NTELOS Poised to Split into Two Companies

Strong Growth at Lumos Networks Implied by Current Trading Levels

About nine months after first announcing its intention to split into two companies-a wireless operation that would retain the brand name NTELOS and a wireline operation comprised of the NTELOS wireline and FiberNet fiber operations-NTELOS announced last month that it intends to effect its separation on October 3, 2011.

James Hyde, Michael Moneymaker and the team have worked furiously over the past year to ensure that both sides of the business have attractive growth prospects and achieve better cost efficiencies in advance of the spin. New executives have been named for Lumos Networks—the recently announced brand name of the to-be-spun wireline business—and the company’s second quarter results press release and conference call were filled with discussion related to future growth prospects—although pro forma results for the wireline business in particular did not demonstrate substantial growth just yet…

Investors, nonetheless, appear to be bullish on the split. By analyzing the wireless and wireline segments separately, and comparing to the trading multiples of other public wireless service providers, I was able to back into an “implied” public value for what will become Lumos Networks…and it’s up there.

First, my analysis of the public wireless companies indicated that investors today are paying relatively modest multiples for standalone (non-AT&T and non-Verizon) wireless providers. Each of United States Cellular, Sprint, MetroPCS and Leap Wireless are facing intense competitive issues, most directly from the aforementioned dynamic duo of wireless iPhone fame. But so is NTELOS Wireless. Given that NTELOS derives much of its wireless business via its Sprint PCS wholesale arrangement—and more importantly, much of the anticipated growth is expected from that source—I figure the Sprint trading multiples should represent (at worst) a down side value proxy (Sprint has its own issues weighing on the share price). Sprint is trading presently for about 0.7x revenue, 4.7x cash flow and less than $500 per subscriber-it’s the cheapest of the four comparables. 

But NTELOS Wireless, I believe, deserves better, if only due to its regional focus and the revenue upside it should enjoy as it penetrates its subscriber base with smartphones. Perhaps not dramatically better, but if I base the wireless division valuation on the mean of the four companies, and then the mean of the three values implied by the revenue, cash flow and per subscriber multiples, you get a wireless operation worth about $450m (public value).  That implies more than a billion dollars for the Lumos Networks side of the scale, and multiples of 5.3x revenue, 10.6x cash flow and nearly $5,400 per connection.  These are strong growth multiples!

If I take the high end wireless multiples and apply them to NTELOS Wireless’ recent performance, the indicated value is closer to $550m, which still implies Lumos Networks’ public value is nearly 5x revenue, nearly 10x cash flow and nearly $5,000 per connection.  I guess Lumos Networks is “nearly” considered a growth story!   

I’m only being partially facetious. There’s no doubt in my mind that Lumos, with its aggressive fiber deployment and backhaul initiatives, will enjoy relatively rapid growth over the next few years. But will that growth be strong enough to support today’s trading value? Or have I underestimated the value of the wireless business?

It’s hard to say just yet, but Standard & Poors said at the end of August that it expects to lower the rating of NTELOS (Wireless’) secured debt by one notch upon separation of the two businesses, “reflecting our view that despite the reduction of the term loan from the Lumos dividend, spinning off the wireline properties weakens recovery prospects for NTELOS' secured credit facilities." The press release added, “In particular, that view contemplates the potential scenario in which the Sprint wholesale services contract, responsible for a significant and growing share of revenue, either is not renewed in 2015 or is renewed under markedly less favorable terms. Accordingly, we expect to revise the recovery rating for the secured credit facilities to '3', indicating our expectation of 50%-70% recovery of principal in the event of a default from the current '2' recovery rating, which denotes 70%-90% recovery of principal. “

In other words, S&P doesn’t like NTELOS Wireless as well without the growth prospects of Lumos Networks.

Of course, investors holding the shares today will get to play both sides once the tax-free distribution occurs, presumably in a couple of weeks. The question is, will they continue to hold both pieces of the former NTELOS Holding Corp.?

