By Michael A. Tyler, CFA
Consulting Equity Analyst
Super Stock Screener

While Everyone Was Looking One Way…

The past few weeks have been rife with speculation that that Sprint Nextel and T-Mobile (a unit of Deutsche Telekom) would join forces.  The conventional wisdom was that both of those companies are too small to be credible long-term national wireless carriers, and that together they would have the muscle to take on industry titans AT&T and Verizon Wireless.

Seemingly out of left field, AT&T has plucked T-Mobile from Sprint’s arms, with an agreed offer of $39 billion of cash and stock – about 7x T-Mobile’s anticipated 2011 earnings before interest, depreciation, and taxes (or EBITDA).  Since AT&T is trading at only about 6x, the deal will be dilutive to AT&T, probably for two years – this despite huge cost-reduction synergies. Management didn’t specify any detailed expectations in the press release today, but it’s easy to see multi-billion dollar savings related to eliminating T-Mobile’s corporate offices, its advertising expenditures, much of its retail and other distribution channels, roaming expenses, customer churn, etc.  AT&T has the balance sheet to pull off this acquisition, especially because all of T-Mobile’s debt will remain with Deutsche Telekom.

Can This Deal Be Done?

One of the reasons that this deal is so unexpected is that the Obama Administration has been sending clear signals that it doesn’t want AT&T or Verizon Wireless to acquire any more spectrum; the FCC’s body language regarding upcoming spectrum auctions has focused on strengthening weaker players, not enriching the titans’ portfolios.  So the first – and ultimately most important – question here is simply whether the federal government will allow the transaction to proceed.

In its press release, AT&T lists all sorts of reasons why the deal is in the public interest, including its new commitment to extend 4G availability to 95% of the U.S. population, better service quality, and greater data capacity.  Expect opponents of the deal to highlight the obvious reasons that it shouldn’t be allowed:  market concentration, possible elimination of T-Mobile’s lower priced services, fewer handset and network choices for consumers, etc.

The crux of the regulatory decision may hinge on how the term “market concentration” is defined.  On a national basis, AT&T and T-Mobile are the #2 and #4 carriers, and the transaction would put AT&T and Verizon substantially ahead of #3 Sprint.  But in many local and regional markets, the picture isn’t so straightforward.  In San Francisco for example, T-Mobile is fifth, well behind Metro PCS.  And in Cincinnati, AT&T is a distant third.  Further, it’s plainly obvious that voice prices have plunged in the past decade, despite steady consolidation in the industry; and since Sprint, Metro PCS, and Leap Wireless (among others) still have plenty of capacity, with LightSquared and Clearwire still building, it’s easy to argue that consumers will have many network choices and that there’s plenty of room for any of these smaller carriers to continue offering high-quality low-price service.

I think the companies can manage the regulatory process and secure regulatory approval for the transaction, given time and enough willingness to agree to conditions that may be imposed.  The $3 billion breakup fee is a meaningful incentive, too.

I also think it is quite unlikely that any other strategic bidder will emerge for T-Mobile, because no one else can match the cost synergies that AT&T should be able to extract from T-Mobile.  For starters, Sprint or Verizon have incompatible 3G technologies, which would delay most cost savings for years until the 4G networks are fully deployed in the future.

Investment Impact on Other Wireless Stocks

So where does this leave the rest of the wireless industry?  Let’s assume that the deal will be completed successfully, and look at the other major players one at a time:

• Verizon.  This is modestly negative for the nation’s largest carrier.  AT&T will now have a superior spectrum position (both in capacity and contiguity), more customers, and 100% ownership of its cash flow.  Even if regulators allow it, Verizon will have fewer options to bulk up its spectrum portfolio, and any capital required would make it that much more difficult to realize its ultimate goal of acquiring the 45% of Verizon Wireless now owned by Vodafone.  At best, the transaction will distract AT&T’s management and enable Verizon to pick up some market share in the interim, and perhaps snag some properties that AT&T might be required to divest.

• Sprint Nextel.  This is really bad news.  In one stroke, the company has lost its most attractive merger partner, lost its only logical network-share prospect, probably lost access to 6,000 towers that could have improved its coverage area, and become much more dependent for spectrum on wholesalers LightSquared and Clearwire.  Some people are saying that this deal will give Sprint Nextel more pricing room without having to compete with T-Mobile, but the ever-growing presence of Leap Wireless and Metro PCS negate that argument, in my opinion.  Further, AT&T will become a bigger presence in the prepaid space where Sprint has multiple offerings.  Finally, this deal does not make Sprint a likely takeover candidate, since Verizon most likely would not be allowed to acquire it (especially given its majority ownership of Clearwire) and since Leap and Metro couldn’t pull it off financially.

• Leap Wireless and Metro PCS.   These two carriers are probably cheering with gusto today.  The transaction would remove one of their two biggest direct competitors for low-priced service, and positions both companies as likely takeover targets should Verizon want to test the regulatory climate by bidding to acquire another carrier.

