Sprint Corporation Valuation - Texas Tech University

[Pages:54]Sprint Corporation Valuation

April 1, 2005

Andrea Armenta Brianne Braudt David Dencklau Kent Ewalt Matt Milatoni

armenta_a83@ angelgirl125@ d_dencklau@ kewalt@ mjmilantoni@

Table of Contents

Executive Summary..................................................................... .............3 Business & Industry Analysis.............................................................................................6

Company Overview..............................................................................6 Five Forces Model................................................................................6 Competitive Strategy Analysis.................................................................9 Accounting Analysis................................................................................11 Key Accounting Policies.......................................................................11 Potential Accounting Flexibility..............................................................12 Strategy Analysis...............................................................................12 Quality of Disclosure...........................................................................13 Potential Red Flags.............................................................................14 Ratio Analysis & Forecast Financials............................................................17 Ratio Analysis...................................................................................17 Forecasting the Financial Statements.........................................................25 Valuations Analysis..................................................................................29 Method of Comparables........................................................................30 Discounted Dividends..........................................................................33

Cost of Equity...............................................................................33 Discounted Free Cash Flows...................................................................35

Cost of Debt.................................................................................35 Weighted Average Cost of Capital.......................................................36 Discounted Residual Income...................................................................37 Abnormal Earnings Growth...................................................................38 Long Run Average Residual Income Model.................................................39 Z-Score...........................................................................................39 Conclusion........................................................................................40

References............................................................................................41 Appendix.............................................................................................42

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Executive Summary

Plan for Paradise

DEBAM Investment Group

Analysis of Sprint Corp

Investment Recommendation:

Sell

Evaluators: Andrea Armenta, Brianne Braudt David Dencklau, Kent Ewalt, Matt Milantoni

Date of Valuation: April 1, 2005

NYSE: FON

52 week price range Revenue (2004) Market Capitalization

Shares Outstanding

Dividend Yield 3-month Avg Daily Trading Volume Percent Institutional Ownership

Book Value per Share ROE (2004) ROS (2004)

Cost of Capital Estimates Ke Estimated 5-year Beta 3-year Beta 2-year Beta Published Beta

Kd

WACC(bt)

$22.74 $16.83 - $25.80

27.43 Billion 34.78 Billion

1.48 Billion

2.11% 12,555,409

80.58%

EPS Forecast For the Year Ended:

EPS

2005 2006 2007 2008 2009 2010 2011 2012 2013 (0.28) (0.28) 0.07 0.27 0.50 0.74 1.01 1.31 1.62

Valuation Ratio Comparison Trailing P/E Forward P/E Forward PEG M/B

Sprint

N/A 14.96 N/A 2.48

Industry Average

13.53 14.35 N/A 2.21

$9.17 -7.67% -3.69%

Valuation Estimates

Actual Current Price (April 1, 2005)

$22.74

Beta

1.357 1.898 0.820 1.342

5.09% 6.10%

Ke

8.158% 9.781% 6.547% 8.113%

Ratio Based Valuations P/E Trailing P/E Forward PEG Forward Dividend Yield M/B Epic Valuation

Intrinsic Valuations

Discounted Dividends Free Cash Flows Residual Income Abnormal Earnings Growth Long-Run Residual Income Perpetuity

21.76 N/A N/A 9.36 20.26 30.35

6.20 59.26 13.56 13.85 20.67

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Sprint Corporation is in the business of global communications for both residential and business customers. They are comprised of two divisions: Sprint PCS, a 100% digital wireless communications service, and Sprint FON, the number one local fixed-line provider next to the Baby Bells. Between these two divisions, Sprint offers long-distance, local, and wireless communication services to its customers on local, national, and global levels.

Sprint currently has a market cap of 34.78 billion. In 2004, they had revenues of over 27 billion but ended up with a net loss for the year of 1 billion. This follows net income of 1.3 billion in 2003 and .6 billion in 2002. Although Sprint was able to increase its revenues in 2004, offsetting increasing in expenses and the lack of nonrecurring income items found in 2003 and 2002 resulted in a net loss for the company.