Sprint, Clearwire and the Cablecos Dance Around a Deal

Clearwire Shares Double on Word of Renewed Talks

Earlier this month I commented on the untenable situation that has developed between Sprint (NYSE:S) and Clearwire (Nasdaq:CLWR), and also wondered about the wisdom of the announcement Sprint made that it had entered into a nine year, $13.5b network deployment deal with startup LTE wholesaler LightSquared. 

Specifically, I pointed out that if Sprint continues to ignore Clearwire’s financial woes, it stands to lose its nearly 50% ownership position should Clearwire end up restructuring via bankruptcy….I also mentioned the fact that LightSquared’s spectrum is still constrained by interference issues with GPS providers.

Well according to a report published by Bloomberg last Friday, Sprint hasn’t completely lost sight of its investment in, not to mention reliance upon, Clearwire. In fact, the two may be in deal discussions as I write, and their cable step-brothers Time Warner Cable (NYSE:TWC) and Comcast (Nasdaq:CMCSA) may also be seated at the table.

Shares in Clearwire skyrocketed on the rumor last Friday, more than doubling from the sub-$2/share level they had fallen to in the wake of the Sprint/LightSquared announcement.  While Clearwire was trading at present levels (around $3/share) just a month or so ago, after tumbling to a low of $1.32 in early August, $3+ per share suddenly looks a lot better.

But what does it imply in terms of Clearwire’s value?  Back in June I wrote a story on Clearwire’s ongoing struggles to raise capital via a spectrum sale or a broader deal.  At the time, Pardus Capital’s Karim Samii had written a letter to interim ceo John Stanton bemoaning the fact that, at $4.60/share, Clearwire’s massive spectrum holdings were valued at less than $0.20 per MHz POP.  Samii urged Stanton to sell off some of Clearwire’s excess spectrum in order to get the company’s business plan back on track.

After Friday’s run-up, Clearwire appears to trade at an even more discounted $0.15/MHz POP, and at its low two weeks ago, Clearwire’s public market cap indicated a value of just $0.12/MHz POP….But according to the FCC, not to mention AT&T in its T-Mobile lobbying efforts, U.S. wireless carriers are facing a serious spectrum shortage!

I’ve been flummoxed by Sprint’s refusal to step up and support Clearwire for some time now…clearly the company’s bet on WiMax technology has proven to be a misstep in hindsight, but in the meantime Sprint keeps adding 4G customers, to the tune of 1.7m net new 4G customers on the Clearwire network in the second quarter.

Sprint needs every advantage it can get its hands on in the face of the AT&T/Verizon Wireless duopoly.  Why bet billions on LightSquared’s fledgling plan when it already bet billions on Clearwire’s 4G plan years ago?  And why haven’t the cable guys stepped up sooner?  They desperately need a wireless strategy—and that’s what their investments in Clearwire was supposed to be…but the partnerships have floundered in recent years; the vast majority of Clearwire’s wholesale customers have come from Sprint.

Clearwire’s 2.5 GHz spectrum isn’t as desirable as the 700 MHz licenses that Verizon and AT&T will use to deploy their 4G systems on, but it has LOTs of it. Furthermore, the FCC is still considering a proposal to raise the out of band emission limits, which would enable Clearwire to use 20 MHz of spectrum and deliver speeds of 90 Mbps.

It just makes sense for Sprint and the cable players to really get behind Clearwire and make it the basis of their next generation wireless strategies. But after the drubbing the stock has taken this year, due largely to Sprint’s relative lack of support, Clearwire’s existing backers may now be in a position to take over for a much lower price than would have been demanded last winter.  Maybe that was the point?

Clearwire Urged to Sell Spectrum

Letter to Ceo Stanton Highlights Clearwire’s Missteps--But Imminent Spectrum Sale Seems Unlikely

Private investment firm Pardus Capital issued a press release last week disclosing the content of a letter sent to Clearwire (Nasdaq:CLWR) interim ceo and chairman of the board John Stanton wherein Pardus president/ ceo Karim Samii outlined in detail Pardus’ concerns that Clearwire is increasingly up against the ropes when it comes to its efforts to raise funding for its business plan, as well as in regards to its negotiating leverage with 54% owner Sprint (NYSE:S).

