T Mobile's Hidden Inflection Point Is Ignored by the Street

The wireless space, in short, is very competitive, with low overall growth rates, and significant CapEx needs – upgrades to the system / spectrum purchases. Furthermore, over the past couple of years the industry has gone from effectively a dominant two player (T & VZ) market to a viable four player market, with pricing coming down significantly. Challengers like TMUS have caused a ton of change. Understandably, the sentiment on the sector is very negative. People are worried it’s a race to the bottom. T and VZ though have their hands tied with price competition (because of their large installed bases) and S is bleeding cash and highly levered.

Thesis / Recommendation
Despite the industry headwinds, I believe there is one company, TMUS, which is at an inflection point, in terms of growing market share and profitability, and on the cusp of generating significant positive free cash flow that is underappreciated by the Street. Almost ironically, and arguably myopically, it appears that TMUS’s strong subscriber growth in 2014 (EBITDA estimates were pressured by greater subscriber growth) was a large factor in the stock’s underperformance last year, but sets TMUS up for a great 2015.

I am a buyer at current levels, and believe that the stock will get to $50 (57% upside) in the next 2 years for the reasons outlined below (which equates to 6x my 2018E EBITDA and 13x 2018E EBTIDA – CapEx). I would use any weakness around earnings to build a position.

Investment Highlights
1.TMUS is the only major carrier that is significantly growing subscribers / taking share
a. TMUS grew its branded postpaid phone customers by 19% in 2014
i. While subscriber growth rate is expected to slow down, it is expected to still be significant in 2015
ii. 2014 postpaid porting ratio of 2.1 to 1.0 with competition
iii. Q3 Y/Y growth rates: TMUS – 17.4%; V – 6.5%; T – 3.9%; S – 0.3%

2.The Street fails to appreciate the incremental $ margin from new subscribers. The upfront customer acquisition costs (commissions, breakage, etc.) in 2014 mask the massive cash flow benefits from subscriber growth.
a. In the immediate term, subscriber growth hurts profitability, but assuming reasonable retention rates, and slowing subscriber growth, there is no reason to forecast S,G&A to grow significantly in 2015 over 2014 (as many sell side analyst have done).
b. the significant market share gains from 2014 will begin flowing to the bottom line in 2015; and TMUS will be FCF positive in 2015
c. I project that the Company’s EBITDA and FCF growth will be in the double digits over the next four years, with a CAGR north of 15%.
i. At a blended ARPU of $55/month across postpaid and prepaid, and with ~4mm net subscriber additions (75%+ postpaid), we’re looking at additional revenue of ~$2.6bn. Assuming 70% incremental EBITDA margins (very high fixed cost industry), we could be see $1.8bn of EBITDA growth in 2015 from subscriber growth alone
ii. In addition, we should begin to see synergy benefits of the MetroPCS merger in 2015
1. Mgmt continues to guide to $1.2 - $1.5Bn of synergies ($800 - $1bn OpEx).
2. Only ~ 6% of total costs, but ~18% of 2014 EBITDA
a. 800bps+ improvement in Service Margins when one accounts for 1x costs to achieve synergies
iii. $3Bn of NOL
d. At a 1-year forward EV / EBITDA multiple of 6.3x, TMUS trades on par / at a discount to its peers (that are not growing) – simply too low for a company that will be realizing double digit EBITDA an FCF growth over the next few years.

3. Great spectrum position –large contiguous spectrum position in the mid-band, which means their network has extremely fast data speeds and is prime for delivering data
a. Within their key metro markets, their data speeds are leading the pack (more lanes on the LTE freeway)
b. Spectrum holdings / subscriber is double T & VZ
i. lots of runway / capacity
c. Selectively adding low-frequency spectrum to expand coverage in suburban and rural – their network is only getting better

4. Strong and differentiated marketing (Un-carrier approach), clear leader in terms of plan innovation
a. For example: no contracts, unbundling of phone & service, WiFi calling, no intn’l roaming

5. This mgmt. team has turned around the brand, drastically improved the network quality (both voice and data) – phenomenal CTO, and is ahead of schedule in terms of MetroPCS integration (closing down and refarming) and deployment of additional spectrum
a. Mgmt has a history of being conservative in its guidance

6. TMUS is likely a takeout candidate over the next few years.
a. Republican president likely means that Sprint / TMUS is back on the table
b. There are several other potential buyers with strategic rationale to buy TMUS (see appendix)
c. M&A: while a major disappointment in 2014, there is still plenty of reason to expect M&A interest over the next 2 years

7. Regulatory interest in making sure wireless market is not effectively a duopoly – they want to see a strong 3rd player (if one discounts Sprint, that leaves TMUS)

8. Value of spectrum holdings as backstop

Investment Risks
1. Mgmt is placing higher importance on subscriber growth than profitability
a. TMUS does not realize the $ benefits of its increase in market share
b. ARPU does not stabilize

2.High churn; new customer are unhappy with service

3.Wireless price wars
a.Zero sum industry; just stealing share from others

4.Customer quality (prime vs. sub-prime) from share gains

5. High CapEx; need to purchase additional spectrum
a. Rising cost of spectrum
b. Network quality; not a national player

6. Deutsche Telekom owns 66% of shares – motivated seller; might look to exit sooner

Appendix – Potential Acquirors
1. Softbank / Sprint
Softbank probably pulled back from the deal because they were continuing to get negative signals from the FCC and DOJ, and DT was only willing to pursue a deal if they believed there was a greater than 50% chance of regulatory approval. The logic for a deal makes sense, however, and if we get a Republican administration the likelihood of approval increases. In that case, Softbank is likely to try again.

Wireless is a scale business, and both Sprint and TMUS are sub-scale. The two combined would have fewer towers than AT&T and only 2/3 the subs that T or VZ have. A stronger third player would likely enhance long-term competition in the market, and a Republican administration might be receptive to such a message.

2. AMX
Carlos Slim already has a business in the US (Tracfone) where he rents capacity from all four wireless players. Tracfone has 26M prepaid subs and generates close to $6Bn of revenue. They don’t disclose financials, but migrating Tracfone subs to T-Mobile should lead to significant savings in rent payments.

3.Iliad
Iliad offered $33 per share for a 57% stake in TMUS. The logic from Iliad’s perspective is difficult to identify. Apparently Xavier Niel, who founded and built Iliad from the ground up, believes he can replicate his success in the US by massively cutting prices (and operating costs) to drive significant market share gains. The bid was real, but was swiftly rejected by DT as being too low.

4.DISH
Charlie Ergen owns a large amount of spectrum which he has been amassing for almost a decade. He believes his standalone pay TV business is mature and structurally challenged over the long-term, and that his future is in wireless. He recently said that selling his spectrum to another party was extremely unlikely and that he would consider it a personal failure if that happened. He wants to build a business using the spectrum, but does not want to build a network from the ground up, so will likely look to partner with or acquire someone with a network. That means TMUS or Sprint. Sprint is awash with spectrum so it’s not obvious what they would get out of partnering with Ergen. Acquiring TMUS on the other hand could make a lot of sense. They have a good network already built out and combining the two spectrum positions (which are similar band) would create a formidable player in the wireless space.