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

Company Update

Sprint Nextel (NYSE: S – $5.18) is the nation’s third-largest wireless phone network.  Last Thursday, the company reported third-quarter results that were ahead of expectations, sending the stock up 7%.  But before concluding that the earnings report was unadulterated good news, consider that Sprint is a stock with substantial volatility and a long history of unpleasant surprises.  A quick glance at its stock chart (shown below against the S&P 500 index) demonstrates that grinding improvements are often wiped out by sudden disappointments.  Despite the pleasant earnings print, this might be a good opportunity to lighten up positions.

Wall Street remains deeply divided on the stock:  Bulls, such as Michael Rollins at Citigroup and Philip Cusick at J.P.Morgan, have focused on the company’s rising ARPU (average revenue per unit) and improving customer retention; bears, such as Morgan Stanley’s Simon Flannery and Bank of America’s David Barden, worry about the company’s margins and its dwindling options as the smallest remaining national carrier.  And pretty much everyone is trying to second-guess the company’s 4G strategy and takeout potential.

Over the past year, Sprint’s stock price has roughly matched the market indices, but it’s been a rocky ride. The stock did well through last summer, as the company’s internal improvements began to emerge. It tanked last November and again in April on weak earnings reports, sandwiched around an encouraging print in January. It has steadily regained ground since then, as shown in the chart.

According to Yahoo! Finance, Wall Street opinion is split almost exactly evenly between the bulls and the bears.  Our Super Stock Screener system lands on the optimistic side, rating the stock 1 – Strong Buy.  After more than two decades of watching this stock and its predecessor companies, I am less sanguine.

The Good News…

The critical question facing any prospective investor is this:  Can Sprint improve its operations quickly enough to avoid being marginalized in a capital-intensive industry?

There’s no question that recent results have been impressive.  Wireless carriers have been posting rising revenue per unit thanks to the explosion in demand for smartphones and wireless data usage. Sprint, even without the iPhone, showed a 2.5% sequential increase in ARPU in the March quarter, helped in large part by the company’s decision to charge $10 for all new smartphone contracts (new customers and upgrades).

The other great benefit of a growing proportion of smartphones is that they are sticky, as the carriers have all done a good job of using apps and features to build brand loyalty. Aided by this rising tide and by its rapidly improving customer service operation, Sprint posted its best customer churn rate in years.  The combination of rising ARPU and lower churn helped boost Sprint’s EBITDA well above Wall Street’s expectations.

… And the Bad News

On the other hand, this may be as good as it gets for Sprint.  Bears can point to several factors that will likely impede any further margin improvement at the company:  for starters, competition has begun to erode traffic on the company’s long-haul backbone landline network; most notably, Time Warner Cable is shifting traffic onto its own network.

In the wireless business, despite lower churn the customer base is not growing.  And margins are also likely to come under pressure as the company ramps up spending on its Network Vision program. Sprint currently is struggling with the challenges of operating both a 3G CDMA network and the obsolete Nextel iDEN network, a problem that Network Vision is supposed to solve. The cost of the solution isn’t cheap: Network Vision should add about $200 million or more to the company’s operating expenses through the course of this year.

Margins may also be pressured from competitors’ pricing actions; one possible scenario is that AT&T may decide to cut its data prices as a way of placating the FCC and DOJ in their reviews of the pending merger with T-Mobile USA.

In addition, the migration to 4G is only just beginning. While Sprint was the first carrier to offer a true 4G service, the network is still largely unbuilt. Sprint relies, for now at least, on its 57%-owned affiliate Clearwire for carriage, and payments to Clearwire (NASDAQ: CLWR – $4.86) will rise under the new wholesale agreement the two companies signed earlier this month.

Longer-Term Issues

Most analysts properly see the Clearwire wholesale agreement as a short-term stopgap designed to help Sprint get 4G service to market quickly, but the longer-term solution remains murky.  Clearwire desperately needs additional outside funding to be able to build its network and retain even a nominal retail presence; should Sprint provide further funding for its affiliate, or start reducing its ownership stake through dilution?  While Sprint is generating free cash flow from operations, much of it is already diverted to debt service and the Network Vision plan, so there is little left to fund Clearwire.

Alternatively, should Sprint roll up the remainder of Clearwire? At least Clearwire has some network running in many markets, and plans in place (pending financing) to complete its rollout.  Yet a roll-up would be heavily dilutive, given Sprint’s weak stock price and the scale of a possible acquisition.  It might even make sense for Clearwire to buy Sprint, depending on how the two stocks fare over the next few months.

Or should Sprint sign a long-term deal with LightSquared?  That startup is reasonably well-funded, but it’s considerably farther behind in its construction program.  And if Sprint endorses LightSquared, where does that leave its 57% ownership of Clearwire?

Or should Sprint seek a merger partner?  If so, as acquirer or seller?  Neither is especially appealing, given Sprint’s leveraged balance sheet and its inadequate scale in comparison to the two market leaders. The company can’t simply acquire Clearwire (or LightSquared) without significant equity dilution. Nor can Sprint easily sell itself because most acquirers won’t stomach the debt or the mish-mash of networks the company currently operates.  And acquisition of smaller players such as Leap Wireless or Metro PCS would tip the company’s customer base too far toward the low-price and pre-paid segments without offering enough scale to be worthwhile.

All of this also needs to be considered in light of AT&T’s pending acquisition of T-Mobile USA.  On the one hand, the deal would leave Sprint far behind with respect to customer base and scale, with negative implications for the company’s margins and long-term viability. On the other hand, Verizon might see a wider potential window to acquire Sprint and add to its own spectrum holdings. My guess, though, is that Verizon would much rather acquire raw spectrum from other sources than to get entangled in Sprint’s ongoing challenges; Verizon also may want to keep its powder dry in the event that it can acquire Vodafone’s 45% stake in Verizon Wireless.

A Stock for Gamblers?

In the end, Sprint is caught in no-man’s-land.  If all goes exceptionally well, the economy will continue improving, Sprint’s operational improvements will gain momentum, and the company will gain enough steam from Network Vision to fend off the 4G challenge for awhile. That scenario might lead to a doubling of the stock price.

Conversely, any combination of economic weakness, missteps in the operational improvements, funding difficulties at Clearwire, or price pressure in its core business could crush the company’s margins once again, leaving the company too weak to be thrive.  (As an aside, it’s worth pointing out that further weakness in the dollar could increase Sprint’s handset costs and pressure its margins even further.) With so much debt, the company could easily find itself losing half or more of its equity value.

These two outcomes are quite far apart; I don’t think there are many scenarios that result in in-between outcomes.  So the stock is likely to be bipolar: swing for the home run, but risk the embarrassing strikeout. I generally don’t like the odds in such situations, and in this instance I think the probability of a negative outcome is higher than that of a positive outcome. There are simply too many things that can go wrong for Sprint, and not enough options that lead to more favorable results.

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 holds a long position in the shares of Clearwire (CLWR); we have no intention of adding to, or reducing, the size of this position in the immediate future.  The Fund does not currently hold long or short positions in the shares of any of the other companies mentioned herein.

This document is a general investment commentary; it 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. Further information is available by contacting West Shore Investment Management LLC or Mr. Tyler at michael.tyler@westshorefund.com.

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