U.S. Leveraged Finance Spotlight Series

Transcription

1 U.S. Leveraged Finance Spotlight Series March 2016 Sprint Corporation

2 Sprint Corporation Full Rating Report Telecommunications / U.S.A. Ratings Sprint Corporation Long-Term IDR B+ Senior Unsecured Notes B+/RR4 Sprint Communications, Inc. Long-Term IDR B+ Sr. Unsecured Credit Facility BB/RR2 Jr. Guaranteed Notes BB/RR2 Senior Unsecured Notes B+/RR4 Sprint Capital Corp. Senior Unsecured Notes B+/RR4 Clearwire Communications LLC Long-Term IDR B+ First-Priority Secured Notes BB+/RR1 Exchangeable Notes BB+/RR1 IDR Issuer Default Rating. RR Recovery Rating. Rating Outlook Long-Term IDR Financial Data Stable Sprint Corporation ($ Mil.) FY 3/31/15 LTM 12/31/15 Revenue 34,532 32,391 Operating EBITDA 6,086 7,786 Total Debt with Equity Credit 32,725 32,891 Total Debt with Equity Credit/EBITDA (x) FCF (3,622) (4,267) FFO Interest Coverage (x) Key Rating Drivers SoftBank Support Key: Sprint s rating is primarily supported by SoftBank s tangible support, which essentially sets a floor to the rating at B+. The Mobility Leasing Solutions LLC (MLS) structure combined with the expected network financings that leverage SoftBank s extensive financial relationships are a credit positive and are expected to inject substantial liquidity on an on-going basis, thus demonstrating further tangible support of Sprint. Additionally, Fitch does not perceive SoftBank s support toward Sprint as having changed during the past year. Standalone Profile Weak: Fitch views Sprint s standalone rating as B and expects the rating will remain weak for an extended period due to the time required to address numerous executional and operational challenges. Sprint will need additional liquidity to fund these operating deficits. Rating concerns would increase if operational improvements do not materialize during the next 12 to 18 months. Consequently, Fitch believes some risks exist SoftBank could reassess its level of support if the turnaround strategy fails to gain traction. Heightened Execution Risk: Sprint faces several challenges including operating deficits, operational trends that have shown some improvement but remain subpar combined with significant execution risk surrounding Sprint s numerous strategic initiatives. The competitive intensity and market maturity within the wireless industry along with the much stronger financial profiles and good execution of its peers only serve to increase this execution risk. Secured Financing Critical: Sprint s LTM free cash flow deficit was $4.3 billion without consideration for the $1.1 billion in net cash proceeds from the sale-leaseback transaction in December. Through the next two years, Fitch expects Sprint could continue to experience a FCF deficit in the range of $4 billion $5 billion. As such, Sprint will need to seek funding primarily through handset and network leasing structures, receivable securitizations and other funding structures that are permitted under Sprint s credit agreement and bond indentures. Substantial Maturity Wall: Upcoming maturities are substantial and increase the urgency to close the deficit. Debt maturities during the next three years total approximately $9 billion (excluding certain items) including $155 million remaining in fiscal 2015 (FY15), $3,675 million in FY16, $1,677 million in FY17 and $3,127 million in FY18. Fitch expects handset leasing and network financing to address the majority of refinancing requirements in FY16 and FY17. Rating Sensitivities Related Research Fitch Affirms Sprint s IDR at B+ ; Outlook Stable (February 2016) Analysts Bill Densmore bill.densmore@fitchratings.com David Peterson david.peterson@fitchratings.com Positive Rating Triggers: An upgrade is not considered likely over the rating horizon. Longer term, sustained postpaid gross addition share in the upper-teen range with a strong mix of postpaid prime handset additions; improved churn by at least 20 basis points; positive net postpaid handset additions; permanent cost structure improvements in excess of $2 billion; and improvement in network operating performance that further closes the gap to its national peers could all boost the ratings. Improved operating trends would drive financial results that mostly exceed Fitch s current expectations for revenue, EBITDA, FFO, CFO, FCF and leverage. Negative Rating Triggers: Lack of expected improvement in metrics for gross addition share, churn, net postpaid additions and network operating performance that further degrades the financial profile could undermine the rating. Fitch s concern would also increase if there were changes in the level of expectations for support from Softbank or the expected network financing structures are not available that affects liquidity.