The letter raises numerous valid points, but the most pertinent one in my mind is the question of who has the upper hand between Sprint and Clearwire today.  Clearly Sprint believes that it does—and it may be right, for now anyway, although I’m not fully convinced. And despite Pardus' many arguments for a "small spectrum sale" now, I don't see it happening in the near-term.

Sprint’s Network Vision plan to reconfigure its network over the next several years will decommission its Nextel/iDEN network and repurpose the spectrum and network assets for CDMA service; presumably there is also a path-to-LTE element in the planning which would reduce Sprint’s reliance upon the Clearwire WiMax network. But the project is expected to last for three to five years and that’s an eternity in the wireless marketplace.  Without Clearwire and pre-Network Vision completion, Sprint doesn’t HAVE a 4G strategy.  Meanwhile, Verizon (NYSE:VZ) introduced a handset for its LTE 4G network in mid-March and reported 250k sales of the device in just two weeks before the quarter ended. 

Customers—the high-value ones anyway—want 4G services.  AT&T (NYSE:T) doesn’t have it, MetroPCS (NYSE:PCS) has it in just a few markets and others, most notably Leap Wireless (Nasdaq:LEAP), are looking to LightSquared to provide it.  At this point, however, I see LightSquared as a red herring.  Not only because the pure wholesale business model has never succeeded before, but because it now says it might lean on AT&T for early LTE capacity, because the interference issues it has with global positioning services (GPS) have not been resolved, because its capacity will be limited as a result of that interference and because, “Service will be available in the second half of this year,” is the most detail I’ve seen on the actual buildout…LightSquared is reportedly now in talks with Sprint too…it’s all getting very incestuous but the fact is, for now anyway, the only up and running 4G networks with measurable coverage are Clearwire’s and Verizon’s.

Which brings me to subscriber growth.  Sprint has turned its sub growth around admirably compared with the serious losses it was experiencing a few years back.  But if you look at the detail of Sprint’s most recent quarter, of the 1.1m in net adds, they were ALL either prepaid subs (not likely to be heavy spenders or data users) or they were added by Sprint’s wholesale partners and affiliates.  On the postpaid, retail side of the business, Sprint lost 114k customers.  Obviously the Verizon iPhone and AT&T’s competitive response had an impact on its ability to retain high-value postpaid customers.

Now take a look at Clearwire’s results in the same quarter.  The company added 1.6m new wholesale subscribers—those are essentially all Sprint customers.  My interpretation of these data points would be that Clearwire’s 1.6m new wholesale customers are 1.6m customers who would have moved from Sprint to Verizon if the 4G product that Sprint offers—over Clearwire’s network—wasn’t available.  Had that happened, Sprint would have been reporting a loss of half a million subscribers, even with the prepaid growth. Yes, this is probably an oversimplification, but the point is, I think Sprint needs that 4G network, for its marketing and for its status as a carrier and to ensure that its entire subscriber base isn’t comprised of $28/month prepaid subscribers in a few years.

Clearwire on the other hand, has a different set of woes.  First, it’s gone out and invested billions in a next-generation wireless data network that runs on a technology that increasingly appears to be the Betamax of 4G wireless data technology. 

Now it’s nearly run out of money, has had to suspend its retail strategy and is scrambling to cover costs, while Daddy (Sprint) has refused to up its allowance.  In fact, it cut the allowance if you buy into Pardus’ argument that the new wholesale agreement came in 30% low:

“The market also took as a negative the ultimate resolution of the Sprint pricing dispute.  We expected the deal would yield around a penny per megahertz for Clearwire. It appears to have come in closer to $0.007/MHz. Another way to look at it: instead of yielding $7.60 per in-market subscribers in more mature markets, Clearwire should be making $10.00 per sub. The market took this as a “sweetheart” deal for Sprint.”

