Sprint’s (NYSE:S) recent earnings announcement may have lit a fire under the stock but several risks still remain. The company saw revenues grow 6% y-o-y and generated $209 million of positive cash flow during the quarter despite incurring expensive iPhone subsidies and heavy capital expenses on the execution of its Network Vision strategy. This came on the back of another strong quarter of postpaid net adds to the Sprint core platform (CDMA), as the iPhone brought in a good number of new subscribers and increased ARPU.
iDEN death will slow down subscriber growth a year from now
However, most of the net adds that Sprint posted on its core platform were recaptured from the iDEN network it is shutting down. During the Q2 earnings call, Sprint said that it had managed to migrate 431,000 of the total subscribers that left its iDEN platform to its core Sprint CDMA network. Moreover, the percent conversion rate has been increasing in the recent quarters as the iDEN shutdown nears. Historically, the company has managed only a 25% conversion rate, but over the last three quarters, the figure has increased to 39%, 46% and 60% respectively.
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What this means is that the strong Sprint platform net adds that we have seen in the last few quarters have mostly come from its own outdated iDEN network and not its competitors. Excluding these additions, Sprint added only about 65,000 subscribers to its CDMA platform. Once this ready source of subscribers is closed down (Sprint expects to shut down iDEN by mid-2013), Sprint may have a tough time finding new subscribers.
This is however reflective of the broader industry trend of an increasingly saturated market with slowing subscriber growth at both the top wireless carriers, Verizon and AT&T. Both of the carriers have seen decreasing y-o-y growth in postpaid net adds, with the iPad boosting their overall numbers quite a bit. While the iPad carries no subsidies, it brings in fewer revenues per subscriber and is hence not as valuable as a smartphone. It is therefore a good sign that Sprint has increased its iDEN recapture rate while it can and boosted its postpaid subscriber base so far this year. With the wireless market increasingly saturated, subscriber growth will be far less important than profitability, going forward.
From a profitability standpoint, betting on the iPhone has allowed the company to grow its retail postpaid ARPU by 7.4% y-o-y, the most among its peers. The iPhone accounted for about 600,000 new subscribers to Sprint, 40% of its total iPhone sales. Banking on its unlimited plans, Sprint managed to increase its market share of iPhone sales as well, keeping its iPhone sales flat in a quarter both Verizon and AT&T saw sequential declines of 14% and 16% respectively.
The high number of iDEN subscribers that shifted to Sprint’s core CDMA platform in the last few quarters will help push the overall postpaid ARPUs further up going forward since iDEN postpaid ARPUs are lower than Sprint platform ARPUs. Postpaid ARPUs will also continue to be positively impacted by an increasing iPhone penetration and the $10 premium add-on charge that Sprint had started levying on all smartphone activations in 2011.
CapEx headwinds could limit cash flow
Meanwhile, the risks from its highly leveraged balance sheet and an ever-growing capital spend due to the ongoing implementation of its Network Vision strategy still persist. So far, it has spent only about $2 billion of the $6 billion it plans to spend on LTE infrastructure, 3G upgrades and iDEN shutdown this year. The remaining $4 billion spend could negatively impact free cash flow generation in the coming quarters. Sprint is highly sensitive to capital expenditures, as can be checked by moving the trend line in the forecast chart below and following the corresponding impact on its price estimate.
However, while the Network Vision plan is very expensive, a successful implementation of the strategy will reduce the operating expenses substantially by eliminating the duplicate fixed costs of maintaining different networks. It will also allow for better 3G/4G coverage and reduce roaming costs as the spectrum previously used for iDEN would be utilized for the CDMA/LTE network. (see Sprint To Build LTE Over iDEN’s Grave) Rolling out an LTE network will also help it improve its service gross margins since it is a more efficient network to manage than the existing 3G networks. The positive impact on profits was seen last quarter when Sprint improved its adjusted OIBDA margins by 277 basis points sequentially and 69 basis points over the same period last year.
Improving visibility of the benefits of the iPhone as well the Network Vision plan has helped move the stock up by over 25% since the earnings call. However, we believe that risks surrounding its high debt levels (almost $26 billion in debt on the balance sheet as compared to a market cap of $13 billion) and burgeoning capital expenses still exist, as reflected in our price estimate of $4 for Sprint, about 7% below the current market price.