.
We think 2.5GHz is extremely well suited to 5G deployments, and the US is very short on spectrum that works well for 5G. Carriers in most other developed markets have access to 2.5GHz and 3.5GHz spectrum (the prime 5G bands). In the US, Sprint has virtually all the 2.5GHz, the 3.5GHz is tied up in an awkward licensing regime because the navy uses it, and the next best thing, 3.7GHz, is in the hands of satellite companies and at least two years from being available to carriers.
Verizon and T-Mobile are short on spectrum right now. We think both networks are straining under rapidly growing usage, and deals with Netflix and Disney+ will only add to the strain. AT&T has just surged ahead of them, with 60MHz of new spectrum. And Dish and Cable have emerged as new entrants with an interest in more spectrum.
We think the intrinsic value of 2.5GHz is very high. 60MHz could easily be worth $25BN to $30BN. That would solve a lot of problems for Sprint, both funding network investment and lowering their debt load. The timing is complicated, though.
Timing is cruel
Wireless carriers need new spectrum for 5G right now. If Sprint sold 60MHz of 2.5GHz today, we think it might fetch a very high price. The C-Band auction is on the immediate horizon though, promising another 280MHz of very similar spectrum. The C-Band doesn’t have the complicated license areas, leases, and interference issues to contend with. But it is also only deployable in two to three years. And there will be doubts about the timing if the FCC ends up fighting the satellite companies in court for it.
If 2.5GHz is most valuable right now, should Sprint give up on the deal and sell spectrum now to stave off oblivion? Or push ahead with the deal and risk having to sell spectrum in 6 or 12 months when its value is radically depleted by competing C-Band spectrum. At that point they may not get enough for the spectrum to stave off oblivion.
A cruel choice, indeed.
So where does that leave Sprint
If the deal is blocked, and if Softbank is unwilling to inject new capital, we would expect Sprint to sell spectrum. If their timing is lucky, it may fetch a princely sum. It could mark the beginning of a long road back. If their timing is unlucky, they may end up in Chapter 11 even with a spectrum sale. And the road back will be longer and less certain.
More to come…
As mentioned at the outset, we are still debating and analyzing these scenarios, and we will publish more detailed thoughts in due course. We thought it was worth laying out the framework we are working from in the meantime, though.