Clearwire’s failure to sell excess spectrum last fall, before T-Mobile was taken out of the picture as a potential buyer, means that it has an even smaller potential buyer pool today, which translates generally to lower values, despite the widely espoused view that the country is heading for a major spectrum crunch.  And herein lies Clearwire’s biggest problem with regards to an immediate spectrum sale.

As Pardus Capital points out in its letter to Stanton, Clearwire’s current equity value implies a value per MHz POP of less than $0.20.  Assuming that some value should be assigned to the subscriber base and network assets (admittedly fairly low), the implied public spectrum value falls even further.

Clearwire’s spectrum is comprised of 2.5 GHz BRS/EBS licenses, which does not have the attractive propagation characteristics of lower band spectrum like 700 MHz.  But it has  a LOT of it; the company’s 10-K reports 46 billion MHz POPs and more than 150 MHz in top markets.  Its deployed network covers 70 markets nationwide, or about 130m POPs.

Of interest regarding BRS/EBS spectrum is a recent FCC release where the Commission asks for comments on proposed changes to the out-of-band emission limits for BRS/EBS service.  Proponents, including Clearwire, have suggested that the change would allow WiMax-based networks to use channel bandwidths of 20 MHz rather than the 10 MHz used today, and Clearwire suggests that it would then be able to deliver data speeds of 90 Mbps, which it cannot do today. Satellite concern Globalstar has opposed the proposal saying that it would result in interference with its service, but other engineering studies refute that claim.  The FCC is taking comments on the matter but it seems clear to me that should the out-of-band emission limits be raised, the relative value of Clearwire’s spectrum holdings would rise--yet another possible reason to wait for a sale. 

At the end of the day, Clearwire remains challenged in many respects, but so too does Sprint.  And the spectrum assets Clearwire holds, assuming it can keep its head above the water, could, in my opinion, be worth a little more than Wall Street is acknowledging.  That’s Pardus Capital’s opinion too, though the investment firm is clearly losing patience.

But John Stanton didn’t become a wireless billionaire simply by virtue of being in the right place at the right time.  As he pointed out on the company’s last earnings call, “Every time a kid downloads a video onto his phone or a company arranges for a video conference call via their iPads, you're in effect seeing the value of spectrum rise. And I think that it would be prudent for us to be in a position to hold that spectrum, all the spectrum, even that which is beyond what we immediately need.”  I tend to agree. As long as Sprint continues to load the Clearwire network with customers, the company should have enough cash flow to survive this year and on into a period where its excess spectrum assets may be more highly coveted.

Sprint Waging War Against AT&T/T-Mobile Combination

State Level Investigations and Excerpts from Dan Hesse's Senate Subcommittee Testimony

I have written here before that I see AT&T’s proposed buy of T-Mobile as a negative, not only for the industry and competition, but frankly, for AT&T and T-Mobile.  From where I stand, the two companies serve fairly different primary constituencies and many, many T-Mobile subscribers are likely to flee once faced with the higher prices that AT&T will eventually demand.  In my mind, this could potentially be a good thing for more price competitive carriers, primarily Sprint (NYSE:S), Leap Wireless (Cricket, Nasdaq:LEAP) and MetroPCS (NYSE:PCS).

Clearly, however, Sprint ceo Dan Hesse and his posse don’t view it quite the way I do…over the past two weeks, Hesse has testified before the Senate Judiciary Subcommittee on Antitrust, Competition Policy and Consumer Rights, and the company has begun to take its campaign to the state level.  Meanwhile, literally thousands of individuals have filed comments against the deal with the FCC (I searched Sprint’s web site to see if it has a button for people to click right through and file their opposition, but so far didn’t find anything).

While it isn’t really clear whether or not states will have any jurisdiction in the matter, California's PUC announced yesterday that it will open an investigation into the merger.  Sprint has also formally asked Louisiana and West Virginia to look into the matter; Louisiana said a week ago that it would accept public comments.

