If the DOJ or state attorneys general really are preparing to sue to block the deal, we think they would be making a mistake. They would be missing the fact that the distribution of capacity across market participants could have a far bigger impact on competition and pricing than the number of participants. Prices are likely to increase if the deal is blocked, particularly for low income customers. Prices are more likely to stay low or head lower if the deal is approved.
Investors and some of the market participants appear to be making the same mistake. Verizon and AT&T are better off if the deal is blocked. These companies would face tougher competition if the deal is approved. In fact, it could be devastating for them. Verizon and AT&T should be fighting approval viciously (and perhaps they are, quietly).
We lay out the argument in this iteration of the Global Weekly review.
T-Mobile’s acquisition of Sprint doesn’t seem to be going well
Sprint’s discount to the offer price has widened considerably over the last few weeks as stories of skepticism among DOJ staffers and opposition from state attorneys general have circulated. The market has mostly been reacting to news reports of factors we have long built into our framework for evaluating the likely outcome. We have seen no recent real data that would cause us to change our view of deal approval odds. But we have always been more skeptical than the market that the deal would pass Blair set deal approval odds at less than 50% soon after the deal was announced (LINK), and he has been consistently below 50% since then. In the last couple of months he lowered approval odds to 35% as the likelihood of state attorneys general suing has risen and the ex partes suggest continuing staff skepticism of some of the company arguments (see his most recent note here: LINK)..
If true, weBy “we”, we are not including Blair, who remains fanatically agnostic on the merits and demerits of the deal and singularly focused on the merits and demerits in the mind of the multiple decision makers. think the regulators are making a mistake
If regulators are preparing to block the deal, we think they would be making a mistake. The deal appears challenging on a traditional market concentration analysis, particularly when the analysis is focused on low-income users. But this kind of analysis misses a critical difference between the wireless industry and other industries. In wireless, capacity drives prices, particularly when there is an uneven distribution of capacity across market participants.
T-Mobile has used excess capacity to take share
T-Mobile has had excess capacity over most of the last five years, and they have used it to take 600bps of market share. They introduced unlimited plans and cut price. Their ARPU has fallen, but they have more than offset this with customer growth. T-Mobile set usage caps on unlimited at double the level of Verizon and AT&T, giving customers an even better deal per unit of consumption (see Slide 9: LINK).
The excess capacity also improved T-Mobile’s network performance relative to peers, which has led to lower churn and improving margins. T-Mobile has reinvested those margin gains in expanding its network and selling efforts to rural markets that they did not contest previously, and on targeting less price-sensitive customers that previously would only consider Verizon and AT&T.
T-Mobile’s price driven share gains forced Verizon and AT&T to cut price and offer unlimited plans. The industry has followed T-Mobile on free content offerings, cheaper (or free) international plans, and other consumer-friendly initiatives. T-Mobile’s pricing actions have benefited customers of all the carriers over the last five years.
The excess capacity is gone
After adding 26MM customers over the last five years and driving average usage that is close to double Verizon and AT&T’s, T-Mobile no longer has excess capacity. Now they have less capacity per unit of consumption than Verizon and AT&T. This hasn’t impacted their network performance and their ability to acquire subs yet because they are still in the process of deploying new spectrum, but it will sooner or later (see Slide 10: LINK).
Without more capacity they will have to take up price
Without new spectrum, T-Mobile will eventually have to slow subscriber and usage growth on their network. They would do it by taking up price. T-Mobile’s customer growth is driven by pricing that is 20% below Verizon and AT&T’s for a product that is substantially the same (slides 24 & 25: LINK). If they narrowed the price gap with peers, customer growth will slow, but T-Mobile would generate more FCF than if they continued growing customers (slides 28-33: LINK).