3 Table of Contents What Investors Want to Know Assessment of Liquidity... 2 Review of Mobile Leasing Solutions.. 4 Softbank Ownership... 6 Key Operational Imperatives Cost Structure... 8 Network Performance Spectrum Restoring Luster to Brand Postpaid Gross Addition Share Postpaid Churn Telecom Sector Outlook Sprint Guarantees Recovery Sprint Debt Structure Diagram Corporate Governance Covenant Summaries Financial Summary What Investors Want to Know What Is Your Assessment of Liquidity and How Does Sprint Fund Itself for the Next Two Years? Leasing, Network Financing Critical for Liquidity Sprint s LTM FCF deficit was $4.4 billion without consideration for the $1.1 billion in net cash proceeds from the sale-leaseback transaction in December. Drivers for the deficit include the negative working capital effects of the substantial ramp-up with the handset leasing receivables and equipment installment receivables, cash capital expenditures, high cost structure and various competitive pressures. FCF Profile Three Months Ended 12 Months Ended ($ Mil., As of Dec. 31, 2015) 12/31/15 12/31/14 12/31/15 3/31/15 Cash From Operations 806 (233) 3,579 2,450 Total Non-Operating/Nonrecurring Cash Flow Capex (1,631) (1,610) (7,846) (6,072) Dividends FCF (825) (1,843) (4,267) (3,622) Source: Company filings, Fitch Ratings. Fitch's key assumptions within the rating case for the issuer include: Postpaid gross addition share flat to FY2015; Postpaid churn of approximately 1.5%; Net postpaid additions in excess of 1.5 million; EBITDA of $9.4 billion; Cash restructuring costs of approximately $1 billion; FY2016 FCF deficit to exceed $4 billion without consideration from additional MLS-like transactions; Network financing funding in excess of $4 billion; Additional handset leasing funding in excess of $3 billion; Minimum cash liquidity of about $2 billion. Related Criteria Corporate Rating Methodology Including Short-Term Ratings and Parent and Subsidiary Linkage (August 2015) Through the next two years, Fitch expects Sprint could continue to experience an FCF deficit in the range of $4 billion $5 billion. As such, Sprint will seek further funding primarily through permitted asset securitization structures including handset leasing, network and spectrum. The expected cost structure enhancements of at least $2 billion are key to improving the deficit although restructuring costs of approximately $1 billion, primarily in fiscal 2016, create a material headwind. Fitch believes it is critical for Sprint to generate FCF in FY18 driven by improved operating performance and cost structure reductions that would allow the company to begin reducing debt and demonstrate its longer-term viability within the wireless industry. Fitch does not expect any capital infusion directly from Softbank to fund operating deficits given the current plans to use Sprint s balance sheet to address liquidity during the next 12 to 24 months. Sprint s network densification primarily through the use of small-cell technology will require elevated capital investment during the next two years. Current Liquidity Sufficient As of Dec. 31, 2015, Sprint s liquidity position was approximately $6.0 billion supported by $2.2 billion of cash and short-term investments, $3.0 billion in borrowing capacity under its $3.3 billion revolver that matures in 2018 and $778 million available under its $4.3 billion securitization facility that matures November Proceeds from accounts receivable sales consist of a combination of cash and deferred purchase price receivables. Sprint determines how much cash it elects to receive from each sale based on current liquidity needs. The maximum amount of proceeds depends on several factors and currently represents approximately 50% of the total amount of receivables sold. In addition, Sprint has approximately $600 million of availability under vendor financing agreements with approximately $500 million of additional availability coming in April Fitch believes Sprint will maintain about $2 billion of cash to ensure adequate liquidity. Sprint Corporation 2

4 Sprint Funding Sources (Dec. 31, 2015) Available Size Outstanding Capacity Comment Secured Equipment Credit Facilities EKN 1, Was fully drawn. Finnvera Borrowing available through October K-sure Borrowing available through April D D Borrowing available through Total 2, ,165 Mobile Leasing Solution LLC 1,300 1,036 Sale-leaseback transaction. Sprint received $1.1 billion in cash and $126 million deferred consideration. Future payments include $176 million in 4Q15, $673 million in FY16 and $113 million in FY17. Accounts Receivable (AR) Facility 4,300 1, In November 2015, Sprint increased size of AR facility to $4.3 billion. The receivables facility consists of $1 billion for leasing, $1.5 billion installment and $1.8 billion service receivable sales. Maximum commitment prior to discounts for bad debt, etc. EKN Exportkreditnämnden. D D Delcredere Ducroire. Source: Company filings. Substantial Lien Flexibility Greases Path for Additional Liquidity Sprint has substantial flexibility under its bond indentures and credit agreements to pursue additional funding through permitted securitizations, liens arising in connection with sale and leaseback transactions or liens on capital assets and inventory. The credit agreement does not contain any restrictions on the total size of such agreements. This allows Sprint flexibility to pursue new opportunities for financing utilizing network infrastructure, spectrum, inventory and potentially real estate assets. Under its bond indentures, Sprint has a carveout for permitted liens up to 15% of consolidated net tangible assets. After netting the revolving facility and Export Development Canada loan, Sprint has approximately $4.3 billion of secured capacity. It is not expected that the network or spectrum financing structures would affect the permitted lien carveouts under Sprint s bond indentures. Consequently, Sprint has the ability to raise a significant amount of funding to address pressing liquidity requirements considering the limited funding options currently available in the highyield bond market. With the MLS sale-leaseback transaction setting up the framework for future transactions, Sprint expects to execute additional handset sale-leaseback transactions on a quarterly basis that are expected to provide $3 billion to $4 billion of funding in fiscal 2016 depending on the amount of leasing sales. The MLS agreement covers only this tranche. Future tranches could have different variations including with or without residual values. Sprint also expects a network financing entity could provide between $3 billion to $5 billion of cash in fiscal The funding is expected to include new network assets related to the densification initiatives along with the majority of Sprint s existing radio access equipment and a portion of Sprint s spectrum portfolio. The network financing plans are critical to address the FY16 maturities. Fitch expects Sprint may use additional spectrum assets as collateral in FY17 to address further liquidity and refinancing requirements. Guaranteed Capacity Not Expected To Be Used The credit agreement and bond indentures allow for subordinated debt guarantees by subsidiaries up to $6 billion. Sprint has issued $4 billion. Fitch does not expect Sprint to issue additional guaranteed debt at this time given the current negative investor sentiment and the likely high coupon required. Sprint Corporation 3