In reading Dan Hesse’s comments before the Senate subcommittee, I found several comments worth repeating...We've heard many of these arguments before--we've made several of them ourselves. It seems now the question becomes political, with Republicans tending to support the merger and Democrats opposed. 

Excerpts from Dan Hesse's Testimony Before the Senate Subcommittee on Antitrust, Competition Policy and Consumer Rights:

“If…the DOJ and FCC decide to permit the takeover, the wireless industry would regress toward a 1980s-style duopoly. AT&T would become the largest wireless carrier in the country with over 94 million subscribers and approximately 43% of the post-paid market. Coupled with Verizon's over 83 million subscribers and 38% of the post-paid market, the scope and scale of the resulting duopoly, controlling more than 80% of all U.S. contract customers and approximately 80% of all wireless industry revenues, percentages that would likely grow each year after that, would be prohibitive to viable competition from other carriers…This merger would put Humpty Dumpty back together again, and it should be stopped.”

“…[W]ireless communications is a fundamental platform for our entire economy. For example, in 2010 the wireless industry accounted for nearly $160 billion in revenue, approximately $25 billion in capital expenditures, and employed, directly or indirectly, an estimated 3.6 million Americans. If the industry remains competitive, wireless devices and services could generate productivity gains over the next 10 years amounting to almost $860 billion in additional GDP.”

The Wireless Industry and America

“The Mobile Age has arrived. It took 100 years to build one billion fixed phone lines, but only 20 years to add five billion mobile subscribers. At the end of 2010, over 302 million wireless subscriptions were active in the United States, a population penetration rate of almost 96%. And for the first time, the U.S. wireless industry last year carried more data traffic (e.g., email, text, and web browsing) than voice traffic. Robust competition in our industry has resulted in steadily dropping prices for higher quality wireless communications services.”

"More American households are abandoning fixed phone lines and looking to wireless exclusively for voice and data communications...Ironically, because of their landline monopolies, AT&T and Verizon have the least incentive to price wireless service competitively enough to stimulate "cord cutting" of fixed phone lines.”

“If the T-Mobile takeover is approved, AT&T and Verizon would control 88% of all wireless industry profits. Consequently, the disparity between the duopolists and all other providers is likely only to worsen. Going forward, it would be difficult for any company to effectively challenge the Twin Bell duopoly.”

"Moreover, as descendants of the Bell monopoly of local wireline telephone companies, AT&T and Verizon each control a vast wireline infrastructure. Among other advantages, this allows them to obtain backhaul - a critical input of wireless service connecting towers to the larger network - at cost. This point cannot be underestimated. While we look at our handsets and the wireless towers they connect to as "wireless", from that point on, wireless traffic travels by landline, over the legacy wireline networks that are largely controlled by AT&T and Verizon. By contrast, because Sprint and other wireless carriers are not owned by large local telephone companies, we are forced to purchase backhaul service, in most cases from our largest competitors - AT&T or Verizon. Whereas Sprint must pay more than $2 billion a year in backhaul fees to its competitors, AT&T and Verizon earn enormous profits from their control over backhaul. By controlling the availability and price of backhaul, AT&T and Verizon are also able, to a large degree, to control their competitors' costs and quality of service.”

“In 1992, the U.S. General Accounting Office issued a report that concluded "duopoly markets are unlikely to provide a product at a competitively set price" and recommended that the FCC grant commercial wireless (Personal Communications Service) licenses to additional entrants because, "by giving consumers an additional choice, the new PCS provider could spur cellular telephone carriers to improve their services and lower their prices." (U.S. GAO, Telecommunications: Concerns About Competition in the Cellular Telephone Services Industry (July 1992) at 41-42.)”

“According to CTIA data, the average monthly billing charge for cellular services dropped from $97 in 1987 to $39 in 1998, and voice revenue per minute dropped from $0.44 in 1993 to $0.05 in 2008.”

