With rumors and speculation swirling around a potential merger between Sprint (NYSE:S) and T-Mobile US (NASDAQ:TMUS), a big question is whether such a move would reward shareholders. In theory, consolidation in the wireless space should eliminate the aggressive pricing in the sector and benefit the remaining companies.
Based on the recent consolidation to three major legacy airlines, the airline sector is stronger and more profitable but not all of the players are performing the same. In addition, the consolidation in the wireless sector would leave AT&T (NYSE:T) and Verizon (NYSE:VZ) as dominant players with the new Sprint a very distant third.
Price to sales tells the story
A basic method to gauge whether a stock has upside potential from multiple expansion if the company improves operations and costs controls is the basic price-to-sales multiple. In the wireless case, the combined Sprint and T-Mobile trade at substantially lower multiples of sales than the market leaders of AT&T and Verizon. If the merger were to make Sprint an equal in the sector and allow for margin growth and huge profits, then Sprint could see a significant gain from it.
The above chart is very suggestive of stock gains in Sprint, but a quick review of the airline industry suggests that investors shouldn't rush into the company's stock. Currently, Delta Air Lines trades with a price-to-sales multiple of roughly double that of United Airlines. Both airlines compete in the suddenly consolidated airlines sector, but United can't generate the same level of profits.
Sprint still bleeding cash
A big problem remains in the form of Sprint's inability to generate profits. The combined company would need to dramatically reduce costs to simply break even, much less record the profits and the cash flow needed to compete in the wireless world against AT&T and Verizon.
For the first quarter, Sprint reported operating income of $420 million that topped its performance for the last seven years, but the company still produced a net loss of $151 million. The loss combined with capital expenditures of $1.1 billion lead to free cash flow loss of $1.1 billion for the quarter.
The level of capital expenditure at Sprint is a major concern going forward considering that the company is going to compete against Verizon; that company averages spending $4 billion on a quarterly basis and is targeting up to $17 billion for the full year. AT&T expects to spend an even larger $21 billion on capital expenditures for the year, with the majority of that focused on wireless. The additional spending provides the company with converged offerings of landline and pay-TV services that offer an advantage over anything Sprint has to offer.
A merger between Sprint and T-Mobile has the potential to create a wireless industry where competition between the three remaining players isn't very intense. Unfortunately, the new Sprint would remain a distant third provider with meager margins and low capital expenditures in relation to the market leaders AT&T and Verizon. If anything, the larger two providers have the incentive to prevent Sprint from becoming an equal in the domestic wireless market. Based on the airline industry example, the prospects for Sprint obtaining higher multiples and hence stock gains aren't encouraging.
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Mark Holder owns shares of AT&T.; The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.