by David Dixon & Mike He of FBR & Co.

Summary:

An elegant Ericsson and Nokia driven network upgrade plan that from inception created a 10X increase in capacity continues to bear fruit for TMUS, as seen in strong 3Q financial and preannounced subscriber results. The recent launch of the T-Mobile One unlimited plan and market perception of T-Mobile as a value leader are resonating well with consumers, as both net add and churn were well ahead of Street estimates. After more than three years of continuous share taking, we believe TMUS is close to full network capacity.

We expect Sprint to build momentum from here, and even though heightened competition has forced both VZ and T to diverge their businesses away from wireless while undergoing a network topology shift that favors edge application processing, storage, and content, we think margin pressure is likely needed for TMUS to gain more market share. As more of the device base are seeded with 700 MHz, this will accelerate the capacity crunch that could stymie momentum.

Key Points:

■ 3Q16 results recap. Consolidated revenue of $9.2B (+17.8% YOY) was modestly ahead of our $9.1B estimate but below the consensus $9.5B estimate, consisting of 13.2% YOY growth in service revenues, +37.6% YOY growth in equipment revenues, and 26.0% YOY growth in “other” revenues. Adjusted EBITDA of $2.6B were meaningfully ahead of our Street-comparable estimate of $2.4B, driven by strong cost discipline and a strong top line that benefited from strong market acceptance of T-Mobile One plans. Postpaid net adds were 969,000 with churn of 1.32%, and prepaid net adds were 684,000 with churn of 3.82%.

■ Capacity expansion going well—capacity crunch ahead? May improve M&A approval chances. Management recently lit AWS-3 spectrum and plans to leverage unlicensed 5 GHz spectrum in 2017 using LTE-U and LAA, followed by unlicensed 3.5 GHz LTE spectrum in 2018. Covered PoPs under extended-range LTE on 700 MHz A-block increased by 25M during the quarter to 225M, with overall covered PoPs of 312M almost in line with VZ. Coverage improvements drive a 4x increase in capacity. A spectrum-constrained T-Mobile may increase the probability of regulatory approval of a Sprint merger.

■ T-Mobile raised FY16 guidance. Management raised full-year branded postpaid net adds and adjusted EBITDA guidance following 3Q results. Brand postpaid net adds are now expected to be in a range of 3.7M–3.9M, up from 3.4M–3.8M. Adjusted EBITDA guidance has been raised to $10.2B–$10.4B from $9.8–$10.1B.

Q & A: 

1. Can T-Mobile continue to take market share?

We believe Ericsson and Nokia in 2012 provided an elegant blueprint for T-Mobile to add capacity at low cost for three to four years under the current capex envelope. Today, our industry checks suggest that T-Mobile is facing capacity challenges and that adding 700 MHz coverage spectrum (although only used 17% of the time, according to the latest Root Metrics results) will increase demand for capacity spectrum by 4x, exacerbating performance challenges. We also believe that capacity demand elasticity for BingeOn will prove challenging as a broader set of customers sign up for free video service. Indoor coverage is still the differentiator, and T-Mobile faces variable performance in this area due to its reliance on voice over Wi-Fi, but this should improve with 700 MHz spectrum and the ability to add 600 MHz ahead of the 39-month clearing time frame.

2.  What is the outlook for Sprint’s ability to improve its momentum in the market?

We believe Sprint is starting to leverage its 2.5 GHz spectrum portfolio to greater effect and should be able to improve its performance in multiple markets across the U.S. going forward. Indoor coverage improvement from small cells, increasing device power, and higher-power 2.5 GHz transmitters could drive market share gains going forward at the potential expense of T-Mobile US.