5 Substantial Maturity Wall Sprint s upcoming maturities are substantial and create a more urgent need to close the deficit during the next two years. Debt maturities during the next three years total approximately $9 billion (excluding the principal portion of capital leases, towers and other obligations) including $155 million remaining in FY15, $3,675 million in FY16, $1,677 million in FY17 and $3,127 million in FY18. Fitch expects the handset leasing and network financing structures to address the funding shortfalls including the majority of refinancing requirements in FY16 and FY17. Beyond FY18, maturities total in excess of $10 billion during the next four years. A lack of execution on current strategic plans to improve cash generation and materially reduce debt in FY18 would increase Sprint s financial profile risk. Review of Mobile Leasing Solutions Handset Financing Model a Cash Drain With the wireless industry adopting a handset financing model either through equipment installment billing or leasing plans, wireless operators have experienced a substantial negative working capital effect due to the timing of cash flows. Previously in the traditional subsidy model, wireless operators would receive an upfront cash payment of up to $200 and then receive monthly recurring revenues for providing service. In a leasing model, which Sprint and T-Mobile both offer, no upfront payment is received. The customer will pay a monthly lease fee along with a monthly recurring service charge that is less than the traditional subsidy model. The chart below shows that for Sprint, device financing began to increase substantially in late 2014 due to industry changes and the rapid adoption of leased devices. Device financing as a percentage of sales should stabilize at current levels with approximately 55% of postpaid devices financed via leasing, since handset leasing is limited to higher-end handsets with relatively stable residual values. With approximately 44% of Sprint s total postpaid base currently on a financing program including 30% for leasing, Fitch expects total device financings will increase to approximately 70% of the total base driven by increases in leasing. Postpaid Device Financing as a % of Postpaid Sales (%) Leasing EIP Contract /14 6/14 9/14 12/14 3/15 6/15 9/15 12/15 Source: Sprint. While the total cash flows between the traditional subsidy and leasing models are expected to be relatively similar, the timing of the cash flows is substantially different. Thus, operators have moved to set up financing structures to limit the negative working capital implications. With Sprint expected to spend in excess of $10 billion annually for handsets, handset saleleaseback transactions and accounts receivable facilities are key to mitigating the negative cash flow effects. Sprint Corporation 4

6 MLS Expected to Ease Working Capital Impact In November 2015, Sprint completed the first sale-leaseback transaction with MLS that provided an upfront cash infusion of $1.1 billion. Fitch believes this is an important step toward mitigating the negative working capital effect associated with the leasing model. Importantly, this structure must be repeatable to enable Sprint sufficient time to stabilize and strength its financial profile. A structure that is less permanent and requires Sprint to seek other alternatives would be a material concern. MLS is a limited liability company formed by SoftBank and equity investments from six leasing companies. The lenders include three international banks that provide low-cost capital to MLS. Brightstar manages logistics and acts as sole remarketing agent for MLS to monetize returned devices. Residual value protection is provided by Brightstar through a forward purchase commitment with Foxconn Technology Group that provides insurance to minimize the downside risk of future changes in device residual values. As part of the MLS transaction, Sprint entered into a series of agreements and contributed $1.3 billion of leased device assets (approximately 2.5 million iphones) to wholly-owned, consolidated, bankruptcy-remote special purposes entities (SPE) of Sprint. The SPEs then sold the devices and transferred certain lease end rights and obligations in exchange for a maximum purchase price of approximately $1.2 billion. The purchase price included net cash proceeds of $1.1 billion, a deferred purchase price of approximately $126 million payable February 2018 and a contingent purchase price also payable on the final settlement date. MLS Structure Economics Lease iphone Example Customer purchases a $650 handset. The payment stream consists of: 24 payments of $20, Assumed residual value at contract end of $170. Discounted present value of handset at 6% rate $585. Payment considerations to Sprint from MLS assuming 10% DPP: $ cash proceeds, $58.50 DPP (which Sprint may receive when handset is returned). The following case assumes a Sprint customer purchases an iphone from Sprint. Following the sale to MLS, Sprint will lease the device back from MLS and in exchange will make monthly lease payments to MLS over the lease term. Sprint s monthly lease payment to MLS is substantially similar to the lease payments that Sprint receives from customers. The deferred purchase price (DPP) consideration, which is capped at 10% of the total purchase price, will be available to offset certain device losses potentially incurred by MLS. Sprint will guarantee, subject to a 20% cap of the aggregate purchase price, the lessees obligations to make device lease rental payments to MLS (if a subscriber stops making payments) and termination payments owed to MLS in the event that the master lease is terminated early. Fitch adds this guarantee to its waterfall recovery analysis. The implied cost of funds is in the mid-single digits Sprint is entitled to 100% of any net residual value on a returned handset that is greater than the contractually agreed amount. For an iphone, residual values typically range between $150 and $200 per handset. In the event that the residual value of a returned device is less than what is specified in the contract, the insurance would offset that portion. Reflecting the higher value, Sprint has only included iphones initially in the first MLS transaction. Sprint expects to execute future tranches on a quarterly basis and to receive $3 billion to $4 billion of funding in FY16 depending on the amount of leasing sales. Based on the simple analysis above, Sprint would receive in excess of 80% of the cash outlay for iphone related handsets within the first three months. At the end of the contract, Sprint could receive up to approximately 9% of the outlay through the DPP payment, providing the lessee returns the phone, along with any residual value upside. Fitch views this as an appropriate structure to mitigate the majority of upfront costs of handsets. If Sprint were to execute on $3.5 billion of MLS-type funding (midpoint of guidance), that would suggest approximately two-thirds of Sprint s new handset leases would be through an MLS structure. This is based on an LTM run rate on total new postpaid handsets of 17 million. Sprint Corporation 5

