Sprinting to the Wrong Customers

In the last quarter alone, Sprint Nextel (NYSE: S  ) has added 1.3 million subscribers, bringing its total to 48.9 million customers. On the surface, this seems exciting. Yet somehow, Sprint's net income fell to $419 million (or $0.14 a share) from $472 million (or $0.31 a share) in the year-earlier period, which was prior to the company's acquisition of Nextel Communications.

Net income of Nextel Partners (Nasdaq: NXTP  ) , the company's largest affiliate, rose to $66 million from $56.5 million a year ago, indicating synergies from the acquisition. The drop seems contradictory, but the obvious explanation is that Sprint's heavy marketing expenses were responsible. Sprint suffered from merger-related marketing expenses, which reduced earnings by $0.19 per share.

These expenses may just be a bump in the road. However, there's another reason I'm cynical about Sprint's future prospects. Out of the 1.3 million new subscribers, only 563,000 were postpaid subscribers, while 502,000 were customers of Boost Mobile, Sprint's prepaid brand. With such a low number of the more profitable postpaid subscriber additions, it's not surprising that Sprint isn't meeting income expectations.

According to a recent Wall Street Journal article (subscription required), prepaid subscribers add customers with poor credit, as well as young people -- two segments that would otherwise remain untapped -- but they don't provide the steady, reliable, and lucrative revenue that contracted (postpaid) customers do.

The Wall Street Journal went on to say that Sprint had tremendous marketing expenses, and not much to show for it in terms of subscriber growth. This is an assessment I wholeheartedly agree with. Such a low return on investment indicates that the benefits of the merger are not yet materializing. While the long-run implications are still uncertain, Sprint will undoubtedly face serious challenges in the near term as it struggles to get its marketing costs in check and attract new subscribers.

In contrast to Sprint, Cingular Wireless, a joint venture between Motley Fool Stock Advisor recommendation SBC Communications and BellSouth (NYSE:BLS), added 1.7 million customers, 900,000 of whom were postpaid customers. Cingular is the largest wireless communications provider, with 55.8 million customers. With its current trajectory, Cingular will continue to be the big dog. Conversely, if Sprint continues to have difficulty attracting postpaid customers, then the company will have tremendous difficulty growing.

The WSJ article also indicated that Sprint lost 2.1% of its customers to competitors or to cancellations in the first quarter. This is in comparison to a 1.9% turnover rate at Cingular. In an industry that, on the whole, is showing many signs of slowing down, Sprint can't afford to continue losing ground to its competition.

In light of the huge expenses it's incurring in the process, I don't feel that Sprint will be an attractive prospect for the next few years. The current P/E of 29 suggests that the stock is still not a bargain, despite the recent dip in the share price. As mentioned above, the wireless communications industry as a whole is slowing down and is thus no longer in a growth phase. I expect that Sprint's P/E should fall to around 20 before it becomes in line with its expected growth. While the stock has been able to outperform the S&P 500 by nearly 20% in the past two years, given the relatively weak financials, I believe that Sprint may be headed for a correction.

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Fool contributor Tarek Sultani is a freelance journalist who likes to play Tetris on his phone. P/E information was obtained from Yahoo! Finance. Tarek has no financial interest in any of the companies mentioned above.