Please contact the author at ketuls@gmail.com for the valuation model used in this report and a pdf version of this report. The author or his firm does not hold any position in this stock.
S - Intrinsic
Sprint’s revenue has been growing in the range of 4% per year, excluding the effects of the Nextel merger; this growth rate will decline to 2% in 2007. Sprint has relied on the Nextel acquisition in order to return to profitability; Nextel’s subscriber base, although a necessity, came at a significant premium that will fail to provide commensurate benefits due to the high customer churn Sprint is experiencing from Nextel’s customer base. Wireless market is saturated with high penetration rates among mobile subscribers and future growth in wireless sector will come from non-voice data services or customer acquisition (at a significant cost) from competitors. Leap Wireless and MetroPCS are successfully targeting Sprint’s niche low end customer segment with unlimited calling plans. At this point, it is difficult to see how Sprint can make up lost ground without any major competitive advantage. Sprint has placed a large bet on the WiMax network to stop its current downslide and get back onto a growth trajectory. It will be on a recovery path next year as it adds WiMax customers; Revenue growth for 2009 through 2011 is expected to be in the neighborhood of 7% (Figure 1). However, returns on WiMax investments will be slow to materialize due to unavailability of WiMax devices. Wireline revenues will continue to decline through 2011 as Sprint is divesting from its wireline business.
| Wireless Revenues | (in millions, except ARPU) | ||||||||||
| Items | Q1-06 | Q2-06 | Q3-06 | Q4- 06 | Q1-07 | 2006 | 2007E | 2008E | 2009E | 2010E | 2011E |
| Net, new Post-paid subs | 0.563 | 0.210 | -0.188 | -0.306 | -0.220 | 0.059 | -0.800 | 0.400 | 0.800 | 1.000 | 1.200 |
| Net, new Boost subs | 0.502 | 0.498 | 0.216 | 0.171 | 0.275 | 1.662 | 0.800 | 1.000 | 0.900 | 0.800 | 0.500 |
| Net, new Wholesale subs | 0.273 | 0.000 | 0.205 | 0.876 | 0.513 | 1.354 | 1.000 | 1.000 | 1.100 | 1.300 | 1.500 |
| Net Subscriber Additions | 1 | 0.708 | 0.233 | 0.741 | 0.568 | 3.075 | 1.000 | 2.400 | 2.800 | 3.100 | 3.200 |
| ARPU | $60.07 | $59.75 | $58.64 | $57.55 | $59.00 | $59.00 | $59.00 | $59.00 | $60.00 | $61.00 | $61.00 |
| Total Wireless Revenues | 8,515 | 8,524 | 9,072 | 9,004 | 8,723 | 35,115 | 35,817 | 37,250 | 39,485 | 42,249 | 45,629 |
| YoY Change | | 8% | 4% | 9% | 2% | NM | 2% | 4% | 6% | 7% | 8% |
| | | | | | | | | | | | |
| Wireline Revenues | | | | | | | | | | | |
| Net Operating revenues | 1,669 | 1,641 | 1,626 | 1,635 | 1,598 | 5,913 | 5,617 | 5,336 | 5,016 | 4,715 | 4,385 |
| YoY Change | -3% | -5% | -6% | -2% | -4% | NM | -5% | -5% | -6% | -6% | -7% |
| | | | | | | | | | | | |
| Source: Company Reports | | | | | | | | | | | |
Figure 1
Sprint will disappoint investors with ROCE in the neighborhood of 3% for the next two years; primarily due to goodwill impairments and then steadily improving to a ROCE of 9% by 2011. Goodwill impairments are required to account for the high churn rate of Nextel customers; Nextel acquisition forms a major chunk of Sprint’s $30 billion goodwill account and projections reflect an impairment charge of 5% per year over the next five years. Similarly, customer relationship (intangible asset) account is also impaired at historical rates in the projected income statement. The primary driver for ROCE growth beyond the next two years is a reduction in interest expense and an increase in revenues from WiMax deployment. Gross margins have been improving but will stabilize at 62% while depreciation expenses are expected to grow at 2%. Intangibles such as FCC licenses are typically granted for ten years with an option for renewal; Sprint doesn’t need additional spectrum for the next five years and this account should not change. Nextel acquisition was primarily through equity issuance; and their debt to equity ratio has been declining significantly. However, future equity issuances are unlikely and long-term debt will decrease over the next five years.
