Telecom’s Cat Fight
The only thing more complicated and mysterious than your monthly wireless bill is the industry that created it. After a decade of mergers and acquisitions, the U.S. telecommunications industry has consolidated around four players loaded with $220 billion in net debt at a time of dwindling returns.
The industry might be much healthier if regulators had allowed it to consolidate into a three-company oligopoly. Instead, repeated attempts to merge -- AT&T (ticker: T) offering to buy T-Mobile US (TMUS) in early 2011, Sprint (S) contemplating its own bid for T-Mobile this year -- have been foiled by regulators. That has led to a structural imbalance in the industry where Verizon Communications (VZ), the largest wireless operator by customer count, and AT&T both benefit from having vastly larger customer bases.
“We argued that Sprint and T-Mobile together would have created a third nationally scaled carrier. That would have increased competitiveness,” T-Mobile chief financial officer Braxton Carter told Barron’s. “The Department of Justice and Federal Communications Commission didn’t see it that way.”
So this lopsided fight continues, though T-Mobile in particular has been biting and scratching its way to higher subscriber numbers, adding more than one million customers a quarter for six quarters in a row, thanks to bringing down the cost of plans and restructuring the way customers buy their phones. “We’re kicking the s -- out of the industry,” John Legere, the outspoken CEO of No. 4 player T-Mobile recently said at a technology conference.
The numbers speak for themselves.
Verizon has 85 million of the richest subscribers, so-called post-paid users for phone service; AT&T has 70 million; and Sprint and T-Mobile trail far behind at just 27 million and 25 million, respectively. The low-margin, prepaid consumers, who pay their bills up front on a month-to-month basis, are dominated by Sprint and T-Mobile, with a combined 31 million, compared with a combined 17 million for Verizon and AT&T.
With further consolidation apparently off the table, the status quo is likely to persist for telecom investors. The dividend-rich shares of AT&T and Verizon have held up best. T-Mobile and Sprint have surged momentarily on merger-and-acquisition hopes, only to surrender their gains when those hopes were dashed.
Verizon, which has the highest wireless profit margin in the industry, at 49.5%, is participating in the price chopping and it is starting to affect profit. Earnings before interest, taxes, depreciation, and amortization (Ebitda) missed analysts’ expectations in the third quarter. While the price cutting is unlikely to topple Verizon from its top spot in wireless, the company may have to contend with a diminished view of its profitability in the coming year.
As Craig Moffett, who runs the research boutique MoffettNathanson, observes, going long Verizon over AT&T has become “a crowded trade.” But he thinks T-Mobile has the most potential upside. “T-Mobile has the industry’s best growth at the industry’s lowest multiple, and is the only one of the Big Four to already have their price cuts behind it.”
AT $34.91, AT&T’S shares have returned 4.6% so far this year. None in the group have fared particularly well when compared with the broad market, as the right-hand chart shows in the nearby Dwindling Returns chart. Verizon, which has returned 8%, is the best performer. Sprint is down 56%, and T-Mobile is down 16%. The only time these two operators have held investors’ attention has been when M&A activity drove a flurry of speculation.
Last year, it was an attempt by satellite TV provider DISH Network (DISH) to buy Sprint for $37 billion, a bid canceled after Sprint was recapitalized with a $40 billion infusion by SoftBank (9984.Japan), the Japanese investment conglomerate.
More recently, Sprint attempted to purchase T-Mobile this summer, but then backed away, fearing the same regulatory disapproval that hampered AT&T. That was followed briefly by talk of Dish making a run at T-Mobile. French telecommunications firm Iliad (ILD.France) last month announced a $35 billion bid for T-Mobile, but dropped it as well. T-Mobile, which traded Friday at $28.34, is 66% owned by German telecom giant Deutsche Telekom (DTE).
Says one longtime Sprint investor who has since gotten out of the stock, “We thought Masa-san would roll up T-Mobile,” referring to SoftBank Chairman Masayoshi Son, whose firm owns 80% of Sprint. “He might still do it, but not in a time frame that’s meaningful for our investment approach.”
The economics of the industry are challenging. At 278 million “connections,” including tablets, the incremental number of net new subscribers has consistently declined over the last five years as a percentage of the total market. (See Dwindling Returns chart on this page.)
That said, all four players have to look to a time in the not-too-distant future when the Internet of Things will have a profound impact on their networks, with the number of connected automobiles, freight cars, airplanes, and factories potentially dwarfing the wireless connections for phones.
The industry generates enormous free cash flow -- some $140 billion over the next five years, forecasts Moffett. That’s $45 billion in excess of dividends. AT&T and Verizon yield 5.3% and 4.3%, respectively. Neither Sprint nor T-Mobile pays a dividend.
But with two big auctions for wireless spectrum coming up -- one this month, the other in 2016 -- Moffett says the group could collectively spend $60 billion.
After years of bulking up through acquisitions and spectrum purchases, Verizon and AT&T have simply developed greater scale and cover most markets, with T-Mobile and Sprint not as reliable, broadly speaking.
J.D. Power & Associates, the touchstone for network quality rankings, regularly doles out ratings on wireless service. Verizon customarily receives the “among the best” rating for overall coverage. AT&T gets good marks in some markets, but not as good overall as Verizon. T-Mobile and Sprint regularly fall far behind in the rankings.
With a comfortable lead in both network coverage and customer count, AT&T and Verizon have a free hand to pursue their strategy of levering up to pay shareholders, backed up by steady streams of profits.