Sprint competes in a fairly competitive environment. Rivalry among existing firms is high, fueled by increasing concentration as more and more telecommunications providers merge and low switching costs for customers. Sprint also must be aware of the threat of substitute products. For its FON division, this comes from the growth of the mobile phone industry. For its PCS division, this comes from the increasing use of the Internet and e-mail to communicate as well as from high-speed internet phone companies such as Vonage. On the other hand, the threat of new entrants is relatively low due to large startup costs and the bargaining power of both buyers and suppliers is low considering Sprint's size.

Sprint competes by differentiating itself from its competitors. Sprint's main strength is its ability to provide customers with tailor-made solutions by combining its wireless, wire line, local, long distance and global services. Sprint's key success factors include its emphasis on innovation of service alternatives, customization of business solutions, cutting edge products and services, and cost efficiency.

In evaluating Sprint's accounting policy, we found that Sprint is fairly conservative in its choice of accounting methods. We also found that the quality of disclosure for Sprint is moderate. Although some information was aggregated, Sprint was open about presenting both bad and good news with its shareholders. Sprint's website2 proved a clear and easy to use source of information. Overall, we feel that Sprint provides the information necessary for investors to make an appropriate analysis. We also computed sale and core expense manipulation ratios for Sprint and two of its competitors. We found that Sprint's ratios tended to be similar to those of their competitors. Based on our research, we felt that Sprint's financial statements were accurate and did not need to be restated.

We forecasted the financial statements of Sprint Corp for the next ten years using information from the prior five years. We used pro forma financial statements of the past five years as well as liquidity, profitability, and capital structure ratios to identify trends in computing our forecasts. After considering Sprint's sustainable growth rate, average growth rate, and other analysts' opinions5, we calculated that Sprint's revenue will grow at 3.2% per year. This results in revenues of 37.5 billion in ten years. Based on our

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forecasts, we believe Sprint will grow, but only very slowly because they are not able to transfer much of their revenues to their bottom line. Forecasted net income in ten years is only 1.1 billion out of 37.5 billion in revenue. Finally, we valued Sprint using multiple valuation models. Using the method of comparables produced mixed results. The forward P/E, Market to Book, and Price/Sales ratios came closest to Sprint's observed price of $22.74. Three of the four intrinsic valuation models (discounted dividends, discounted residual income, and abnormal earnings models) resulted in Sprint being overvalued. The discounted free cash flows resulted in Sprint being undervalued by nearly $30. This is clearly an outlier and was discarded. The discounted residual income model and the abnormal earnings growth models both found that Sprint is overvalued by around $8.00. We computed a cost of equity between 6.5% - 9.7% and a cost of debt for Sprint of 5.1%. This results in a weighted average cost of capital of 6.1%. Clearly, our valuation will change based on which cost of equity is used. We performed a sensitivity analysis for each valuation model to see the effect of changes in the cost of capital and the growth rate assumed for each model. Even allowing for these changes, we still found that Sprint was overvalued. Given our in-depth analysis and countless man-hours of research, we believe that Sprint is overvalued and recommend it as a sell.

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Business and Industry Analysis

Company Overview

Sprint Corporation specializes in global communications for residential and business customers. Among their services are long-distance, local service, and wireless communications. Sprint Corporation is comprised of two divisions: Sprint PCS, a 100% digital wireless communications service, and Sprint FON, the number one local fixed-line provider next to the Baby Bells. The FON Group includes Sprint's global market division, local division, and other business activities, including wholesale distribution of telecommunication products and operation of a transatlantic Tier 1 internet backbone network. The purpose of this report is to analyze Sprint Corporation in relation to its competitors in the industries in which it operates. We first analyze the industry using the Five Forces Model and then discuss Sprint Corporation's competitive strategy.

Five Forces Model

The Five Forces Model provides a framework for analyzing the potential profits in a given industry. The factors that affect profitability include the degree of actual and potential competition, as measured by the rivalry among existing firms, the threat of new entrants, and the threat of substitute products, and the bargaining power in input and output markets, as measured by the bargaining power of buyers and the bargaining power of suppliers. We discuss each of these factors for Sprint Corporation in the next several pages.

Rivalry Among Existing Firms

Rivalry among existing firms is determined by several factors, including industry growth, industry concentration, the level of differentiation, switching costs, scale and learning economies, excess capacity, and exit barriers. We discuss each of these individually.

