Quick Thoughts: Things I Think About the TMUS-S Merger

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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May 1, 2018

Quick Thoughts: Things I Think About the TMUS-S Merger

  • It’s a good deal for TMUS investors and more likely to pass DoJ muster than many assume. We believe concessions (cheap wholesale and 5G commitments, possible divestures) will win the day.
  • 5G deployment will be delayed 6-9 months awaiting approval but should accelerate very quickly thereafter. The pace will pressure VZ and T to move faster as well.
  • The combo increases the odds of a viable 4th network – CMCSA/CHTR, DISH, etc. – and more viable MVDOs – GOOGL Fi, TracFone, etc. The result could be greater pricing pressure.
  • We expect early cycle 5G plays – test equipment (e.g. KEYS, NATI, etc.), optical backhaul gear (e.g. CIEN), etc.- to work 2H this year, and 5G semis (e.g. QCOM, XLNX) to accelerate into 2019.

By now, investors have had the chance to review the details of T-Mobile’s $26B acquisition of Sprint. Despite having traded up both stocks over the previous few weeks (S +24% since April 1, TMUS +6.5%) in anticipation of just such a deal, sentiment turned around and slammed it on Monday once it was announced. Given the huge and obvious synergies, noted by every analyst that has looked at the deal, the share price hit seems a huge vote of NO CONFIDENCE that the deal will pass regulatory muster. We are a bit more optimistic. We also note that the length of time that it takes to complete the deal could have a significant impact on the pace of deployment for 5G, not just for T-Mobile, which must hold up its network planning given the uncertainty, but also for rivals Verizon and AT&T, which could alter their own network deployments depending on the outcome that they expect. It could also affect the plans of wireless outsiders, like the Comcast/Charter alliance or Dish Networks to step up, or step down, their plans to build independent 5G connectivity. With that, some further thoughts:

1. 4 networks are not necessarily better than 3 – We can all agree that the FCC is likely to rubberstamp this deal – commission chairman Pai has explicitly voiced skepticism that competition would be hindered by a shift from 4 national networks to 3. The bigger issue is the DoJ, which has fought AT&T’s attempted acquisition of Time Warner tooth and nail on the altar of competition in Pay TV. Some see this as clear evidence of a strict “Herfindahl Index concentration ratio” approach to measuring the competitive impact of M&A. On this basis alone, the combination of the 3rd and 4thlargest national wireless carriers could be ruled as against the public interest, leading to a government suit to block it. Still, there is more to it than that.

International markets suggest that having 4 national carriers as opposed to 3 is no panacea – many markets with just 3, like Germany and Austria, remain fiercely competitive, while the US, with 4, sports the second highest monthly bills of any developed nation while supporting better than 20% operating margins for its market leading duopoly. Sprint may be a fourth network, but its presence does not seem much of a catalyst for more consumer-friendly behavior from the big two. The lesson from Europe seems to be that viable MVNOs, 3rd parties that buy capacity wholesale from network operators and resell it to consumers, is the best ticket for driving competition. The government could demand cost-plus wholesale rates to MVNOs as a condition for approval. Moreover, given Sprint’s dismal performance and T-Mobile’s record of undercutting Verizon and AT&T, it is not beyond imagination that a combination and the cost synergies that it could provide might result in lower prices to consumers than the status quo.

2. Deal delays could set back US 5G – The combined company will need to revamp 5G network deployment plans to account for the merged existing network and spectrum assets, meaning that the network build could be pushed later into 2019. Similarly, Verizon and AT&T could back off on their own spending plans under an assumption that the deal will be tied up and potentially scuttled. Given the Trump administrations intervention in the Broadcom/Qualcomm proxy battle, it is possible that leadership in 5G is considered more important than market concentration. T-Mobile seems willing to give assurances that it will step up its 5G investment if allowed to merge with Sprint. If so, one more reason why the DoJ may green light the deal more easily than many assume.

Still, US carriers are likely to hit the brakes a bit on 5G network building until the path forward is a bit clearer. This may soften immediate demand for early cycle 5G plays like test equipment (e.g. Keysight, National Instrument, Anritsu, and others) and optical backbone equipment (e.g. Ciena, Cisco, etc.), particularly if a protracted legal slog to approval becomes evident. When it comes, resolution in either direction should yield a sharp ramp in spending. While the combination would yield capex synergies for T-Mobile/Sprint, we believe the competitive impact on Verizon and AT&T and a greater potential for new players (Comcast/Charter, Dish, etc.) should leave 5G suppliers well off over the longer-term in either case.

3. A deal could portend new network entrants – A T-Mobile/Sprint network merger might make it easier for additional wireless competitors to enter the market. For example, Cable operators have eyed wireless for years, hoping to leverage their millions of residential customers and their many millions of miles of fiber under city streets and strung alongside suburban roadways. Comcast has already begun reselling Verizon service as an MVNO and combining it with its growing network of public Wi-Fi hotspots. It has also acquired spectrum in recent FCC auctions, signing an alliance deal with fellow cable operator Charter for a broader wireless initiative that will include building out 5G capacity. We believe the combination of the 3rd and 4th place wireless networks could accelerate that move, with the potential of picking up additional spectrum or network assets should the DoJ demand divestitures as a condition of approval.

Similarly, Dish Networks, sitting on $22B worth of spectrum licenses and a government deadline of 2020 to “use it or lose it”, is investing $1B to build a 5G network covering the requisite 70% of the US population with limited narrowband service for the “Internet of Things” (IoT). This would seem a placeholder until the company can gain financial support for a more ambitious rollout. That support – perhaps from the cable duo, perhaps from the tech world (Amazon has been rumored as part of the IoT project), or perhaps from elsewhere (e.g. financial partners, foreign carriers, etc.) – might be more forthcoming once the laggard Sprint brand is removed from the market.

Finally, if a government deal mandates lower costs for 3rd party MVNOs, we will see more MVNOs. In the UK or Germany, dozens of virtual network operators compete – more than operate in the US, despite the significantly larger size of our market – capturing more than 10% of subscribers. Now, MVNOs typically look to fill underserved niche markets or to exploit existing consumer relationships (e.g. TracFone’s Straight Talk for Walmart, or Comcasts Xfinity Mobile). Lower wholesale prices would open more room for aggressive pricing and creative usage plans.

Conclusions – We think this deal will be approved, and, likely, without need for a trial. T-Mobile has room to negotiate – firm 5G investment and wholesale pricing commitments, and, perhaps, some spectrum divestitures to would-be market entrants. We hope that such approval can be gained within 9 months, keeping the company on a schedule for aggressive 5G rollouts in 2019. We believe that such a scenario would spur both Verizon and AT&T to step up their own network investment and induce the Comcast/Charter alliance to a more aggressive pace and scope for their own 5G initiative. We would not be surprised to see new investors drawn to Dish Network’s 5G buildout, possibly allowing it greater scope as well. We would expect to see MVNOs gain greater traction, generating pressure on the big three network operators’ ability to take price.

TMUS will end up a winner, while VZ and T see continued competitive pressure. The early cycle 5G plays we favor – test equipment (KEYS, NATI) and optical transmission gear (CIEN) – will see a 6 to 9-month delay in what we still expect to be a strong acceleration in demand that should favor these stocks heading into 2019. More aggressive 5G investment across the whole US market will benefit these names, along with suppliers of key components (e.g. QCOM, XLNX, etc.). We would expect smartphones and other consumer wireless devices to see a modest shift in premium segments toward 5G capable models in the second half of 2019.

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