At WideAlpha we developed, and internally employ, a machine learning algorithm that we nicknamed AlphaPilot™. It uses advanced AI techniques, including neural networks and a variation of hidden Markov models to find companies that will markedly outperform in the next 3 to 5 years.
One of the top ideas that AlphaPilot gave us for the month of March was surprising in multiple ways. The algorithm usually recommends high-quality growth companies at a reasonable price (GARP), but it sometimes comes up with deeply contrarian value plays. The last time it recommended such an unpopular company was with Macy’s (NYSE:M) last October when it was trading around $22 a share. The share price actually went much lower after AlphaPilot’s recommendation, touching $18 per share, but it has since rebounded in a spectacular fashion.
We think Sprint (NYSE:S) could have a similar outcome, and there are clear similarities in the situation. Both are companies in an industry experiencing headwinds, shunned by most investors, carrying high levels of short interest. Both companies have been working hard to turn the business around, are showing signs of improvement in key metrics, and have valuable hidden assets that are undervalued by the market. In Macy’s case, it was real estate, in Sprint’s case, it’s the valuable 5G spectrum they own. Finally, both companies are finding smart ways to leverage these assets that are under-appreciated by the market.
The other reason we were surprised by this recommendation is that we follow SoftBank (OTCPK:SFTBY) and Masayoshi Son, who happen to own a controlling stake in Sprint. We have written articles on SoftBank before and have to admit that Sprint was far from being what got us interested in investing in SoftBank shares.
Looking under the hood one starts finding some green shoots of what could finally be a turnaround into sustainable profitability. Debt levels have more or less stabilised and the company is finally generating some non-negligible free cash flow. At the same time, the valuation has come down with an undemanding EV/EBITDA of ~4.7.
What is even more promising is that for the last few years, the operating margin has been showing a clear improvement trend.
Despite the margin improvement, the market is currently valuing Sprint’s revenues at less than half what it values the revenues of its closest competitors, including T-Mobile US (NASDAQ:TMUS), Verizon (NYSE:VZ), and AT&T (NYSE:T). While arguments can be made in each case on why they deserve a higher multiple, we believe a >2x difference is not justified.
Some of the turnaround signs the company is highlighting include a significant reduction in operating expenses of over a billion dollars, the highest adjusted EBITDA in eleven years, significant network improvement based on download speeds, and the highest retail customer additions in three years.
The turnaround is more evident when seeing the improvements the company has made over the last five years. The company has gone from horrible losses to a stable condition. We find the improvement with respect to free cash flow to be the most impressive of all, increasing by ~6B into positive territory.
The turnaround momentum could actually accelerate after Sprint hired as CFO Michel Combes, an industry veteran who has turned around telecom businesses in the past.
For more than 30 years, Combes, 55, has led telecommunications and cable companies including wireless, wireline and equipment manufacturers. He is globally respected as a turnaround strategist who achieves success through a mix of growth and cost management. Most recently, he served as CEO, and previously Chief Operating Officer, of Altice N.V., a convergent global leader in telecom, content, media, entertainment, and advertising, and chairman and CEO of SFR Group, a leading French telecommunications and media company. During his tenure he led the company through the integration of newly acquired U.S. businesses, developed significant partnerships and media rights to bring exciting and in-demand content to its customers.
Combes delivered two of the most successful turnarounds in the telecommunications industry in recent history. In 2013 he joined Alcatel-Lucent when the company was near bankruptcy. As CEO, he helped strengthen the company and orchestrated its sale to Nokia. From 2003 to 2006, Combes held various senior financial positions with France Telecom, including CFO and Senior Executive Vice President for Financial Rebalancing and Value Creation. When he joined the company it was the second most indebted company worldwide in terms of short-term liabilities. During his tenure, he oversaw the operational transformation of the company and led the financial restructuring of the business which allowed the struggling company to rebrand as Orange, now the largest fixed and wireless telecommunications operator in France.
To accelerate a turnaround and gain scale to better compete, Sprint was looking to merge with T-Mobile US. However, the merger negotiations were called off when the companies could not agree on the terms. After the merger with T-mobile was called off, the share price declined and short interest increased. SoftBank took advantage of this price decline to buy more shares in the open market.
One key asset that Sprint has to gain ground against the competition is the massive 5G spectrum it owns. As the world transitions from 4G to 5G, Sprint should find itself in a much better position.
Sprint’s CEO Marcelo Claure recently made the following comment on how these assets and technology can help the company:
Competitors won’t be able to do 5G speeds. We will offer new applications no one else can offer and there will be no reason to continue discounting. In the meantime, we will be the price leader with some modest price increases.
One can also see that the company is quite confident on its 5G advantage when looking at its ads:
Another key advantage that Sprint has is having SoftBank on its side. As a world leader in the wireless industry, SoftBank can share technology, network management expertise, and its strategic relationships with mobile phone manufacturers. This creates valuable synergies and operating efficiencies for both companies.
Despite the significant debt load, the company at least has enough liquidity in the short term to meet its current maturities and to start the transition to 5G. If it is able to show traction and continuing improvement, the markets should continue to provide financing to the company.
Source: Sprint investor update
We see the following catalysts for Sprint to unlock shareholder value:
- Re-entering negotiations to merge with T-Mobile US or another partner.
- Continuing with the turnaround improvements, going from a stabilised company to a solidly profitable one.
- Improving financing costs and liquidity, potentially with more spectrum-backed bonds, or other spectrum monetization strategies (e.g. renting some to competitors)
- Partnerships leveraging the 5G capabilities and spectrum Sprint owns.
As we were finishing this article, the news broke out of SoftBank building a stake in Charter Communications (NASDAQ:CHTR). There is speculation SoftBank could be looking to push for a merger between Sprint with Charter Communications. These would position both companies to compete a lot better against their bigger rivals.
If the company is able to complete its turnaround strategy, it could mostly close the gap with its competitors in terms of what the market is willing to pay for its revenues, implying more than a doubling in the share price.
This is not a sleep easy at night investment due to the amount of leverage, as well as the number of headwinds in the industry. It should therefore be viewed more like an option with a long expiration period.
That said, the potential for an incredible turnaround is there. If the company continues to execute its turnaround strategy and leverages its valuable assets, 5G spectrum and support from SoftBank, it can become an incredibly valuable company.
Disclosure: I am/we are long S, SFTBY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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