Industry Growth

The wireless communications industry has been growing quickly due to the increasing need for mobility. Switching from analog to digital wireless networks has also encouraged the rapid growth. However, with competition increasing and new customer subscriptions declining except in underdeveloped nations, price competition is becoming more prevalent. Wireless internet access may provide an important opportunity for additional growth in the industry.

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In the fixed line industry, deregulation in the form of the Telecommunications Act of 1996 has opened the door for anyone to offer service. Growth in this industry has slowed with the increase of wireless communications as services like the internet and e-mail lessen people's reliance on fixed line communications. With more than 90 million miles of fiber-optic cables constructed by U.S telecom companies across the nation with up to 90% unused capacity, there is plenty of opportunity for the industry to meet future demand growth for services such as broadband communications.

Concentration

The Wireless industry is dominated by several merged companies including Verizon Wireless (Verizon and Vodaphone Group), Cingular Wireless (SBC Communications, Bell South and recent acquisition, AT&T Wireless), and Sprint PCS. As a result of deregulation in 1996, there are now many smaller players in the telecommunications industry. Verizon Communications, SBC Communications, Bell South and Qwest Communications International are the four "Baby Bells" that still dominate local phone services and the roll out of DSL broadband access. With just few major companies controlling the majority of the telecommunications industry, prices are not as low as they will become as more competition develops in the future.

Differentiation/Switching Costs

With the major carriers of wireless and telecommunication companies using relatively similar technologies, there is little differentiation between competitors except for usage plans and equipment styles. The major switching costs in the wireless industry are long contracts, large penalties for early contract termination, and purchase costs for new hardware. Switching costs for the fixed line telecommunications industry are minimal, consisting of moderate setup fees and hardware costs.

Scale/Learning Economies

The sheer size and dominance of the major companies in both industries makes gaining any significant market share by newcomers difficult. With billions of dollars spent by wireless companies for third generation licenses and the debt incurred from network development, it will be difficult for new entrants to afford to compete in the wireless industry.

Excess Capacity/Exit Barriers

There is excess capacity in both the wireless and the fixed line telecommunications industries causing price competition to intensify. Also price wars will escalate as it is

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extremely costly to exit the industries given the huge amount of money invested in capital and Research and Development.

Threat of New Entrants

In the past, the telecommunication industry was very hard to break in to. Now, the Telecommunication Act of 1996 has deregulated the industry. The act was passed to help stimulate competition and make it easier for new, start-up companies to jump into the mix and compete with the big boys of the industry. The large established corporations still have the upper hand against new firms entering the market. The industry requires a tremendous amount of capital that established corporations already have. New entrants would find it difficult to raise that capital and compete with the established corporations. Another problem new entrants face is getting licensed, which is costly. This process can also be very lengthy. The threat of new entrants is a possibility that Sprint Corporation must consider, but is not a major factor. Sprint has established relationships with customers and suppliers that take time to develop. They already have their research department established and are coming up with new technologies and ideas to stay one step ahead of their competition.

Threat of Substitute Products

The FON Group faces a huge threat from the continuing growth of the mobile phone. Cell phones are beginning to take the place of land lines as the primary communication device for most households. In conjunction, the Internet and e-mail are also helping with the lapse of land line phones. Meanwhile, the PCS Group is Sprint's bread winner as the wireless communication industry continues to build.

A threat to the wireless communication industry comes from the new kid on the block: high-speed internet phoning. Companies like Vonage are potential threats to Sprint PCS because with wireless internet you could, in a sense, take your computer with you and always have a phone to make unlimited calls to anywhere. Some of Sprint's competitors have counted on the new idea and are continuing to diversify themselves into this new technology. Verizon, for instance, is now offering this new service through what they call VoiceWing.

Bargaining Power of Buyers

Overall, the bargaining power of buyers has a low impact on Sprint Corporation. The bargaining power of buyers is composed of two factors: price sensitivity and relative bargaining power. The price sensitivity of buyers for Sprint's products varies. On one hand, buyers are very price sensitive for commodities. One example of this is the local and long-distance telephone services provided by Sprint's FON component. There is little differentiation among local and long-distance telephone services and switching costs

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