“AT&T claims that its acquisition of T-Mobile will give AT&T the additional spectrum it needs and allow AT&T to extend wireless service to some parts of rural America that are without adequate coverage. This is a myth. Even without this transaction, with the Qualcomm spectrum it is purchasing, AT&T has the largest, licensed spectrum holdings of any wireless carrier. But it does not use that spectrum efficiently. Specifically, AT&T is not using on average 40 MHz of its spectrum across the nation - spectrum that could be used to improve service for its customers - but that AT&T has chosen instead to "warehouse" for future services.”

“AT&T could invest in its network to increase its capacity where necessary and use its spectrum more effectively. AT&T does not face a spectrum crisis, but rather a spectrum deployment problem of its own creation. Verizon has less spectrum and more subscribers than AT&T, but just weeks ago Verizon stated publicly that it has sufficient spectrum to meet its needs until 2015. Increasing demand for data-based communications, such as video and internet content, are not unique to AT&T; all carriers have to use their spectrum assignments efficiently.”

“T-Mobile is already heavily using its spectrum in the same high demand areas where AT&T asserts it needs additional capacity. Thus, the proposed merger would bring little spectrum relief to AT&T where it claims to need it the most. If AT&T invested only a fraction of the $39 billion T-Mobile purchase price into its own network, AT&T could alleviate its alleged capacity concerns, upgrade its network, and deploy advanced wireless technologies, without harming wireless competition."

“AT&T also has attempted to justify the T-Mobile takeover by arguing it will enable AT&T to extend wireless services to rural America. This is a false choice. There is nothing in the proposed merger that changes the fundamental economics of rural broadband deployment. Rural areas do not suffer from any shortage of spectrum given the lower demand for services that results from lower population densities. Rather, rural expansion has been delayed because the lack of population density in rural areas simply makes build-out more expensive per subscriber. The addition of the T-Mobile network to that of AT&T would not change this fact, and would only extend the AT&T network to about 1% more of the population than are already in AT&T's network coverage.”

Local and Regional Carriers Cannot Replace T-Mobile

"AT&T argues that there will be adequate competition after its acquisition of T-Mobile by pointing to regional and local competitors, such as niche prepaid carriers, MetroPCS and Cricket. These smaller prepaid companies provide a viable option for a limited group of customers, principally those who want a low cost phone with fewer options and features, and whose usage is primarily in a limited geographic area. However, these smaller prepaid companies will not be able to keep the Twin Bells from raising prices for the vast majority of consumers who want robust wireless device options, a national footprint and continued innovation."

"Importantly, the smaller companies all rely on competitive access to the national carriers' networks for wholesale roaming service, the pricing of which would be controlled by the Twin Bells following the proposed transaction. And for both domestic and international companies that need GSM, with the elimination of T-Mobile, they would now have no alternate nationwide choice."

“As Chairman Kohl noted regarding the proposed MCI WorldCom/Sprint merger in 1999: "One need not be a rocket scientist - or even an antitrust lawyer - to be wary of a merger which results in just two dominant players in an industry." AT&T's takeover of T-Mobile would entrench two dominant players, just as Chairman Kohl cautioned against.”

“If this takeover is allowed, on what pretense would Verizon not be allowed to acquire remaining competitors?”

Refaire Le Monde: Sprint + CenturyLink = Giant Slayer?

If AT&T/ T-Mobile Goes Through (Even If It Doesn’t), This Deal Makes Sense

Should CenturyLink (NYSE:CTL) acquire Sprint (NYSE:S)? There’s been a good deal of speculation in recent weeks that Sprint may need to sell in order to stay competitive should the proposed AT&T (NYSE:T)/ T-Mobile deal go through, speculation that was confirmed by ceo Dan Hesse’s own testimony before Congress earlier this month.  Numerous analysts have suggested that the most logical buyer of Sprint would be CenturyLink, which is now the #3 wireline company nationwide, following its buy of Qwest (that deal closed April 1).  CenturyLink (then CenturyTel) exited the wireless business back in 2002 when it sold its wireless operations to Alltel (now part of Verizon, NYSE:VZ). 