Sprint operates in a highly competitive and capital-intensive telecom industry that typically provides anemic ROA. Sprint’s WiMax network is geared towards providing high speed wireless data services with low capital expenditures. Sprint’s competitor, namely Verizon, is investing in a high capex fiber-to-home network to provide high speed wired data services. Currently, Sprint is the only major telecom service provider that is prepared to offer high-speed wireless data services in 2008. Overall, companies in this industry have high fixed costs and minimal marginal cost of selling an additional minute of service; hence the industry suffers from perennial cutthroat competition. Eventual winners in this industry will be companies that can provide more services with minimum capex and generate maximum revenues from their networks.
Financial Statements
Although Sprint’s financial statements were informative, some changes recommended:-
1) Operating leases: Sprint has materially significant operating leases which should be capitalized. The attached financial statements reflect balance sheets adjusted by converting operating leases to capital leases. After adjustments, capital leases for Sprint are at 25% of its total liabilities implying that Sprint is significantly more leveraged than what its current balance sheet reveals. The impact of adjustments on ROCE components is shown in Figure 2.
| Key Financial Ratios with Operating Lease adjustments | ||
| Ratios | Without Capital Leases | With Capital Leases |
| Debt to Equity Ratio | 42.00% | 64.00% |
| Asset Turnover | 0.407 | 0.364 |
| Financial Leverage | 1.92 | 2.15 |
| Return on Assets | 2.34% | 2.09% |
Figure 2
2) Goodwill: Sprint’s Goodwill asset account increased significantly due to its recent Nextel acquisition and it is about 30% of total assets. Sprint might be overestimating its Goodwill assets; hence, the projected net income reflects Goodwill impairments for the next five years.
Profitability Analysis
Sprint’s ROCE (Figure 3) has been highly volatile over the last five years; some of this variance can be attributed to the Nextel merger. Overall, Sprint has been reducing COGS and investment in PPE&E while focusing on steadily reducing leverage by repaying long-term debt. Although, Sprint’s long-term debt increased by one billion dollars over the last one year, it was due to a recent spate of acquisitions. Inspite of a slight increase in profit margin since 2002; a two point reduction in financial leverage and 0.7 point reduction in asset turnover caused an overall decline in ROCE.
Figure 3
ROS increased marginally since 2002; a 4.62-point decrease in COGS as a percentage of sales (Figure 3) was the main driver for increase in ROS. A decrease in depreciation and severance expense was offset by an increase in amortization. Asset turnover increased slightly between 2002 and 2006 while Financial Leverage decreased by three points to 2.14. Total assets as a percentage of sales (Figure 4) declined by 32 points whereas equity increased by 71 points. The decline in asset was due to a 75 point reduction in net PP&E and a 52 point reduction in capital leases since 2002. All increase in equity was due to the increase in paid-in-capital after the Nextel merger. A decline in liability as a percentage of assets (Figure 4) over the last five years has been due to a lower increase in long-term debt and a reduction in capital lease liability.
