TMUS: Wireless Ain’t What it Used to Be

sagawa

We believe that TMUS is worth $55-60 based on projected future market share gains and margin improvements. It is winning a zero-sum game in the increasingly stagnant US wireless market, as consumer priorities shift from voice coverage to data service, flexibility and pricing. The market leading duopoly of VZ and AT&T cannot afford to follow TMUS’s bold “Uncarrier” initiatives and aggressive pricing for fear of killing their cash flows, while S remains mired in a never ending turnaround. We also see TMUS as well suited for potential future wireless growth markets, such as residential broadband, IoT, Automotive and others. Against this, top line expansion will yield leverage against TMUS’s network, spectrum and customer acquisition investments, including an anticipated $10B investment, at a FCC sanctioned discount, in the 600-700 MHz spectrum block to be auctioned in 2016. All of this could drive 50% upside to the current market valuation. A combination with DISH or S could yield operating synergies worth an additional 25% to the base valuation.

US mobile wireless is a mature business. Wireless carrier sales were down (1.7%)  YoY in 1Q15, capping a 15-month slide from robust 7.4% growth in 4Q13. Market saturation is a major concern – total sub growth has decelerated to 4.3% in 1Q15, with total penetration up to 110% and smartphones representing 75.6% of the mix. Add to this ARPUs that appear to have peaked under pressure from TMUS’s aggressive pricing, a harbinger of future deflation across the industry. Despite this, analyst estimates for the 4 major US carriers project a return to sales growth, accelerating into next year. We are not so optimistic, and expect total US mobile wireless service revenues to trend down going forward.

The basis of competition is evolving. In the early days of smartphones, VZ and T were able to exploit their early 4G builds, and coverage advantage – plus T’s iPhone exclusivity – to drive sub gains and ARPU growth. 8 years into the smartphone era, TMUS’ 4G speeds and availability now exceed the big 2 in many major markets, and data performance, usage/upgrade policies, and price trump service coverage as a buying criteria for many consumers. The duopolists, with 75% collective market share to lose and 5.3% average cash flow yields to protect, are trapped in the classic incumbent’s dilemma, facing attack from below but hesitant to respond for fear of cannibalizing their own profits.

TMUS is winning the zero-sum game. TMUS is the only carrier posting sales gains, as it continues to churn subscribers from its 3 rivals with its customer friendly “uncarrier” moves – unbundling device sales, liberalizing usage terms, adding free bundled perks (zero rated music, international roaming), and cutting prices. Accompanied by an aggressive, hip advertising and promotional campaign, these moves have driven 260bp of share gain in the two years since the introduction of “Uncarrier 1.0” which set low, simple rate plans and eliminated bundled phone subsidies. As expected, VZ and T’s complacency and S’s bungled operations have allowed TMUS to build considerable momentum.

Top line growth feeding bottom line profits. The very high fixed cost, very low marginal cost nature of the wireless communications business rewards market share leadership and high prices. This dynamic sees TMUS operating with its COGS + depreciation at 2/3rds of sales, substantially more than T (59%) or VZ (52%). While TMUS anticipates significant further CAPEX to license additional low-band spectrum and expand its network to address its coverage and in-building deficits, its relatively underutilized capacity in more densely populated markets is considerable asset in its subscriber growth driven strategy. With time, we believe the resulting sales growth will narrow the COGS+D gap vs. the duopoly and yield significant margin and cash flow expansion.

Spectrum is a key variable. In the beginning, VZ and T’s wireless networks were endowed with lower frequency spectrum that enabled significantly wider coverage at significantly lower cost than either TMUS or S. This advantage widened with the duopolists’ acquisition of the biggest swaths of 700MHz spectrum auctioned in 2008. Another 80-100MHz of this unusually valuable spectrum will be auctioned in 2016. The FCC currently plans to restrict VZ and T from bidding for 30MHz of this block, a limit that TMUS has lobbied hard to expand and that the leaders propose be eliminated. We believe that the FCC will likely proceed with the current rules proposal and that TMUS will obtain at least 10MHz filling in important gaps in its coverage map and supporting its current service in its top markets. It is possible that partners (GOOG, DISH, etc.) could also acquire spectrum that would work to TMUS’ benefit.

There will be new opportunities. The internet of things, including connected automobiles, could be a new source of revenue for mobile operators, likely with a severe price sensitivity that will benefit lower margin operators like TMUS. We also believe that “5G” technology, based on a standard expected for 2018, will allow wireless to effectively compete with fixed residential wireless.

TMUS worth 50% upside to current valuation. Assuming 10.4% 5 yr annual sales growth and an expansion of operating margins from 6.4% to 17.7%, we believe TMUS shares are worth $55-60. This assumes that the company is able to license at least 10MHz in the 700MHz band auctions for roughly $10B, spurring an increase to 20% subscriber share by 2019 as coverage sensitive consumers begin to churn. We are not factoring significant revenues for IoT or residential broadband, but expect both to be important growth markets post 2020.

M&A or partnerships cold enhance value. TMUS is an often rumored object of acquisition interest. Of potential buyers, we see S as having the most synergy – assuming a post 2016 FCC would allow a deal – able to leverage spectrum assets, existing subscribers, and network operations to drive costs lower. DISH is also an obvious match, with 50MHz of unused spectrum nearly adjacent to TMUS’ primary holdings, a potentially synergistic video business, and similarly pugnacious approach to competition, although financing could be an obstacle. Either of these could add $10-20/share to our valuation. GOOG is already partnering with TMUS for its Fi MVNO and could be a source of capital for network expansion. We are less optimistic in a CMCSA acquisition, given its previous lackluster moves in wireless and a lack of obvious operating synergies.

Please see our published research page for the full note.

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