A Sprint-T-Mobile Merger Would Make Financial Sense, But It’s Unlikely To Materialize

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There has been renewed speculation that T-Mobile (NASDAQ:TMUS), the third largest U.S. wireless carrier, could be looking to be acquired, given the possibility that the new Presidential Administration could be more amenable to consolidation within the telecom industry and the openness of parent company Deutsche Telecom to pursue a deal, after the completion of the ongoing spectrum auction. There could be several potential suitors, ranging from cable firms – who see value in entering the wireless space to bolster revenue and reduce churn by cross selling wireless services to their subscribers – to internet giants such as Google, who are looking to disrupt the wireless business model. However, a deal with Sprint (NYSE:S), which considered buying T-Mobile back in 2014, could make the most economic sense, given the significant overlap between the operations of the two companies and the related synergies.

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Scope For Cost Synergies Is Considerable 

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Running a wireless network calls for high fixed costs and at a base level, these costs are independent of the number of subscribers that a carrier has. Moreover, these costs are typically higher for U.S. carriers, given the country’s large geographic area, which calls for a greater number of cell sites. During 2015, T-Mobile incurred cost of services expenditure of roughly $5.5 billion, while Sprint’s cost of services stood at ~ $8 billion (likely due to higher backhaul costs). In comparison, Verizon‘s (NYSE:VZ) cost of services stood at just $7.3 billion, despite the fact that its wireless customer base (~112 million subs) is almost as large as Sprint and T-Mobile’s combined. If Sprint and T-Mobile were to merge, there could be significant savings relating to cell site costs such as rent, maintenance, utilities and labor costs. There could be significant scope for reduction in SG&A expenses (which stands at ~$19 billion combined) as well , given the scope to cut down redundant marketing, distribution and administrative spending and also due to the possibility of lower subscriber churn, which limits customer acquisition costs.

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If we assume that the combined entity is able to cut total costs by just about $1 billion for the first year post closing, with cost savings coming in at $2 billion in year two and remaining at ~$3 billion from year three to perpetuity, the present value of synergies after tax (35% tax rate and 9% discount rate) would stand at roughly $20 billion according to our estimates. This could add considerable value for Sprint shareholders, while justifying a significant premium over T-Mobile’s current market price.

Obstacles Remain Significant 

However, despite the strong economic rationale, there are significant obstacles. Firstly, Sprint remains heavily indebted, with net debt standing at over $31 billion, and the carrier has had to resort to improving liquidity by mortgaging its core assets and slashing costs. Sprint’s parent firm Softbank also has its hands tied to an extent after it announced a $32 billion deal to buy British chip designer ARM Holdings earlier this year. Separately, the competition between T-Mobile and Sprint in recent years has actually been very healthy for the U.S. wireless market, fostering a lot of service innovation while helping to keep pricing in check. This could give the deal an appearance of being anti-consumer, resulting in significant regulatory obstacles.

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