In this installment of Refaire Le Monde (literally, to “remake the world”), I’ve done an in-depth analysis of where CenturyLink stands today, pro forma its recent Qwest buy as well as the pending Savvis (Nasdaq:SVVS) data center buy, and what the company might look like if it swallowed Sprint. While CenturyLink ceo Glen Post did note in the company’s recent quarterly earnings call that the company is focused on integrating what it’s got for now, I don’t think for a moment that Mr. Post, who has proven himself VERY adept at making large acquisitions and creating shareholder value, isn’t looking out to 2012 and beyond, and seeking a way to bring a wireless play back into the fold.

First, let’s see where CenturyLink will be pro forma its recently completed/announced buys.  Using annualized first quarter 2011 results I’ve come up with a pro forma 2011 P&L.  Because Qwest didn’t close until April 1, and Savvis won’t close until later in the year, CenturyLink’s actual guidance for 2011 calls for about $15b in revenue—but Wall Street is always looking ahead and discounting anticipated results. 

What Wall Street sees when it looks at CenturyLink today is a company that will have more than $19b in revenue going forward, up from actual 2010 results of about $7b.  OIBDA on a combined basis, before any synergies, would be about $8b, for a 42% margin.  The company will have more than 23m connections, including about 1.1m wireless connections it picked up from Qwest, and 48 data centers in the U.S. and abroad.  Longer-term, the synergies expected from integration of Qwest are much higher, but for year one we’ve assumed $80m from Qwest and also factored in the $70m in anticipated Savvis synergies.  That bumps up run-rate OIBDA to about $8.2b, and another $30m in capex savings from the Qwest deal are expected this year. 

So how does it compare with AT&T and Verizon at that point?  Still pretty small potatoes.  Based on annualized first quarter results, AT&T’s top line is running at about $125b (6.5x my pro forma estimate for CenturyLink) and Verizon was at $108b (5.6x CenturyLink).  And where CenturyLink had more than 23m connections including Qwest, AT&T had more than 161m and Verizon had nearly 142m.  Should AT&T be allowed to acquire T-Mobile, its total connections as of 1Q11 would have been more than 195m! 

Now, let’s see what CenturyLink would look like if combined with Sprint too.  Total connections would exceed 75m—that includes 51m wireless subscribers as well as 8m local lines that Sprint’s wireline division serves (more on that in a moment).  Pro forma annualized first quarter results would have been about $52.5b in revenue—still less than half of either AT&T or Verizon.

Needless to say, I don’t see how regulators could deny the combination—even if they do ultimately axe the T-Mobile deal (which still seems unlikely, but I have to admit that the groundswell against the deal is gaining momentum and could in fact have an impact in the end…but I digress).

Clearly the biggest benefit to a Sprint buy is its more than 50m wireless subscriber base and spectrum holdings.  The company is presently undertaking a major network overhaul that will eliminate the Nextel iDEN system over the next several years.  It will cost upwards of $5b but the company believes that major cost savings will result, not to mention it will free up 800 MHz spectrum for new technology deployment, like LTE.  Since he took the helm in early 2008, Dan Hesse has accomplished an impressive turnaround, and while the company isn’t out of the woods yet, it did manage to grow its subscriber base by 1.1m in the first quarter--its best growth in five years--even in the face of the Verizon iPhone.  Both churn and ARPU have been improving, which raises the quality of the subscriber base, and Sprint has several B2B and M2M initiatives underway.

One thing not often mentioned in any discussion of Sprint, however, is its relatively large wireline operation.  The company does about $1.2b per quarter in wireline revenue and wireline OIBDA in 2010 was nearly $1.1b.  Sprint markets local voice, data and Internet service primarily to business customers, and the company’s web site says, “Currently, Sprint manages more than 8 million local phone lines—a number that grows every year as our local phone service footprint expands.”

