Sprint Still Worth $4.25 Despite iPhone Deal, Debt Concerns

Sprint’s (NYSE:S) stock has been under a lot of pressure recently after the company announced plans to sell the hugely-subsidized iPhone even as it continues to invest heavily on building out new 4G LTE infrastructure. The substantial costs associated with these moves forced the company to pile onto its already high debt load with a $4 billion notes offering, the interest rates on which were higher than usual. Sprint also owns over 50% of its 4G network provider, Clearwire, which has been facing a severe cash crunch. Sprint had to use some of its cash on hand to participate in Clearwire’s stock offering in order to provide the struggling carrier with a temporary respite from its liquidity issues. Sprint is hardly in a position to be providing bailouts given its own financial straits and a distant third-place market position behind Verizon (NYSE:VZ) and AT&T (NYSE:T).

With the company’s recent troubles attracting heavy attention, the stock has taken a beating. However, we believe the sell-off has been overdone and the company’s strategy holds long-term promise. We have a $4.25 price estimate for Sprint’s stock, which is almost 80% higher than the market price.

See our full analysis of Sprint’s stock here

The iPhone Deal

Sprint has been steadily losing postpaid customers, who are on long-term contracts with higher average monthly bills and are therefore more valuable than prepaid subscribers. Last quarter, the company lost almost 44,000 postpaid subscribers. Sprint struck a deal with Apple to sell the iPhone mainly in a bid to reduce this churn and also drive higher ARPU levels in the long term, as iPhone users are generally known to be heavy data users.

However, owing to its popularity, the iPhone comes with huge subsidies that carriers offer their subscribers in return for long-term contracts. Sprint will therefore have to suffer a near-term hit to its margins, as it loses money on each iPhone sold. We believe that the market is hugely discounting this near-term margin hit while not taking into account the long-term positive impact on ARPU levels.

Although Sprint’s iPhone sales are not out yet, the overwhelmingly positive response that the iPhone 4S has garnered since its debut as well as the historical data usage of iPhone users leads us to believe the company’s faith in the iPhone will serve it well in the long run.

Phasing Out Unsuccessful Networks

Sprint’s current postpaid subscriber losses can also be attributed to its failed bet on the push-to-talk iDEN network that it acquired when it bought Nextel, as well as its expensive bet on Clearwire’s 4G WiMAX network. Verizon and AT&T’s 4G LTE networks offer higher speeds to customers than Clearwire’s WiMAX, while Sprint’s 3G coverage has also been the subject of user complaints. These factors have been contributing to the defection of Sprint’s customers to rival networks. As part of its Network Vision project, Sprint is trying to phase out iDen gradually and consolidate its network holdings into one 2G/3G network using a combination of CDMA and EV-DO. This would not only reduce operating expenses substantially, but also allow for better 3G coverage and reduce roaming costs as the spectrum previously used for iDEN would now be available for the CDMA network. The company also plans to roll out 4G LTE, which would likely eventually replace WiMAX, in order to compete with rivals’ 4G networks. We expect this long-term strategy will help stem postpaid market share losses and also improve margins.

Near-Term Capex Spike Should Help Margins

Sprint’s network costs will increase rapidly as it rolls out its own 4G LTE network by mid-2012 and funds Clearwire’s LTE plans. The company will also be spending significant capital on the Network Vision project. These rising costs led the company to issue capital expenditure guidance of approximately $3 billion for 2011, a jump of more than 30% over last year. The company also increased its capex estimates related to the LTE rollout and Network Vision to about $10 billion in 2012 and 2013. ((Sprint Nextel Reports Third Quarter 2011 Results, Sprint Press Release, Oct 2011))

After 2013, we estimate a sharp decline in capital expenditures as the company completes its LTE build-out and gradually phases out the iDen network. Sprint’s stock is, however, highly sensitive to its capital expenditures. You can see how the stock price plummets when you tweak the trend-line to increase capital expenditures over the forecast period in the chart below. We think the current market price reflects this sensitivity, as the market likely doesn’t have confidence in management’s guidance.

High Debt Could Derail the Stock

While we believe the market’s response has been somewhat exaggerated, it’s not entirely unwarranted. Liquidity concerns arising from excessive debt on its balance sheet will continue to be a major deterrent to its business, and should this strategy not pay off, Sprint could be in dire straits. (see Sprint Plunges on LTE Expansion Costs, May Tap Capital Markets) On the other hand, if the company is able to grow its postpaid user base by selling the iPhone and execute its Network Vision plan successfully, its long-term prospects look very promising.

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