Investors and analysts have long figured that Sprint eventually would recombine its two tracking stocks: FON (FON), which represented the traditional phone company, and PCS (PCS) for the wireless business. Sprint's board has been discussing a potential recombination for nearly two years, as tracking stocks, a fad from the market's bubble days, have fallen out of favor. What Sprint watchers could only guess at was the timing of the recombination, the details of how the shares would be converted, and whether the stocks would trade up, down, or flat as a result.
As it turns out, the news could hardly have gone better for Sprint shareholders. When investors got a chance to act on the Sunday, Feb. 29, announcement that the PCS shares would be absorbed into FON, both tracking stocks immediately traded higher and kept climbing. FON shares, which closed on Feb. 27 at $17.73, rose to $19.21 on Mar. 1 -- an 8% gain. PCS, which had last traded Feb. 27 at $9, closed on Mar. 1 at $9.51, a 6% jump.
Things could have turned out quite differently: FON shareholders might not have relished the idea of absorbing PCS, which only recently turned cash-flow positive. The wireless division reported a loss of $661 million in 2003, in contrast to FON's 2003 net income of $1.88 billion. But FON investors were able to see past PCS's recent losses and embrace the opportunity to get a piece of the far faster growing wireless division as the long-distance business stagnates. The recombination, which requires no voter or regulatory approval, takes effect on Apr. 23.
TURNING POINT? "Having a wireless piece in their profile substantially increases their earnings growth, even though it may be dilutive to earnings in the near term," say SG Cowen analysts Tom Watts and Jonathan Schildkraut. Now that Sprint is a unified entity, its growth profile is better than that of its competitors -- companies such as BellSouth (BLS), SBC Communications (SBC), and Verizon (VZ) -- if only because it gets more of its revenues from wireless (49% for Sprint, vs. about 20% for its competitors), and because wireless is growing much faster than long-distance and local-phone service, the Cowen analysts explain.
In January, Watts and Schildkraut forecast five-year compound average annual earnings growth of 20% for Sprint, while they expected the earnings of its competitors to grow by just 1.5% over that time. "Sprint's wireless business is right at the inflection point where earnings are rapidly moving from negative to positive," says Schildkraut. "That really helps drive the growth rate."
Even when you take into account the benefit SBC and BellSouth will get from the purchase by their joint venture, Cingular Wireless, of AT&T Wireless (AWE), their growth will still be unlikely to climb beyond the high single digits. "It's still going to fall short of where Sprint is," says Schildkraut.
SURPRISE DEVELOPMENT. Sprint's larger exposure to wireless justifies a higher valuation for its shares, he believes. Sprint forecasts 2005 earnings of $1.05 to $1.13 a share, which gives it a forward 2005 price-earnings ratio of 17 or 18. Sprint's full-service competitors have an average p-e of 15.4 times 2005 earnings, Schildkraut says.
After the announcement, many analysts thought PCS shares were sure to drop, since the terms of the recombination were at a slight discount to PCS's $9 closing price on Feb. 27. For every two PCS shares, investors will get one FON share. At the Feb. 27 closing price, that would mean they would have to exchange a $9 stock for about $8.87 a share worth of FON. There was also the chance that a sizable chunk of PCS investors were looking for a wireless pure play and would sell the integrated company.
As FON traded up on the news, however, PCS followed. Another reason PCS shareholders got on board is that under the terms of the deal, they'll be included in FON's 12.5-cent dividend payout later this year -- nice compensation for investors who took on the risk of a wireless play.
BIG SAVINGS. Officially, Sprint is absorbing PCS because that will clarify its financial reporting, as well as better align its capital structure with its core strategy of offering customers a bundle of wireless, long-distance, and local services. But neither tracking stock would have risen if investors weren't gaining faith in Sprint Chief Executive Gary Forsee's strategic vision.
In September, 2003, Forsee announced that Sprint would be reorganized into consumer and business divisions, each of which would aim to sell a bundle of wireless and wireline phone services. The new structure makes it unnecessary for Sprint to attribute specific revenues, costs, and business opportunities to either its FON or PCS divisions. SG Cowen analysts estimate that the restructuring will save the combined company $1 billion annually, as it reduces operating expenses by 5% to 7% over the next three years.
William Stofega, an analyst at market research firm IDC, also gives credit to Sprint Chief Financial Officer Robert Dellinger for coming up with ways to reduce costs and bring down debt while improving customer service. "They have great plans and seem to be executing on what they need to do," he says. "That's the real story."
MINORITY VIEW. Watts also believes that the new structure will better enable Sprint to face a consolidating telecom landscape. One advantage: It protects the wireless unit from unsolicited takeover bids that the board would have to consider if they came in ahead of the stock market price. It also clears the way for Sprint to buy a competitor, such as Nextel Communications (NXTL), he says.
BusinessWeek Online took the minority view in pointing out all that was going right at Sprint in this column last November (see BW Online, 10/11/03, "Making the Case for Sprint PCS"). At that time, most analysts were negative on the shares, and the stock was down to $4.40 after Sprint reported a disappointing third quarter. We pointed out that operating results were improving rapidly and that the stock was much cheaper than the shares of its peers.
Many analysts are still on the fence. Deutsche Bank Securities analyst Viktor Shvets pointed out in a Mar. 1 research note that the "recombination does nothing to solve the fact that Sprint is not a top-2 carrier in any of its chosen markets." He raised PCS from a sell to a hold and kept FON at a hold. Some analysts worry that the change could result in shareholder lawsuits. But judging by the first day of trading following the announcement, shareholders have yet to see something they don't like. By Amey Stone in New York