3.  What is the outlook for M&A in the wireless segment?

We believe T-Mobile US lack of new spectrum capacity, coupled with inferior coverage from both T-Mobile and Sprint, suggests a merger could be revisited under a new FCC administration in 2017. Given our contrarian outlook for capacity spectrum valuation one of the three valuation components for a wireless company (spectrum, network, and customers) we believe Comcast is less likely to seek to acquire T-Mobile but may instead enter the wireless segment through a low-cost coverage network and lowcost indoor capacity network. Lastly, we believe there is greater synergy for a deal with Sprint relative to DISH Network.

Risks:

• T-Mobile holds a smaller amount of absolute spectrum than its larger competitors. As T-Mobile expands and adds more customers to its LTE network, the company’s smaller spectrum holdings will require higher capex (cell-splitting) and higher variable operating costs (larger amount of leased back-haul).
• T-Mobile does not own a substantial spectrum position below 1 GHz. T-Mobile’s network operates primarily in the AWS (1700 MHz) and PCS (1900 MHz) bands with roaming on AT&T at 850 MHz. The lack of lower-frequency spectrum for data impedes in-building coverage, which could lead to higher churn. The company could compensate by adding more cell towers or by winning the upcoming incentive spectrum auction for 600 MHz spectrum.
• Overall industry risks continue to center on pricing pressure, particularly in the business segment and accelerated wireless substitution in the consumer segment. Economic recovery factors continue to play key roles in a sector where growth in wireless subscribers, growth in revenue from existing subscribers, and enhanced wireline services are large determinants of growth.
• Deutsche Telekom AG owns a majority stake in T-Mobile US. Deutsche Telekom AG owns roughly 65% of TMUS common stock. The low float could potentially impede the stock from achieving our price target and create difficulties for institutions that may want to build positions.

Company Profile:

Based in Bellevue, Washington, T-Mobile US, Inc. is a wireless communications services operator that provides wireless voice, messaging, and data services in the U.S., Puerto Rico, and the U.S. Virgin Islands. T-Mobile’s network covers 96% of the U.S. population through its EDGE 2G/HSPA 3G/HSPA+, 4G/4GLTE LTE networks. T-Mobile operates its business under three brands, including T-Mobile, MetroPCS, and Go Smart Mobile.

Conclusions:

While T-Mobile has benefited in earnings growth, lower churn, and subscriber growth from its network overhaul, we see limited organic growth opportunities beyond the next two years due to growing network capacity challenges.

Competition: 

Sprint’s earnings report released today (Oct 25, 2016):

Sprint Reports Year-over-Year Growth in Net Operating Revenues for the First Time in over Two Years

David Dixon’s comments on Sprint’s earnings, outlook & possible M&A:

Sprint’s strong fiscal 2Q results highlight that the turn around is on track. We e material improvements ahead, and believe Sprint is close to cash flow inflection by sustaining low capex spending and progressive interest expense reductions. Relative to TMUS, we believe  Sprint is better positioned for long-term sustainable growth due to ample excess spectrum capacity.

* Management achievements have been significant. Leveraging network vision upgrade tailwinds, management has done well to enhance franchise value through effective re pricing, marketing and distribution improvements, while slimming down beyond expectations. As it pivots to a (still poorly understood) new network coverage and capacity model with 5 G attributes, management is demonstrating it can spend less on the network while maintaining performance by garnering greater-than-expected utility from its 2.5 GHz spectrum asset.

* Much more to come in 2017. We think management can maintain low capex spending as it ramps low-cost indoor voice and tri-band LTE data small cells to improve indoor coverage; achieve 3GPP approval for high-power UE in December, which will increase network coverage area by 40%. Vendor checks highlight that prototype testing shows a link budget in line with the 1.9 GHz grid, which suggests less high-cost densification will be required. Checks with power amplifier and filter companies indicate high-power devices will be available in 2017.

*  M&A potential still exists. Vendor checks suggesting TMUS is close to full capacity and in need of expensive densification may increase the chances of regulatory approval for a merger with Sprint. Cable companies are also a potential buyer but we discount this as we think cable is more of a strategic threat to wireless via an organic WiFi box upgrade cycle to include cellular on spectrum bands offered free to customers.