“Sprint provides a comprehensive menu of local business communications packages for customers in our local service areas that includes calling features, domestic long distance, and Internet services. In addition to these local services, Sprint also offers integrated wireless and data services. Many of the most popular services and features are available in packages at discounted rates or can be purchased individually.”  The company’s 10-K describes the network as “an all-digital global long distance network and a Tier 1 Internet backbone.”  Based on the 8m line figure and trailing revenue, Sprint generates about $52/line/month in its wireline division.

A map of Sprint’s CLEC markets shows the extensive coverage as well as a minimum of overlap with CenturyLink’s ILEC and CLEC markets. CenturyLink’s goal of becoming less dependent upon consumers also fits well with Sprint’s existing focus on business markets—also an area the company has recently refocused on with its wireless offerings.

So what about capitalization and valuation?  First I ran separate Discounted Future Income (DFI) analyses on both CenturyLink and Sprint to see what the market is requiring today in terms of equity returns and what the public valuations imply.  For CenturyLink I used my pro forma 2011 revenue and expense figures, although admittedly, the company won’t actually generate $19b this year.  I then projected 2012 and 2013 results for CenturyLink in its current configuration (including Savvis). Due to continued access line losses, the top line could fall to just $18b by 2013, despite growth in the to-be-acquired data business.  Net cash flow is also projected to fall, albeit slowly.  Based on my expectations for capitalization and using a 7.5% cost of debt, CenturyLink’s current trading price indicates that Wall Street requires a relatively modest 8.2% rate of return on equity.  The implied enterprise value is $46.8b, or 2.4x pro forma revenue and 5.7x pro forma OIBDA.

Next I ran a similar analysis on Sprint.  Shares in Sprint have risen impressively in recent months—some of that may be related to deal speculation, but there’s no doubt that the company’s turnaround (Clearwire woes notwithstanding) is also having an effect.  Despite plans for higher capital investment over the next few years, Sprint’s free cash flow should grow fairly rapidly, especially once the benefits of the Network Vision overhaul kick in.  That assumes, of course, that Sprint can continue to grow its subscriber base.  It looks to me like the market is valuing Sprint at about $32.6b these days—less than 1x revenue—and demanding an equity rate of return of nearly 28%.  That’s an improvement over last year, however, when a similar analysis showed that the market needed more than 31% to invest in Sprint shares.  

So, what happens when you combine the companies?  Several things of significance, even before cost synergies can be factored in.  The debt/ cash flow ratio for Sprint falls—it’s at about 3.4x now.  I figure a combined Sprint/CenturyLink would have a debt/ cash flow ratio around 2.8x.  The growth profile of the combined companies also improves dramatically.  In my mind, this translates to a much less aggressive required rate of return on equity.  Using 14%, and with no synergies yet built into the model, my DFI analysis indicates that CenturyLink-Sprint would be worth more than $87b and have an equity value of more than $55b.  In comparison, the current combined public equity value of the two companies is about $43.1b—indicating the potential for a 28% gain.  Synergies could make that even higher, although the 1% perpetuity growth rate I’ve estimated is highly dependent upon Sprint’s continued success in growing its subscriber base—something the company says would be threatened by an AT&T acquisition of T-Mobile.  Despite Dan Hesse’s very public outcry, however, I tend to think that Sprint would have a good opportunity to steal a lot of T-Mobile’s existing subscriber base as they are forced onto higher-priced AT&T price plans.

At the end of the day, Glen Post will likely stick to his knitting for the immediate future, and observe with interest as the AT&T/ T-Mobile discussion takes place in Washington.  But regardless, a telecom company today needs a wireless play (said the 20-year wireless industry analyst) if they intend to keep growing.  Sure, there are other opportunities that beckon a wireline company, but let’s face it, wireless is where the greatest upside remains, and Post has a solid history of buying for growth (except maybe that wireless division sale back in ’02).  I think the combination makes sense and I don’t see how Washington could deny it given the size of the two largest competitors.  The biggest question now isn’t really IF but WHEN.