Competition in the wireless industry seems to step up every few months. Investors know that Sprint (NYSE: S) and T-Mobile (NASDAQ: TMUS) are on a path to merge, but we can’t ignore what Sprint is doing today to try and grow its business. Apple’s (NASDAQ:AAPL) release of its next generation of iPhones could prompt a significant number of upgrades. Sprint has an aggressive plan to try and acquire subscribers, but is this a stroke of genius or a move of desperation?
3 ways to play
If we look at how different companies in the wireless industry approach acquiring subscribers, there seem to be multiple approaches. First, a company can try and lure in subscribers with lower cost plans and hope to make up this shortfall by profiting on equipment sales. Second, subscribers might be acquired by offering a deal on equipment and hoping that higher priced service plans will benefit the company.
The third possibility is a company like Verizon (NYSE: VZ), with such pricing power that it can grow service revenues while also growing equipment revenues. If we look at how Sprint and its peers performed in their most recent quarters, the separation is very clear.
Postpaid Service Revenue
(Source: 10-Q reports for Sprint, T-Mobile, and Verizon)
It seems that Sprint hopes deals on equipment will drive subscribers, whereas T-Mobile is moving forward with postpaid service revenue growth. Verizon is in a rare position, growing both service and equipment revenue as well as subscribers.
The combination of Sprint and T-Mobile may end up being a more substantial competitor for Verizon in the future. However, Sprint is hoping to capitalize on a significant opportunity regardless of what happens with its impending merger.
350 million reasons to be aggressive
Some investors ignore Apple’s announcements, thinking that everyone buying an iPhone is a sheep following the herd. Whatever your feelings about Apple and its products, there are hundreds of millions of users who have been waiting on the “big screen” iPhones. Over the last several years, most users have bought or upgraded a phone under a two-year purchase agreement. Though Sprint offers its Flex lease, this represents the minority of the marketplace.
Looking at the last two years of iPhone models and recent sales data, clearly iPhone users are looking for big screen options. In the first quarter of 2018, the iPhone X was the number one selling smartphone. By the second quarter of 2018, the iPhone 8 Plus took number one and the iPhone X took the number two spot. The iPhone 6 Plus through the iPhone 8 Plus all offer bigger screens, yet users have been asked to compromise by accepting a bigger handset.
If we compare the size and weight difference between the iPhone 8 Plus versus the iPhone XS, and upcoming XR, there are obvious reasons for users to upgrade.
Height x Width x Depth
iPhone 8 Plus
6.24” x 3.07” x 0.30”
5.94” x 2.98” x 0.33”
5.65” x 2.79” x 0.30”
Users are no longer required to compromise by accepting a larger size handset to gain a larger screen. Given that the iPhone X has only been available for a few quarters, it’s likely that most iPhone users are holding an iPhone 6 through the iPhone 7 Plus.
Given this backdrop of millions upon millions of users with a prior iPhone version, there are some analysts who suggest over the next 12-18 months as many as 350 million iPhone units could be sold. If older iPhone models didn’t give users the larger screen size in a compact size, it seems likely the iPhone XR at $749 or the XS at $999 could find the sweet spot of the upgrade market.
Given the potential for significant upgrades, there is little doubt that investors should pay close attention to deals customers have access to. When it comes to buying or upgrading a smartphone, users are likely to compare carriers and Sprint has an offering that is surely going to turn some heads.
Head and shoulders above the rest
Sprint’s current offer for iPhone users is a game changer for customers. Before we get to how this might affect Sprint’s business in the future, first we need to see how Sprint’s offering compares to the competition.
Total 24-Month Cost
Hulu (normally $7.99)
4th line free
Netflix (normally $11.99)
$300 Prepaid MasterCard per line
$300 account credit per line
(Assumes family of 4, iPhone XS for each user, basic unlimited data, total cost subtracts any promotional values and any included values.)
We should clarify that Sprint’s equipment deal is a lease, so the user doesn’t own the devices at the end of the term. In addition, to get the iPhone XS for free, the user has to trade in at least an iPhone 7 or a similar value Android device. However, Sprint’s value proposition is almost laughably better than even T-Mobile which it proposes to merge with.
Users who are currently with another carrier simply can’t afford to ignore a monthly cost difference of almost $170 for equipment. The value that Sprint is offering works well enough for a family of four; if a family of five is involved, the 5th line is free as well, which makes the trade-off even more significant. The bottom line from the customer’s standpoint is that Sprint’s deal stands head and shoulders above the competition.
Great for customers, terrible for investors
Though customers should love Sprint’s current offering, to be quite blunt, as great as it is for customers, it’s equally terrible for investors. There is a reason that Verizon and T-Mobile aren’t offering the same deal… it’s not a sustainable business plan.
The problem with this offering can be found in Sprint’s last earnings report. Sprint said its equipment rental income was because, “substantially all of our subscribers chose the leasing option under the Sprint Flex program.” On the surface, the significant increase in equipment rental income would seem to be excellent news as Sprint generated a total increase of $280 million in just equipment revenue alone.
However, there are several challenges with the company’s aggressive Flex Plan pricing when it comes to the new iPhone models. First, Sprint’s equipment revenue growth was the primary reason that the company’s overall revenue declined slightly. The company’s service revenue was down more than $330 million, which of course eclipsed equipment revenue growth. Of course, if many users sign up for the new iPhone lease, Sprint will recognize no equipment revenue at all since the customer’s cost is $0 per month.
When it comes to service revenue, the company should see an increase as users take advantage of the free devices to sign up for service. However, there is a cost on Sprint’s cash flow statement that will also grow, and likely far outpace service revenue growth.
The simple math is unfavorable. Sprint charges $60 a month for the first three lines for a total of $180 per month, minus the $11.99 cost of Netflix for a net of $168.01. If we break this down with four users, the service revenue equates to $42 per person. The retail equipment cost for an iPhone XS at $999 works out to $41.63 per month. Even if we assume that Netflix cut Sprint a deal for less than $11.99 per month (likely), and we know that Sprint isn’t going to pay the retail cost of $999 per iPhone XS (certain), Sprint’s margins are going to be razor thin on this deal.
As point of quick comparison, Verizon’s wireless operating margin was nearly 37% last quarter. Sprint’s overall operating margin was just 10%. If Sprint can successfully grow its customer base by giving away the newest iPhone for free, the company is going to make very little from these users. The users who don’t opt for a free phone may contribute to equipment revenue, but there is a cost on Sprint’s cash flow statement that will haunt investors as well.
Let’s assume that a good portion of Sprint’s customers stick with Android devices under the traditional leasing option. There is a line item on Sprint’s cash flow statement that investors need to pay close attention to. While equipment revenue increased by $280 million year over year, the company’s capex related to leased devices jumped by $460 million. Largely due to capital expenditures from its leasing, Sprint’s core free cash flow was negative by almost $450 million.
The bottom line for Sprint investors is that the company faces some hard days ahead. If the company gains customers under the iPhone Flex lease, equipment revenue will fall off a cliff, while service revenue will grow, albeit at thin margins. On the flip side, if Sprint can’t gain customers this way, the company’s cash flow will continue to be challenged because of its leasing costs. In either scenario, what at first seems like a great deal for customers, seems like a move of desperation for Sprint. Losing money is something Sprint is all too familiar with, and the company’s iPhone gamble will likely continue this trend.
Disclosure: I am/we are long VZ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.