7 Assuming 53% of handsets will be financed through a leasing arrangement in FY16 (average run rate for past six months), Sprint would enter into 9.3 million new handset leases. As such, Sprint will likely need to contribute non-iphone devices to increase the funding rate through the MLS structure. SoftBank Ownership Fitch believes a material linkage exists between SoftBank Corp. and Sprint given the numerous affirmative steps taken to strengthen the relationship and support Sprint s operations since providing tangible support of a $5 billion capital infusion at the time of the acquisition. The MLS structure combined with the expected network financing structure that leverages SoftBank s extensive and deep financial relationships are a credit positive overall and are expected to inject substantial liquidity on an on-going basis, thus demonstrating further tangible support. Additionally, Fitch does not perceive SoftBank's support for Sprint as having changed or diminished during the past year. Nor does Fitch believe the recently announced internal SoftBank reorganization will affect support for Sprint. These financing structures will result in an increase in overall debt, particularly as Sprint monetizes network-related assets, which could be viewed negatively particularly from a bondholder perspective depending on the extent of the spectrum related securitizations. However, Sprint benefits from a more cost effective access to capital provided by the financing structures compared to traditional financings. In addition, these financing structures enable Sprint to continue substantial network investments that are critical to improving its competitive position and inject further financial discipline into Sprint s operations. If Sprint were on a stand-alone basis, the company would have experienced much greater challenges with executing agreements that could have materially affected both its business and financial profiles. Thus, SoftBank s implied support materially benefits Sprint s Issuer Default Rating (IDR) and reduces the importance of Sprint s standalone financial position. Fitch believes SoftBank s support distinguishes Sprint from other single B issuers and essentially establishes a floor to Sprint s IDR rating at B+. On a stand-alone basis, Fitch views Sprint at B given the operational and liquidity risk associated with Sprint s business and financial profile as well as the execution risk around Sprint s numerous strategic initiatives in its turnaround plan. During the next couple of years, Sprint will need to see improvement in the following operational areas to stabilize its financial profile: cut at least $2 billion from the cost structure, continue closing the network gap through capital investments to improve network performance, sustain postpaid gross share improvement, reduce churn and improve the brand image beyond the best value in wireless. Depending on the level of execution on these strategic initiatives combined with steps to address the liquidity deficit, Sprint could drive improved financial results, including top-line growth. However, the wireless competitive environment and financial strength of its national peers creates significant headwinds. Rating concerns would increase if Sprint's operational improvements do not materialize or fall short of Fitch's expectations during the next 12 to 18 months since the resulting cash drain would require further material increases in debt through asset monetizations or secured debt beyond FY17. Consequently, Fitch believes some risks exist that at a future date SoftBank could reassess its level of support. In this scenario, Fitch would begin to compress the notching to Sprint s stand-alone rating. Sprint Corporation 6

8 SoftBank Overview SoftBank Group is a combination of Japanese mobile and fixed-line operations, Sprint wireless operations in the U.S., Yahoo Japan and an investment holding portfolio primarily focused on technology start-ups in Asia. SoftBank derives more than 50% and 60% of revenue and EBITDA, respectively, from its Japanese domestic telecom operations. SoftBank group is currently the third-largest Japanese group in terms of EBIT and seventh-largest in terms of sales. SoftBank s 32% ownership in Alibaba, which is worth in excess of $50 billion, represents a significant liquidity cushion. SoftBank s management has an aggressive approach that utilizes debt to fund investments based on its ample access to capital from Japanese local banks and capital markets. Softbank s strategy is to grow inorganically through majority or minority investments in highgrowth markets primarily in technology and telecom. SoftBank has invested around $3 billion to $5 billion each year in technology start-ups in the U.S., Europe and Asia. On March 7, 2016, SoftBank announced an internal reorganization of group companies to better position its two core businesses focused on domestic and global operations. The global and domestic segments will be led by Nikesh Arora and Ken Miyauchi respectively. Both segments will continue to be wholly owned by SoftBank. The transfer is expected to be completed by Dec. 31, 2016 following shareholder approval. Fitch does not view the reorganization as a change in support for Sprint. Proposed SoftBank Group Corporate Structure Reorganization SoftBank Group Corp. (SBG) 100% 100% Domestic Operations Management Company Global Operations Management Company Shares Planned for Transfer from SPG SoftBank Corp., Yahoo japan Corp, etc. Shares Planned for Transfer from SPG Starburst I, Inc. (Sprint), Alibaba Group Holding Limited, etc. Source: SoftBank. SoftBank Ownership Tops 83% As of Sept. 28, 2015, SoftBank controlled 3.3 billion shares or 83% of Sprint common stock. During August and September 2015, Softbank acquired 215 million shares priced in the range of $3.41 to $5.29 per share to increase its stake by 5.4% to demonstrate confidence in Sprint s turnaround plan. The SoftBank merger agreement stipulates that in the event SoftBank s voting interest equals or exceeds 85%, SoftBank must commence a tender offer to acquire all shares of common stock not owned by the company. Sprint Corporation 7

