There’s an interesting phenomenon going on when it comes to Sprint (NYSE:S) stock. Sprint is hoping to merge with T-Mobile (NASDAQ:TMUS) in an all-stock deal. Owners of Sprint stock would receive a little over one-tenth of a T-Mobile share in such a deal. Yet as TMUS keeps moving higher, Sprint shares generally keep moving lower.
Indeed, since Oct. 1, T-Mobile shares have climbed over 4%. S stock has dropped almost 8% despite some recent bullish trades. That divergence seems somewhat strange given that the ratio established by the merger agreement hasn’t changed. Sprint investors still would get a tenth of T-Mobile’s equity (0.10256 shares, to be exact) if the merger goes through. TMUS now is more valuable, yet Sprint isn’t.
There are two reasons for the falling Sprint stock price, however, and neither bodes well for the future. At this point, particularly after disappointing subscriber numbers in the company’s first quarter report, S stock represents a bet on the merger going through. And that doesn’t seem like a bet worth taking.
TMUS Shoots Up, Sprint Stock Price Falls Down
You must assess several factors to estimate the value of a stock ahead of a potential merger. First is the consideration paid. Second is the perceived odds of the deal going through. Third is the imagined price if the deal breaks. And fourth is the time to close: investors won’t pay $100 today for $100 of value that won’t be realized a year from now.
In the case of Sprint, the consideration paid actually has risen since the merger was announced last April. T-Mobile stock is up over 21%. At the current TMUS stock price near $74, Sprint shareholders now would receive about $7.53 per share in market value. Yet the Sprint stock price sits at just $6.02, suggesting an unusually large 25% deal spread. In other words, the consideration paid is 25% above the current trading price.
That spread has widened notably from just 4% to 5% for much of last year. Most of the increase has come just since January. The upside of S stock might look higher in a best-case scenario, but that’s clearly not what investors are focused on at that moment.
A Widening Spread
Two key factors have led to the widening spread. The first is that it appears the odds of the deal going through are much lower. As I wrote back in 2017, when rumors of the merger were again swirling, approval seemed reasonably likely after the surprise 2016 election of Donald Trump.
The oft-cited rule of thumb is that Republican antitrust regulators want at least three competitors in a market, and Democrats four. A new Republican administration seemed to promise a much easier path to approval.
And as Luke Lango wrote back in June, the green light for the acquisition of Time Warner by AT&T (NYSE:T) seemed to strengthen that case. Lango wasn’t alone in making that argument: the Sprint stock price and TMUS shares moved in concert for the rest of 2018. This suggested that investors were valuing Sprint as a discounted version of T-Mobile.
That’s not the case anymore. Another delay in the approval process seems to suggest the odds are lower than previously anticipated. Consensus seems to be that the chance of approval is closer to the 50/50 range. With much less confidence in the merger going through, investors have sold off Sprint stock.
The second problem is that the potential downside in a deal-break seems to be larger. Citigroup (NYSE:C) has said of late that it sees a standalone Sprint as worth $3 per share. Both Q4 and Q1 results show a company losing market share to T-Mobile and Verizon Communications (NYSE:VZ). Generous free line promotions are hitting margins. It does seem like S stock, without merger news, would have declined over the past year-plus.
Indeed, improving market share and optimism for a merger fueled 2016’s rally. Without the merger, S stock doesn’t have much to offer.
Is S Stock Worth the Risk?
Last year, an investor might have argued that Sprint had an 80%-90% chance of being acquired and gaining some $7-plus per share in value. In the other 10%-20% of outcomes, a fall to $5 or so might be expected. That in turn suggested a Sprint stock price — discounted back a couple of percentage points to account for time to close — in the mid-$6 range, which is about where shares traded.
The math looks different now. The upside is a little higher, at about $7.50. But if the odds of approval are truly 50%, and the downside case is a valuation of $3, Sprint stock only should be worth about $5 now, maybe a touch more. Its expected value in this model would be $5.25, less, again, a percentage point or two because the deal likely won’t close until at least the end of this year.
In other words, the market right now is either pricing in greater than 50% of odds of approval or downside closer to $4 than to $3.
To some investors, that might seem an intriguing bet. Sprint isn’t doing great from an operational standpoint, certainly. But its spectrum still has value. 5G still is on the way. Sprint likely isn’t going bankrupt if regulators block the merger. Meanwhile, rising TMUS shares suggest much more in the way of upside should the gamble pay off.
But here’s the problem: if the merger is approved, Sprint stock likely rises 20% or more. If it’s blocked, S stock could fall by a similar amount. Assuming the odds are roughly 50/50 — and that seems about right — owning S stock appears little more than a gamble.
As of this writing, Vince Martin has no positions in any securities mentioned.
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