Sprint’s (NYSE:S) shares have rallied sharply in recent weeks, surging by close to 25% in November on increasing optimism that the carrier’s recently announced Spark strategy will bolster its competitive standing in the wireless industry. Unveiled toward the end of last month, Spark heralds the coming together of two landmark deals that Sprint signed in recent months – the $21.6 billion deal with Softbank acquiring a majority 78% stake in the company, and the Clearwire acquisition funded by Softbank’s cash. The two deals, along with the ongoing Network Vision plan which has freed up iDEN spectrum for LTE, have helped Sprint gain an enviable spectrum position in the industry. Sprint now plans to consolidate its spectrum assets – in the 1.9GHz, the iDEN 800MHz and the Clearwire 2.5GHz frequency bands – into a single tri-mode LTE network that can deliver 4G speeds of 50-60 Mbps and beyond. By pushing LTE speeds beyond 50 Mbps, the Spark network modernization plan will put Sprint well ahead of the 10-20 Mbps downlink speeds currently prevalent in the industry, and help it gain a much-needed competitive edge over rivals Verizon (NYSE:VZ), AT&T (NYSE:T) and T-Mobile.
However, given Sprint’s lagging LTE coverage and the slow pace of TD-LTE deployment, the carrier will continue to face competitive pressures on market share in the near term. This, together with the sustained high CapEx spend in the initial stages of Spark’s deployment, should continue to have a downward impact on cash flows in the coming quarters. However, we are more optimistic about Sprint driving greater efficiency in its long-term CapEx spend as it increasingly deploys TD-LTE on the higher-capacity unpaired spectrum. As a result, we have a revised $7 price estimate for Sprint – about 10% ahead of our previous estimate, but still 15% below the current market price.
The Spark Advantage
Sprint has so far looked to differentiate itself from rivals with unlimited data plans, which have helped it maintain its niche in an industry that is rapidly moving toward tiered data plans. While heavyweights Verizon and AT&T long ago stopped offering unlimited plans and are instead promoting new tiered plans that can be shared across multiple devices, Sprint has steadfastly hitched itself to unlimited plans, even going so far as to offer a lifetime guarantee on these plans. However, this ploy hasn’t worked particularly well in recent quarters, as the carrier suffered continued postpaid subscriber losses due to heightened competition and deficiencies in its LTE coverage. While Verizon has completed its initial LTE build-out and covers over 300 million people currently, AT&T is on course to cover 270 million PoPs with LTE by the end of 2013. On the other hand, Sprint plans to have an LTE coverage of 200 million Americans by year-end. Even T-Mobile, which started its LTE build-out much later than Sprint, has raced ahead with over 200 million PoPs under LTE coverage currently and further expansion plans afoot.
It is in this context that the importance of the Spark strategy comes to the forefront. By helping Sprint catch up in LTE coverage and potentially lead the industry in terms of data capacity and speeds, Spark will finally give the carrier a compelling advantage to differentiate service rather than pricing. This is important for the long-term ARPU growth of the company, which is currently limited by itsover-reliance on unlimited plans. With data demand surging, offering subscribers access to unlimited data could prevent Sprint from capitalizing on the future growth in data usage as LTE speeds become ubiquitous. By differentiating on data speed and capacity, Sprint could come up with innovative speed-based tiers at premium pricing to mitigate the long term impact of its unlimited data plans. We also expect a successful implementation of Spark to help Sprint’s subscriber trends improve, as reflected in the chart below, as the carrier launches its enhanced LTE network in new cities and aggressively markets its speed advantage over rivals in the later part of next year.
However, the pace of these changes will likely be slow. The 2.5 GHz Clearwire spectrum, on which Sprint plans to deploy the faster TD-LTE network, doesn’t propagate as well as the lower frequency bands. This means that the radios operating on this frequency have more limited coverage and are therefore required to be bunched together more densely, increasing costs and the time of deployment. Currently, Sprint’s TD-LTE service is available in five cities and even in these cities not everyone on the carrier’s network can access it. Going into 2014, the issue should persist for a major part of the year as Sprint expects to cover only about 100 million PoPs with TD-LTE by the end of the year. So, while Spark will provide higher speeds than competing networks, its coverage will likely not be large enough to mitigate near-term competitive pressures.
Also, for TD-LTE to flourish, Sprint needs to secure the support of device makers such as Apple and Samsung. Currently, most LTE networks – including Sprint’s initial roll-out – are built on FDD-LTE, which uses paired spectrum unlike TDD which uses unpaired. Apart from combining these technologies, Sprint’s LTE network will have the added complexity of using three different frequency bands, which further limits the number of smartphones that can access its tri-band network initially. Currently, only four smartphones – the HTC One max, LG G2, Samsung Galaxy Mega and Samsung Galaxy S4 mini – can do so. The iPhone, which accounted for 30% of Sprint’s smartphone activations in Q3, doesn’t yet. Going forward, Sprint needs the right mix of smartphones to promote its tri-band network, without which it may not derive as much of a competitive advantage from the network as it seeks.
High Near-Term CapEx
Without the requisite number of compatible flagship smartphones and with limited TD-LTE coverage, we do not expect Sprint’s market share losses to reverse for the next year at least. At the same time, the expensive implementation of Spark will depress cash flows in the near term. Sprint’s capital expenditures have increased substantially this year, and we expect this to continue in the coming quarters as the carrier builds out TD-LTE on Clearwire’s spectrum and expands coverage using the 1.9GHz and 800MHz iDEN spectrum. The carrier is on track to incur about $8 billion in capital expenditures this year, almost 50% higher than last year, and we expect a similar level of expenses in 2014 as well.
Going forward, however, we have revised our CapEx projections downward to account for the more cost-efficient nature of operations after the company has completed the Spark program. Building a TD-LTE network on unpaired 2.5GHz spectrum may require higher expenses initially, as it requires the deployment of a greater number of radio stations as compared to the lower frequency bands for the same coverage footprint. However, the higher data capacity of unpaired spectrum will help cut costs going forward as the carrier incurs lower expenses to add capacity and support burgeoning future data demand. In order to arrive at our long term CapEx estimate for Sprint, we have taken the average of the carrier’s historical CapEx spend per mobile subscriber over the past eight years, which turns out to be about $85 per year and is similar to the averages for Verizon and AT&T. Using this estimate, we arrive at a long term CapEx spend of $4.5 billion for Sprint, about 10% lower than our previous estimate. This has increased our price estimate for Sprint up by about 10% to $7.