Prepaid customers may be most impacted
If capacity is scarce, wireless carriers should try to maximize the revenue they generate per unit of capacity to maximize their value. In other words, T-Mobile should take up price on its lowest value subscribers first. Wholesale contracts would be the first to go. T-Mobile’s wholesale customers mostly serve lower income segments with prepaid offerings. T-Mobile’s prepaid subscribers on low-priced unlimited plans would be the next to go. Even those on plans priced in-line with postpaid plans are worth less to T-Mobile because they tend to churn at a higher rate.
There are other sources of capacity, but none that T-Mobile (and the DOJ) can depend on
T-Mobile could reach a deal with DISH that would get them access to more capacity, but DISH may have other plans for their spectrum (we will cover this next week). The C-band is at least four years away, and with no fiber network to speak of millimeter wave is useless to T-Mobile in most of the country. Unlike Verizon, T-Mobile doesn’t have the scale to invest in fiber. T-Mobile generated just $2BN in FCF last year compared to Verizon’s $18BN and AT&T’s $23BN.
T-Mobile could increase cell site density, but this is expensive. Their margins would be permanently trapped at half of Verizon and AT&T’s (see Slide 16: LINK). They may simply be better off taking up price, slowing share gains, and boosting FCF until the C-band or some other spectrum comes along.
Sprint acquisition would drive continued share gains
With Sprint’s spectrum and network assets, T-Mobile would increase its capacity five-fold. They would have 2x the capacity per subscriber of AT&T and 3x the capacity per subscriber of Verizon. T-Mobile would use the capacity to take share. They would be wildly irrational if they didn’t. Given their momentum, they may not need to take price lower, but they certainly wouldn’t have an incentive to increase price and slow growth.
This is an important point, worth reiterating: if usage starts to outstrip capacity on wireless networks, prices ought to rise. If there is excess capacity, prices tend to fall. Three carriers may be better able to collude on pricing than four carriers, but if one of those carriers has less share and significantly more capacity than the other two, it would be irrational for the carrier with the advantage not to seek to take share.
In 5-10 years, when T-Mobile has captured 500-1000bps of market share and used up their excess capacity again, they may have an incentive to raise price. But in 5-10 years there will be new disruptors. Cable will be a force to be reckoned with in wireless. And if DISH can pull off their bold plan they may be an even bigger force to be reckoned with.
Investors will be fine. Consumers may suffer.
It doesn’t much matter to investors whether T-Mobile keeps growing customers or they take up price. In fact, in the near term, taking up price would deliver higher free cash flow. Consumers will be worse off if prices rise though. All the positive change we have seen in the industry over the last five years have been driven by T-Mobile’s bid for market share. If T-Mobile backs off because they are out of capacity, Verizon and AT&T will gladly nudge prices higher. They have been doing it already (see Slide 9: LINK).
What about Sprint
Sprint is largely irrelevant to competitive dynamics and pricing in the wireless market, and they are growing more irrelevant by the day. They have been offering five lines for $100 for the last two years and, and they still haven’t been able to grow customers. That is an ARPU of $20 compared to an industry average for postpaid phones of $54.
We suspect customers aren’t flocking to Sprint, despite prices that are less than half of what they can get elsewhere, because service quality matters to most of the market. The utility of wireless is so high, and prices have come down enough at all the carriers, such that very few customers are willing to trade a decent network for low prices.
This has two important implications. First, if low prices aren’t enough for Sprint to stabilize its customer base, what will they do if forced to remain independent? They could restructure their balance sheet through a Chapter 11 process, which might eliminate their cash burn. But not for long. They are losing customers at current prices; if they cut price further they will be back to burning cash quickly and cutting price may not help stabilize subscribers. Sprint needs a good deal of capital to survive and who, in their right mind, would give it to them given the state of affairs described here.
Second, it reinforces the fact that T-Mobile can’t allow their network to deteriorate. Continuing to grow customers and usage and allowing network performance to slip is simply not an option. Absent new capacity, taking up price to slow growth may not just be better for FCF and for the share price, it may be a necessity.
Click here for our global multiples excel: LINK
Click here for a summary of this weeks' research and a pdf of our global multiples: LINK