9 Expected Cost Improvements Cost of Services 25% Moderate to Strong Operational and Strategic Linkages The operational and strategic linkages are moderately strong given SoftBank s oversight and Sprint s significant contribution to SoftBank s consolidated financial performance. Softbank effectively controls Sprint s board and takes an active part in day-to-day operational oversight. SoftBank has operational overlap with Brightstar US, Inc. (100% owned by SoftBank), which provides supply chain management services. There are no centralized treasury functions. After the merger, SoftBank s relationship banks, namely Mizuho bank Ltd., Bank of Tokyo- Mitsubishi (BTMU) and Sumitomo Mitsui Banking Corporation (SMBC) began to play an active role in Sprint s daily and strategic financing transactions. Sprint was also able to expand the size of its revolver and participating bank group due to SoftBank ties. During November 2015, Sprint sold $1.3 billion worth of phone lease receivables to Softbank-backed MLS in a sale and lease-back arrangement that will provide $1.2bn in cash to Sprint. SoftBank formed the separate leasing unit by using its access to low-interest loans from Japanese banks for financing. Sprint management has also detailed plans for a network leasing company structure utilizing SoftBank s relationships. Fitch views the legal linkage between SoftBank and Sprint as weak since SoftBank does not provide any direct financial support and is reluctant to provide ongoing financial assistance in the form debt guarantees or equity infusions. Thus, Sprint operates as a financially autonomous entity, although the operational and strategic linkages support its financial profile. Brightstar provides supply chain and inventory management services to Sprint through indirect channels. Sprint may sell new and used handsets and new accessories to Brightstar for its own purposes. The supply chain and inventory management agreement contemplates that Brightstar will purchase inventory from the OEMs to sell directly to Sprint s indirect dealers. As compensation for these services, Sprint remits per-unit fees to Brightstar for each device sold to dealers or retailers in its indirect channels. Key Operational Imperatives Fitch believes Sprint must make meaningful improvement through strong execution on the following top five operational imperatives to drive improved revenues and increased cash generation in order to produce sustained FCF and reduce debt over the longer term. The operational imperatives include cost structure, network, gross addition share, postpaid churn and brand. SG&A 65% Cost of Products 10% SG&A Selling, general and administrative expenses. Source: Sprint. Right Sizing Cost Structure Sprint s top priority is reducing the cost structure to improve the cash generation of the company. During the second quarter of fiscal 2015, Sprint announced plans to reduce at least $2 billion in costs on a run rate basis by the end of fiscal The current cash cost to achieve the cost savings is approximately $1 billion, split equally between operational expenses and capital expenditures with most restructuring costs occurring in FY16. Fitch believes the company has good line of sight on the majority of its plans although execution risks remains. Fitch believes further cost reduction opportunities will continue after this current program ends, resulting in further cash restructuring charges. Approximately 10% or $200 million (see chart to left) of the cost savings is expected to come from cost of products through improved logistics and procurement. Approximately 20% to 30% or $400 million to $600 million of the cost reductions are expected from cost of services driven by time-division multiplexing (TDM) to Internet protocol (IP) migrations in the wireline business Sprint Corporation 8

