I.  T-Mobile USA (TMUS) Excellent 2Q Result on Solid Execution

T-Mobile reported another quarter of solid results that beat market consensus on every metric. With Sprint now making sustained positive strides in network improvement, a greater share of subscriber gains are now coming from Verizon (VZ) and AT&T. Management noted that it usually acquires 50% of postpaid additions from T and a greater portion now comes from VZ, which is encouraging. Recall that over the past few years Sprint lost most of its high-value subscribers to Verizon and these customers are now likely cycling off Verizon. TMUS has been rolling out LTE on 700MHz, increasing LTE coverage to 311M PoPs and slowly closing its network performance gap with the big 2 carriers. This progress is reflected in record-low postpaid churn of 1.27% in 2Q and a positive porting ratio of 1.43.

Specifically, TMUS achieved postpaid porting ratio of 1.64 against T, 1.43 against VZ, and 1.15 against Sprint. While it appears there may be a port-in disconnect with Sprint which also claimed positive port-ins with all carriers, but this may include a mix of TMUS postpaid and prepaid customers.  Postpaid net subscriber adds were 890,000, with churn of 1.27% and prepaid net adds of 476,000 with churn of 3.91%.

■ License purchases underpins LTE coverage expansion:

In 2Q2016, TMUS entered into an agreement to acquire 12MHz of 700MHz A-Block spectrum license from Leap Licenseco (an AT&T subsidiary) which is crucial to its network expansion plans. Financial terms of the deal were not disclosed. This comes on top of 700MHz licenses TMUS acquired from Cavalier License Group and Continuum 700 in 1Q16. TMUS’ Extended Range LTE is tracking ahead of plans, covering 350 markets and more than 200M PoPs now. Furthermore, all current TMUS devices for sale support 700MHz, with the majority also supporting band 12.

■ Coverage Improvement should drive even greater network capacity challenges:

While coverage improvement is correlated to lower customer churn, it also brings a 4x order of magnitude increase in network capacity increases. This is largely due to increased indoor usage where customers previously abandoned usage because of poor network quality. Our latest vendor checks continue to suggest that T Mobile is closing in on a capacity crunch, which plays to our view that there is increased potential for an M&A deal with Sprint in 2017 irrespective of which administration is elected as we expect the circumstances that prevented a deal proceeding in 2013 to be quite different as regulators peek under the hood of both companies.

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 a merger or acquisition of TMUS?

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 g

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.

II. Sprint’s Turnaround Gaining Momentum

Sprint’s fiscal 1Q results were a standout, showing accelerating momentum in its continuing turnaround while providing better-than-expected adjusted free cash flow guidance. Top-line stabilization, subscriber momentum, and low customer churn underpinned better-than-expected guidance of break-even FY16 adjusted free cash flow (FCF) and positive adjusted FCF in FY17. Sprint’s focus on positive FCF generation has driven a more aggressive next-generation network strategy, which, for the first time, is in line with industry trends.

Leveraging small cells and low-cost customer premise equipment (CPE) solutions to do more of the heavy lifting for data traffic consumption in metro areas should position Sprint as the lowest-cost and fastest deployer of incremental data capacity at a fraction of the cost of the traditional macro tower approach. Sprint is beginning to shift its messaging away from being the lowest-cost provider, which will help drive future revenue growth. Network Lease Co. is a further positive catalyst in 2016, in our view.

Postpaid net adds of 173,000 were much better than expected, with churn of 1.39%, which is the highest in company history. Prepaid net losses were 331,000, with churn of 5.55% and EPS of ($0.08). Porting ratios were positive with all carriers.

 ■ Network strategy continues to bear fruit. Nielsen testing and recordlow postpaid phone churn demonstrate that Sprint’s network improvement continues as it begins its pivot toward cost-effective small cells. While management noted the cost of a microcell from Nokia is 20% that of a traditional cell tower, the real kicker is the mass deployment of indoor small cells, which roll off the production line in September at scale.

■ Adjusted FCF guidance gaining credibility. Investors are still challenged by our view that management can sustain a substantially lower level of capex investment while improving network quality and customer churn, but we see more evidence of this. Management guided FY16 adjusted free cash flow of breakeven (including Android and iPhone handset financing) and guided to positive adjusted FCF in FY17. This bodes well for Sprint’s ability to lower interest costs on future debt obligations.

Q &A:

1. How can Sprint leverage its 2.5 GHz spectrum portfolio to improve network quality?

2.5 GHz spectrum is the basis of Sprint s LTE Plus network and makes up the bulk of Sprint’s spectrum portfolio. Sprint controls approximately 120 MHz of 2.5 GHz spectrum in 90% of the top 100 U.S. markets. If Softbank can create low-cost Pico and CPE solutions using 2.5 GHz spectrum to densify its network, Sprint will have the potential to become the lowest-cost and fastest data network among the national carriers that are migrating to a greater dependency on low-cost WiFi spectrum ahead of a migration to low-cost, shared LTE spectrum in the 3.5 GHz band and beyond.

2. How can Sprint shift away from expensive coverage improvement but still improve network quality?

Sprint is shifting away from high-cost, macro-coverage improvement to less costly surgical-capacity improvement. Despite network coverage improvement from Network Vision (NV), substantial coverage gaps still exist, and network congestion is compounding challenges. Network quality remains poor in the eyes of consumers. The good news is that 2.5 GHz deployment will be quick (though now targeted); and, in the postpaid segment, management has cleared the decks of 3G devices and is focusing on tri-band devices, which may provide 3G refarming opportunities at 1.9 GHz. LTE is now used by the postpaid segment 94% of the time. Key will be clearing 3G devices in the prepaid and wholesale segments.

Conclusions:

We continue to believe that Sprint has several potential sustainable advantages:

(1) the simplicity of its offering,

(2) a very strong value proposition,

(3) a solid product lineup expected to include devices with 800 MHz and 2.5 GHz spectrum support this year,

(4) improving network quality, and

(5) financial flexibility—all of which should benefit the company.

However, we think that the competitive intensity within the wireless space is continuing to ratchet up and that competitive responses are expected.