• Clearwire and LightSquared.  These two companies would lose T-Mobile as one of their most promising potential 4G wholesale customers.  But with T-Mobile’s towers and spectrum in AT&T’s hands, many other prospective wholesale customers now have one fewer potential provider.  It’s arguable whether Sprint is truly committed to Clearwire or whether LightSquared can truly get its network financed and built, but the larger point is that every other carrier – from Sprint on down – now is a little more desperate for spectrum and has to be a little more generous to Clearwire and LightSquared.  I think they come out ahead, contrary to the emerging consensus.

• Towers.  Again, the initial impression is that the transaction is bad news for the tower companies.  Investors assume that AT&T will keep the T-Mobile towers rather than sell them (as T-Mobile likely would have done), and that with T-Mobile’s 49,000 cell sites AT&T will likely be both reducing overall presence as a customer of the three big public operators.  Yet almost all of T-Mobile’s sites are in close proximity to AT&T’s sites, which will greatly aid AT&T in enriching its depth of coverage and in offering robust data services.  You can’t simultaneously argue that AT&T will offer better 4G to more people and that it will reduce its tower portfolio.  Further, AT&T’s promise of offering 4G to 95% of the U.S. population represents a big commitment to new tower leases in areas that AT&T hadn’t previously expected to build 4G and that aren’t now served by T-Mobile. By eliminating duplicate capex in other areas, AT&T frees up financial capacity to invest in tower leases.  So this is very good news for the tower companies, even if their stock prices get clipped Monday morning.

• RLECs.  True 4G wireless service is likely to be a superior product to wired DSL, so the wireline rural local exchange companies (RLECs such as Windstream, Frontier, CenturyLink, and Consolidated Communications) will suddenly have a new competitor in their only growth business.  These companies will likely oppose the transaction because it is potentially a big threat to them.

Super Stock Screener Ratings

Although Super Stock Screener’s rating system has not factored the AT&T / T-Mobile merger into its calculations, it’s still worthwhile to take a look at how it ranks the companies addressed above.  Here’s how the Screener sees the ecosystem:

National Carriers     Ticker       Price             Rating

AT&T                  T                $27.94          1 – Strong Buy

Verizon                        VZ             $35.84          1 – Strong Buy

Sprint Nextel            S                   $5.05           2 – Buy

These ratings accurately reflect AT&T’s and Verizon’s strong market positions, but in my opinion the positive stance on Sprint Nextel – supported by operating improvements in the past few quarters – has been seriously undercut by the proposed merger.

Emerging Carriers          Ticker       Price      Rating

Leap Wireless                   LEAP      $12.14     2 – Buy

Metro PCS                          PCS          $14.93    4 – Sell

Clearwire                           CLWR      $5.29      5 – Strong Sell

It’s interesting that Leap and Metro are rated so differently, particularly because the fundamental situation of the two companies are in direct opposition to their respective ratings; in other words, Metro has the stronger business case at the moment, while Leap has some work to do.  I think Metro’s rating might improve.  The harsh rating on Clearwire, meanwhile, reflects its startup nature and vulnerable balance sheet; it’s a bipolar stock, likely to soar or die depending on how events unfold.

Towers                            Ticker     Price            Rating

American Tower        AMT         $50.62       2 – Buy

Crown Castle                CCI           $39.16        1 – Strong Buy

SBA Comm.                   SBAC       $40.60       3 – Hold / Sell

Crown Castle is smaller and growing faster than American Tower, yet its valuation is less demanding, partly because it is farther away from a potential conversion into a REIT.   I agree with the positive ratings on both stocks, though.  SBA’s neutral/negative rating may reflect its disproportionate exposure to Sprint in some way; I don’t know.

RLECs                               Ticker     Price           Rating

Windstream                     WIN       $12.93       2 – Buy

Frontier Comm.             FTR        $8.13          1 – Strong Buy

CenturyLink                    CTL         $41.83        3 – Hold / Sell

Consolidated Comm.   CNSL      $18.01        3 – Hold / Sell

The positive ratings on Windstream and Frontier likely reflect their aggressive actions to bolster profit growth while retaining their dividends; I suspect that Frontier’s recent operational missteps may take it down a notch.  Given a lack of revenue growth and encroaching competition, the negative ratings on the other two stocks seem correct to me.

Michael A. Tyler, CFA, is the managing member of West Shore Investment Management LLC, an independent investment advisor. He also manages the West Shore Fund LP, a long/short equity hedge fund.  The West Shore Fund has a long position in the shares of several of the stocks discussed herein. This document is a general commentary and is not intended to provide specific investment advice.  This document is not intended as and does not constitute an offer to sell any securities to any person or as a solicitation of any person to purchase any securities. The author has no connection to any advertisers on this website.  Further information is available by contacting West Shore Investment Management LLC or Mr. Tyler at michael.tyler@westshorefund.com.

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