10 Wireless SG&A Trends ($ Mil.) SG&A % of Service Revenue 3,000 2,500 2,000 1,500 1, /13 3/14 6/14 9/14 12/14 3/15 6/15 9/15 12/15 (%) SG&A Selling general and administrative expenses. Source: Company filings. along with lower roaming expenses, service repair and rent expense from the WiMAX shutdown. The remainder of the cost savings, approximately $1.2 billion to $1.4 billion, will come from selling, general and administrative expenses (SG&A). Sprint expects cost reductions from improved sales channel mix, marketing expenses through cuts in sponsorship such as for the NBA and NASCAR, customer care costs through call volume reductions and self-help tools, IT expenses through reduced hardware and software maintenance and labor reductions across back office support functions. The new cost structure plans build on previous cost reduction efforts as Sprint has been relatively effective at reducing costs during the past year. Sprint has indicated cost reduction efforts in FY15 exceeded target with $800 million in net reductions year-to-date across consolidated cost of services and SG&A. As part of the new cost-cutting measures, Sprint will reduce its workforce by approximately 2,500 jobs or 7% of the workforce. The layoffs follow two previous workforce reductions in 2014 and 2015 of approximately 5,700 employees. The chart above shows wireless SG&A cost reductions over the past two years with an approximate 600 basis points improvement. For the past nine months, overall SG&A costs declined about $664 million from the year-earlier period. G&A expenses declined 18% or $535 million due to a $354 million decrease in bad debt expense as a result of credit profile improvement and fewer account write-offs with improvements in churn and other cost reductions due to reduced head count and cost-saving initiatives. Sales and marketing costs declined by 3% or $129 million due to lower media spending and a decrease in payments to OEMs, although these were partially offset by higher retail labor costs. Wireless Cost of Service ($ Mil.) 3,000 2,500 2,000 1,500 1, Cost of Service % of Service Revenue 12/13 3/14 6/14 9/14 12/14 3/15 6/15 9/15 12/15 (%) Source: Company filings. Wireless cost of services increased $208 million or 4% during the nine-month period ending Dec. 31, Increased repair costs have been offset by decreased roaming costs primarily due to lower rates. Sprint believes the higher repair costs are correctable through improved Sprint Corporation 9

11 management of the repair process. As a percent of service revenues, wireless service costs have increased by 80 basis points during the past nine months to 29.2%. Network Performance Lags Peers but Performance Gap Improving Total POPs for National Operators (As of November 2015) POPs (Mil.) Sprint 280 AT&T 310 T-Mobile 302 Verizon 308 Source: Company filings. Sprint s execution problems and slow pace with its original Network Vision modernization plan, which caused significant service disruptions, combined with Sprint s poor brand image and other operators aggressive LTE capital investment and marketing efforts are the primary reasons behind Sprint losing millions of subscribers during 2013 and Consequently, Sprint found itself at a significant competitive disadvantage with an LTE network that lagged its peers across the majority of U.S. metropolitan areas from a coverage, network reliability, bandwidth and capacity perspective. Through SoftBank s technical support, Sprint has significantly improved the performance of the LTE network during the past year with improved reliability, capacity and speed through its triband spectrum deployment (1.9GHz, 800MHz and 2.5GHz), two-channel (2x20 MHz) carrier aggregation utilizing the 2.5GHz band and smart antenna technology utilizing beamforming capabilities to improve coverage. As part of these upgrades, Sprint has increased its network densification of 2.5 GHz spectrum, increasing the coverage by 125 million POPs (population density) to more than 200 million POPs. Sprint believes its network optimization allows for more directive beams to where customers are located and offers customers a much improved throughput experience, especially at the cell edges and indoors. Accordingly, in late 2015 Sprint began rebranding portions of its LTE network to the LTE Plus brand, where the company can better market its network upgrade efforts. Sprint expects customers should experience improved service with double the network capacity and speed (peak speeds of 100 Mbps) and more reliable service due to the utilization of the three spectrum bands. Sprint s LTE Plus now covers more than 150 markets including New York, Los Angeles, Houston and Chicago although the company does not specify LTE Plus POP coverage. Postpaid Tri-band Phones % of Postpaid Base % of Postpaid Sales (% Base) (% Sales) /14 3/15 6/15 9/15 12/15 Source: Company filings. With 64% of the postpaid base utilizing tri-band LTE-capable devices (see chart above), a significant portion of Sprint s customers do benefit from the additional spectrum deployment. Penetration should continue to materially improve since 93% of postpaid phones sold in the quarter were tri-band. This compares to 27% a year ago. However, Sprint will need to improve the penetration of two-channel aggregation phones within the base since only 21% of its subscribers had the devices needed to take advantage of the network speed upgrade. During the third fiscal quarter, 76% of the postpaid phones sold were two-channel capable. Thus, Fitch expects Sprint should be able to realize a meaningful penetration increase during Sprint Corporation 10

12 With these network improvements, Sprint claims, through third party testing, that its network delivers the fastest network speeds where the company has deployed LTE Plus. However, crowdsourcing testing for the fourth quarter suggests that Sprint has the slowest network LTE network speeds on a national basis and indicates that Sprint still trails its peers for total overall performance across major metro areas, although the gap substantially closed in numerous markets during The bottom line is that while Sprint has improved its network, the company still has more work to do to advance network performance. Consequently during the next two years, Sprint intends to deploy tens of thousands of small cells and additional macro cells for coverage to improve network performance. One factor that can affect the speed of small-cell deployment is local approval of new cell site locations. Sprint has met with the FCC in an attempt to address the issue. Sprint will likely use wireless backhaul leveraging its 2.5 GHz spectrum to reduce costs for small-cell deployments. Sprint is also planning for three-channel carrier aggregation with deployments to substantially increase capacity and network speeds. Early testing indicates peak download speeds of more than 300 Mbps. As part of three-channel carrier plan, Sprint would increase its 2.5 GHz spectrum deployed to 60 MHz. Deep High-Band Spectrum Position The chart below provides an overview of the nationwide positions of the top holders of spectrum. The deep spectrum holdings Sprint has in the 2.5 GHz range are an important longterm strategic asset particularly given the price escalation that occurred in the AWS-3 auction for higher-band, capacity-oriented spectrum. Thus, Fitch believes Sprint has an opportunity to strengthen its long-term competitive position as the company utilizes its 2.5GHz spectrum to deploy three-channel carrier aggregation. Sprint has approximately 200 MHz or more than 50 MHz on a national basis more than AT&T, which holds the next-largest spectrum position at almost 150 MHz. Sprint s low-band spectrum position with 14 MHz of 800 MHz spectrum is weak compared with other operators. This could impact network performance in areas where its other spectrum holdings (mid- and high-band spectrum) do not materially overlap. Spectrum Positions of Leading Operators (MHz) 2.5 GHz 2.3 GHz AWS-4 AWS-3 AWS GHz 800 MHz 700 MHz Verizon AT&T T-Mobile Sprint Dish Source: FCC filings. Recent speculation around SoftBank s interest in the upcoming incentive auction appears inaccurate following the FCC s release of auction bidders. Successful bidding in the auction by SoftBank, while potentially beneficial to Sprint, would have tied up a substantial amount of capital for several years with a potentially unappealing capital return profile. Sprint Corporation 11