T-MOBILE HAS LED a vast change in the nature of cellular subscriptions, changing the way consumers pay for their phones and forcing the industry to bring down the average price charged for buckets of Internet data.
T-Mobile customers now buy their phones outright -- an Apple (AAPL) iPhone 6 can cost $650 or more -- with financing from the carrier. That makes the cost of service more transparent than the traditional industry model in which the carrier subsidizes the up-front cost of the phone and bundles it into the cost of service.
The two big carriers have aped that approach, creating similar “equipment installment plans,” labeled Edge in Verizon’s case, and Next in AT&T’s, which has had the effect of focusing customers on the price of service and sparking a battle of competing discounts.
Though T-Mobile declined to comment on this month’s auction of new spectrum by the federal government, analysts expect it to be a bidder. T-Mobile CFO Carter says T-Mobile’s approach to building out its network in general is one of “success-based investing; as we continue to perform, we will continue to invest with an eye to balancing growth and profit.” That’s perhaps another way of saying that it doesn’t have the heft to compete with Verizon and AT&T across the board in the bidding.
T-Mobile is expected to earn $193 million, or 22 cents a share, this year on revenue of $29.3 billion, up from $24.4 billion last year. Wall Street thinks the shares are worth $35.43, though it’s unlikely to come anywhere close to that, barring M&A.
Sprint, meanwhile, has announced that it will sit out this auction, instead waiting for the 2016 auction of more desirable spectrum. Sprint has by far the biggest spectrum position of all four, but it is a difficult spectrum. Most of it is in frequency bands of 1.9 GHz and 2.5 GHz. That spectrum requires more tower infrastructure to cover a given area than does the lower frequency spectrum held by the other three.
That’s one reason that CEO Marcelo Claure tells Barron’s that Sprint’s turnaround will take some time. Claure came to the company in August, after nearly two decades building the cell- phone distributor Brightstar from scratch to $11 billion in revenue. A native of La Paz, Bolivia, he is the owner of soccer team Bolivar.
“If investors are expecting a rapid turnaround, this is not the case,” says Claure, who delivered the bad news of a lower profit outlook and 2,000 job cuts with his first-ever conference call last week. “This company was at the worst place it’s ever been when I came in.”
Claure, who says he insists on giving the bad news up-front, avers Sprint will be a free cash flow generator over time as it pares low-quality subscribers and builds out its spectrum to lure more of the premium subscribers that Verizon and AT&T dominate.
Sprint shares finished the week at $4.72. Wall Street expects the company to lose $1.9 billion, or 45 cents a share, on flat revenue of $34.5 billion, with $2.3 billion in cash flowing out the door. Says Claure, “It’s not like it suddenly gets better overnight.”
ALTHOUGH AT&T is also expected to bid, the company seems fairly comfortable with where it is already. AT&T CFO John Stephens emphasizes that after $21 billion in capital expenditures this year to upgrade the network, he sees higher free cash flow ultimately. “The last two years, we have been on an investment program, to transform the company, and so capex has been at a higher level,” says Stephens. “We see a path to getting back to more normal levels of capital investment, which we’d expect to have a positive impact on free cash flow.”
So is the dividend safe? “Absolutely!” he says.
In the meantime, the company has been using its single-A credit rating, the highest of the group (Verizon is at triple-B), to find new ways that debt can be used to its advantage. In the third quarter, the company securitized the receivables from the Next plan -- all those phones that AT&T has given out for no money down -- to the tune of $500 million.
One of the hardest things for investors to swallow is AT&T’s proposed $48 billion acquisition of satellite TV operator DirecTV (DTV). AT&T argues that adding DirecTV’s 20 million subscribers already gives it an edge in content deals for its U-verse video programming. Perhaps more to the point, DirecTV doubled free cash flow in the most recent quarter, and it sees that rising by 20% this year. That’s another $3 billion a year for AT&T to play with.
Wall Street expects AT&T’s earnings per share to edge up only slightly this year, to $2.57 from $2.50 in 2013, on sales of $132.5 billion. The average price target for the stock is $35.71, only 2% above the current quote.
VERIZON IS THE FATTEST CAT, but its stock has become such a knee-jerk investment that support for the shares may not last. Verizon has not been as proactive in repricing its customer plans as AT&T in the wake of T-Mobile’s assault. AT&T has a similar valuation, a higher dividend yield and has been more aggressive at beating back the competition.
Verizon declined to talk with Barron’s, citing a silent period before this week’s spectrum auction. But in public remarks three weeks ago, CFO Fran Shammo was enthusiastic about things other than phones. The company has 6.5 million tablet users, an area where it sees lots of growth. It also had $400 million so far this year in so-called machine-to-machine communications -- basically, the Internet of Things.
Shammo is confident the company will balance promotional deals for customers with paying out to reward shareholders. It raised its dividend 3.8% in September, the biggest such increase since 2008. Verizon is expected to earn $14.6 billion, or $3.50 a share, this year, on revenue of $126.3 billion.
T-MOBILE’S CARTER makes the case the company’s “strategic options are much wider” than most realize. Even if a merger with Sprint is off the table during this administration, he implies that there are prospects for a tie-up with other players, such as Comcast (CMCSA), which is looking to build out WiFi networks in many areas of the country. “We are the only acquirable asset here in the U.S.,” he observes. “The strategic landscape out there makes us a very interesting company.”
And yet, until it’s clear that telecom investors return to M&A fever, or until they show a sudden willingness to bet on growth as opposed to a kind of utility model with steady dividends, AT&T and Verizon, may continue to receive the lion’s share of investment dollars.
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