| PERIOD ENDING | Change | 2006 | 2005 | 2004 | 2003 | 2002 | ||
| ASSETS | Since2002 | Modified Common Size(Assets as % of Sales) | ||||||
| Current Assets | | | | | | | ||
| | Cash and cash equivalents | 0.0% | 5.0% | 30.9% | 19.3% | 11.9% | 5.0% | |
| | Marketable Securities | 0.0% | 0.0% | 6.1% | 2.1% | 0.0% | 0.0% | |
| | Accounts Receivable, net | -2.9% | 11.2% | 14.5% | 14.4% | 14.1% | 14.1% | |
| | Inventories | -0.4% | 2.9% | 2.7% | 3.0% | 2.9% | 3.3% | |
| | Deferred Tax Assets | -1.6% | 2.2% | 6.2% | 4.8% | 0.1% | 3.9% | |
| | Prepaid Expenses and other current assets | 2.1% | 3.8% | 2.7% | 2.5% | 1.4% | 1.7% | |
| | Current assets of discontinued operations | -1.2% | 0.0% | 3.2% | 0.0% | 2.1% | 1.2% | |
| Total current assets | -4.0% | 25.1% | 66.3% | 46.1% | 32.4% | 29.1% | ||
| | | | | | | | ||
| Investments | 0.6% | 0.6% | 8.8% | 1.3% | 0.0% | 0.0% | ||
| Property, plant and equipment, net | -74.6% | 63.0% | 81.0% | 104.5% | 132.8% | 137.6% | ||
| Capitalized Lease (Operating lease adjustment) | -51.7% | 28.8% | 47.3% | 69.4% | 78.5% | 80.5% | ||
| Intangible assets | | | | | | | ||
| | Goodwill | 54.3% | 75.3% | 73.9% | 20.3% | 21.6% | 21.1% | |
| | FCC licenses | 25.5% | 47.6% | 62.6% | 15.6% | 16.6% | 22.1% | |
| | Customer relationships, net | 17.7% | 17.7% | 30.0% | 0.1% | 0.0% | 0.0% | |
| | Other intangible assets, net | 5.7% | 5.8% | 4.7% | 0.1% | 0.1% | 0.1% | |
| Other Assets | -3.3% | 1.7% | 2.2% | 2.8% | 5.6% | 4.9% | ||
| Non-current assets of discontinued operations | -1.9% | 0.0% | 27.3% | 0.0% | 0.0% | 1.9% | ||
| Total non-current assets | -27.8% | 240.5% | 338.0% | 214.2% | 255.2% | 268.3% | ||
| TOTAL ASSETS | -31.7% | 265.6% | 404.3% | 260.3% | 287.6% | 297.4% | ||
| LIABILTIES | Change | 2006 | 2005 | 2004 | 2003 | 2002 | |
| Current Liabilities | Since 2002 | Common Size (Liabilities as a % of Assets) | |||||
| | Accounts payable | -1.3% | 3.2% | 3.1% | 4.7% | 4.6% | 4.5% |
| | Accrued expenses and other liabilities | -0.3% | 4.8% | 4.0% | 5.2% | 5.4% | 5.1% |
| | Current portion of LTD & capital lease | -2.0% | 1.0% | 4.3% | 2.3% | 1.0% | 3.0% |
| | Current liabilities of discontinued operations | 0.0% | 0.0% | 0.7% | 0.0% | 0.0% | 0.0% |
| | Total Current Liabilities | -3.6% | 9.0% | 12.1% | 12.2% | 11.0% | 12.6% |
| | | | | | | | |
| Long-term debt and capital lease obligations | -10.4% | 19.3% | 17.2% | 28.2% | 28.7% | 29.6% | |
| Capital Lease (adjustment for Operating lease) | -51.7% | 28.8% | 47.3% | 69.4% | 78.5% | 80.5% | |
| Deferred tax liabilities | 6.0% | 9.3% | 8.9% | 3.9% | 2.9% | 3.3% | |
| Pension and post-retirement benefit obligations | -2.5% | 0.2% | 1.2% | 2.6% | 2.7% | 2.8% | |
| Other liabilities | 1.4% | 2.6% | 2.4% | 2.0% | 1.7% | 1.2% | |
| Non-current liabilities of discontinued operations | -3.3% | 0.0% | 1.7% | 0.0% | 2.9% | 3.3% | |
| | Total non-current Liabilities | 25.0% | 42.3% | 43.1% | 63.3% | 66.2% | 67.2% |
| | Total Liabilities | -28.5% | 51.3% | 55.2% | 75.6% | 77.2% | 79.8% |
Figure 4
Risk Factors
All current ratios have increased over the last five years due to a gradual decline in current portion of long-term debt as a percentage of total assets. ROA in 2006 was 2.09%, which is lower than the cost of debt (7%), a major cause of concern for all long-term debt; any material change in long-term debt will trigger changes in NI and ROCE. Based on Sensitivity Analysis (Figure 5) of ROCE; it is most sensitive to Goodwill impairment, SG&A and COGS projections. Goodwill is unlikely to change materially in the next few years; however, SG&A and COGS could increase as Sprint improves its network and customer service to reduce churn.
Figure 5