13 Focus on Restoring Luster to Brand as Negative Perceptions Linger Sprint Postpaid Churn Trends (%) Network Vision began to negatively affect network quality. Source: Sprint filings. One of the primary issues Marcel Claure faced when taking Sprint s CEO position in the fall of 2014 was restoring Sprint s poor brand imagine. The company had experienced substantial brand damage over the years due to execution missteps around the Network Vision upgrade that negatively affected customer experience, poor brand positioning, confusing rate plans, bland store image and the phasing out of the Nextel brand. The chart at the left demonstrates how these issues affected postpaid churn trends. Sprint s brand image declined, particularly during mid-2013, and Sprint s net promoter score (a measure of customer loyalty) weakened considerably relative to its peers as consumers churned at higher rates and Sprint began to lose share of new customers. In response to the worsening brand image during the Network Vision infrastructure upgrade, Sprint touted, in a marketing campaign that began in April 2014, "America's Newest Network" intending to highlight a more reliable and faster wireless network. However, that message failed to resonate with consumers given the severe network disruption during the Network Vision plan. Sprint had no choice but to become aggressive with pricing and value by focusing the discussion on the total cost of ownership when Claure arrived. As part of Sprint s new brand repositioning, the company focused on offering the best value in wireless for individuals, couples and families while simplifying the message delivered to consumers regarding its plans and devices. For example, Sprint s individual plans focused on $60 unlimited talk, text and data. This compared to $80 at T-Mobile. For couples, Sprint had a similar offer of $120 versus $140 at T-Mobile. For families, Sprint offered a double-the-data promotion. Sprint also began offering its iphone for Life program with financing options for leasing and equipment installment billing. As a result, Sprint began to regain traction with a new messaging campaign in late 2014 although pricing pressures weighed on top-line results. During 2015, Sprint continued to focus its brand message on providing the best value in wireless through its promotional offer to cut the rate plan in half of Verizon Wireless (Verizon) and AT&T customers that switch to Sprint. During November 2015, Sprint expanded the offer to T-Mobile subscribers. Looking forward, Sprint must focus on reenergizing the brand and improving consumers perceptions of it. Having the best value in wireless as a marginal fourth player with a weak financial profile and brand materially increases long-term risk. Sprint must carve out a niche focused on a robust network, delivering industry-leading performance that will underpin the company s operations and restore pricing power to remain viable over the long term. Sprint s branding has already begun to evolve by leveraging the network improvement theme along with its best-value message. Fitch believes the improved network message will grow, particularly as Sprint focuses its brand message locally to drive postpaid growth. Whether the company can execute on this strategy remains one of the key challenges for the company. Wireless market maturity and the intensely competitive operating environment with vastly larger competitors with significantly stronger financial profiles create substantial headwinds. Sprint Corporation 12

14 Estimated Postpaid Gross Addition Share (%) Verizon AT&T Wireless Sprint T-Mobile Source: Company filings. Postpaid Gross Addition Share Stable; Handset Additions Up The postpaid gross addition share chart above highlights Sprint s struggle with its brand image through 2012 to Sprint s share of gross additions declined from the 20% range to the low-double-digit range as T-Mobile began to take share from all three operators with its highly successful uncarrier brand message that has continued to sustain momentum. Sprint s postpaid gross addition share would have been even worse had the company not chosen to relax credit standards during early 2014 to prop up its deteriorating performance. Estimated 2015 Postpaid Gross Addition Share (%) Verizon AT&T Wireless Sprint T-Mobile 3/15 6/15 9/15 12/15 Source: Company filings. After an initial share bump at the end of 2014 and early 2015 with its new promotional plans, Sprint s overall postpaid gross addition share has stabilized in the 15% 16% range. Due to Sprint s focus on increasing share in the higher-value postpaid handset segment, Sprint s postpaid mix has shifted from tablets to handsets as shown in the net postpaid addition chart on the next page. Sprint estimated its share of postpaid handset additions increased by 150 basis points during the third fiscal quarter of With Sprint s focus on higher-arpu subscribers, overall postpaid share trends were relatively flat during the past three quarters. Fitch believes Sprint will need to improve postpaid gross addition share by at least 200 to 300 basis points longer term to drive sustainable growth. Thus, one of Sprint s primary challenges is to sustain success competing against Verizon and AT&T for higher-quality prime postpaid subscribers, which Fitch believes will be challenging. Going forward, Sprint will need to find a sweet spot where the company can gain share without eliciting stronger competitive responses as it attempts to focus on the prime segment that is the core of Verizon and AT&T s subscriber bases. Additionally, over the medium-term, Fitch believes Sprint could experiment with alternative subscriber acquisition avenues for lower Sprint Corporation 13

