Risk Arbitrage or Long-Term Investment?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In an article by Brian Pacampara on The Motley Fool, he mentioned several companies he saw as possible “...Turnaround Stocks.” Since I've worked in the wireless industry, the one that caught my eye was MetroPCS Communications (NYSE: TMUS). The company is a secondary player in the wireless field behind much larger companies like AT&T (NYSE: T), Verizon (NYSE: VZ), and Sprint (NYSE: S). In wireless, there has been one rule, size matters. The two biggest carriers, each have over 100 million subscribers, which leaves the other companies to fight for the rest. You would think that with just 9.47 million subscribers that a small wireless company wouldn't have a chance.
To be honest, without looking at the numbers, that was my first instinct as well. However, if I've learned anything in the market it's that first instincts can be dead wrong. Two of the more promising numbers I noticed are the company's forward P/E ratio is just 9.6, and analysts are expecting nearly 18% growth in EPS in the next few years. At first glance, this would seem to argue the stock is undervalued. The challenge with accepting these numbers is, MetroPCS has run into trouble meeting analyst estimates before. In fact, in the last three months, analysts have slashed their estimates for 2012 full year earnings by 33%. That being said, EPS doesn't tell the whole story of MetroPCS' capabilities. The company's operating cash flow has grown a total of 18% in the last three years. In addition, in just the first quarter of this year the company generated about $118 million in free cash flow. The concern with MetroPCS is the company's free cash flow generation is wildly inconsistent.
Just looking at the last four quarters, you can see this inconsistency, but also a clear pattern:
While the company's cash flow is cyclical in nature, there is no question that the trend is up. With an upward trend in free cash flow, the company may be able to begin addressing their balance sheet issues.
If there is one thing that worries me about MetroPCS, it's the management of their balance sheet. In the last three years, the company's long-term debt has increased by $1.1 billion. Ironically, the company's combined cash and investments have increased by nearly the same amount. I'm no professional advisor, but that doesn't seem to make a whole lot of sense. Why would the company choose to carry more debt which surely has a higher interest rate, while keeping more cash with a much lower interest rate? I don't know the answer, but as it is the two numbers offset nearly perfectly. A reason for investors to watch the company's balance sheet is, because of the potential for MetroPCS to be taken over by a larger player.
In February of this year, apparently Sprint's board rejected a merger of the two companies that would have valued MetroPCS at $8 billion. Granted, we can't be sure if this was because the acquirer was Sprint, who has its own financial issues to deal with, or because Sprint didn't see enough value in the company. This $8 billion figure is instructive in trying to figure out the value of MetroPCS should another company choose to make a bid. With $2.467 billion in net debt after cash and investments, you can be sure that the acquirer would assume this debt. If the bid price was $8 billion, and you subtract this $2.467 billion in debt, you get a remainder of $5.533 billion. This amount would imply a value of around $15 per share for Metro PCS. With shares trading at just $5.80 recently, this would be a hefty premium. Let's assume for a moment that another bidder didn't think $8 billion was fair, and the amount came in for 25% less. Even with a $6 billion price tag, the equity value would be about $9.73 a share, or nearly a 68% jump from current prices.
It's not as though MetroPCS is sitting on its hands. The company is growing and whether the stock is bought out or not, management is positioning the company for growth in the future. In the first quarter, the company grew subscribers by 7% year-over-year and over 6% of their subscribers upgraded to 4G LTE handsets. More importantly, 16% of subscribers upgraded their handsets in the quarter. Of those who upgraded, 40% went from a feature phone to a smartphone. In addition, cash and debt levels stayed about the same from the fourth quarter, which is important if this company is an acquisition target. The question is, do you buy MetroPCS, or buy one of the potential acquirers?
When you consider you can buy AT&T for about 14 times forward earnings, with 9.6% growth expected and a 5% dividend, MetroPCS starts to look less attractive. Investors could also choose Verizon, which is my personal favorite in this space. At about 17 times forward earnings, with almost 11% growth and a 4.6% dividend, Verizon seems to be the strongest company in the wireless industry. I can't recommend Sprint and their nearly $13 billion in net debt until the company discovers how to generate consistent positive cash flow. While MetroPCS could be an attractive takeover candidate, the value of the firm is directly tied to their ability to grow subscribers, and keep from running up more debt. If you are into risk arbitrage, buying the shares at this point seems like a decent bet. If you are looking for a longer-term play, I would recommend Verizon. Do you agree or disagree? Let me know in the comments section below.
MHenage owns shares of Verizon Communications. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.