15 quality subscribers through programs where third parties assume the default risk for nonpayment of leased devices. Sprint Postpaid Additions (000) Handsets Tablets (200) (400) (600) (800) 3/14 6/14 9/14 12/14 3/15 6/15 9/15 12/15 Source: Company filings. Industry postpaid churn results to the left demonstrate that while the market has been extremely competitive during the past two years, postpaid churn rates have generally been relatively stable for Verizon and AT&T. Postpaid Churn Trends (%) Source: Company fiiings. Verizon AT&T T-Mobile Sprint s agreement to broaden its direct distribution by leasing space in approximately 1,750 cobranded RadioShack stores accelerated efforts to improve its competitive position in a costeffective way, thus allowing the company to close the distribution gap relative to its peers. However, the effectiveness of this distribution channel over the longer term remains in question. RadioShack s small-box consumer electronic stores lost much of their relevance as product innovation led to convergence and reduced the number of items for it to sell. Internet retailers generally made buying more convenient and often cheaper than RadioShack. The firm also struggled with profitability as a third-party distributor for smartphones and tablets with large-box retailers, wireless carriers own stores and on-line buying proving a better consumer option. These structural issues led RadioShack to declare bankruptcy. As part of Sprint s effort to drive better accountability and improved subscriber trends in the region, Sprint restructured the company into four geographic areas West, Central, Northeast and South with targeted resources devoted to 17 top regions. Sprint had tested the new structure in the Chicago market with promising results. The new regional presidents will be responsible for sales strategy, network oversight, customer service, marketing communications and general operations supporting all of Sprint products and services from enterprise to consumer. Postpaid Churn Trending Down; Further Improvement Needed Sprint has the highest churn of the four industry players. However, postpaid churn has shown substantial improvement with a decline of 68 basis points to 1.62% during the past three quarters compared to the year-earlier period following the change in CEO in late The decrease in churn was due to improved network experience and quality of recently acquired customers. Further reduction in churn could be driven by the new leasing model as Sprint further increases penetration. In Sprint s opinion, the leasing model benefits churn by maintaining the customer relationship due to several interactions at the end of the contract. Fitch believes Sprint will need to drive further churn improvements by at least basis points to generate longer-term sustainable postpaid net addition growth. However, Sprint could experience some churn Sprint Corporation 14

16 Sprint Postpaid Churn Trends (%) 2.5 CEO changed, credit standards modified and new marketing programs implemented, including leasing /13 3/14 6/14 9/14 12/14 3/15 6/15 9/15 12/15 Source: Company filings. pressure at times as the company adjusts its marketing efforts in response to competitive offers or if successful with alternative third party financing programs that assume device payment risk. During the latest quarter (the third quarter of FY15), Sprint reported phone net additions of 366,000 compared with net losses of 205,000 a year ago. Sprint indicated third quarter results represented the highest postpaid phone addition growth in the last three years. Fiscal year-todate, postpaid phone net additions were 416,000. This compared with a loss of 1,325,000 from the year-earlier period. Year-to-date tablet additions were approximately 581,000 compared with 985,000 a year earlier due primarily to lower gross additions. Average postpaid subscribers per account for the third fiscal quarter of 2015 rose to 2.72 compared to 2.6 a year earlier. Telecom Sector Outlook Overall Telecom Sector Outlook Stable for 2016 Fitch expects wireless and wireline data service growth to provide the foundation for a stable sector outlook in Overall, Fitch anticipates revenue growth will again be in the 3% to 4% range with stable operating margins. Facilities-based wireless service providers continue to enjoy the strongest competitive position, reflecting the growing demand for mobile data services. However, modest subscriber growth is challenging wireless operators to balance subscriber growth with maximizing profitability and investing in wireless networks. Wireless Competitive Environment Intense The wireless industry has experienced long-term competitive pressure due to aggressive pricing and targeted value-based offers that began increasing in Competitive pressure has continued to the present with promotional price cuts, early device upgrades, increased data bucket sizing and large switching credits. However, Verizon and AT&T have been able to remain relatively strong as measured on a number of metrics (margin, churn, EBITDA generation, FCF). Both companies good financial profiles, with large scale, sharp execution and efficient operations that generate the lion s share of industry profits, have greatly enhanced their competitive position and somewhat shielded them from competitive pressures. The mature wireless industry also displays structural similarities with other industries, most importantly the tendency to be dominated by three volume-driven companies controlling typically 70% 90% of the market with two players substantially larger than the rest of the competitors. In the wireless industry case, T-Mobile is the number three player that has carved Sprint Corporation 15