Time is money, and a prominent telecom analyst says the timing of Sprint’s cash flows doesn’t match up with what the company is reporting. According to Craig Moffett of MoffettNathanson, Sprint sourced 71% of its earnings before interest, taxes and depreciation from “accounting distortions” during the fourth quarter of 2015. The company is following the rules, but Moffett says the rules create misleading financials.
“I’ve never seen anything like this in my career,” said Moffett. “Not just in this sector, but in any sector.”
Moffett says the accounting distortions started when carriers moved to device financing instead of subsidized pricing, and he says Sprint’s financials became even further divorced from reality when the carrier started leasing devices.
“Things really went off the rails when Sprint started doing leasing and I wouldn’t be surprised to see others start doing leasing because of the distortion, or benefit, that Sprint has gotten,” said Moffett. “On an as-reported basis, Sprint looks like it’s growing [earnings before interest, taxes, depreciation and amortization] at just under 30% and it looks like it’s trading at 5.7-times EBITDA, not an unreasonable number. But if you adjust for all the accounting nonsense, Sprint is actually growing EBITDA at negative 30% and it’s actually trading at 12-times EBITDA.”
Cash flow vs. accounting
When U.S. carriers started helping customers finance phone purchases through installment plans, they deferred cash flow, but made their financial statements look better. From a cash flow perspective, subsidized phones and contract pricing were better for the carriers. Even at today’s interest rates, a dollar today is worth more than a dollar tomorrow, so carriers benefit from getting the largest part of the payment when the customer buys the phone at the start of the contract. The total amount collected by a carrier ends up being very similar whether a customer buys with a contract, leases, or buys on an installment plan, but the timing of payments is best for the carrier under contract pricing.
Still, carriers prefer installment and lease plans. Optimal cash management matters less than the income statements Wall Street scrutinizes each quarter. And these look much better in the early months of an installment or lease plan than they do with contract pricing. With installment plans, all the revenue is recognized when the customer buys the phone, but with contract pricing the revenue is recognized over time as the cash comes in.
With contract pricing and installment plans, the payment the carrier makes to buy the phone from the manufacturer shows up as an expense on the income statement. With lease plans, the balance sheet is impacted when the carrier buys a phone. Accounts receivable goes up and cash goes down. Carriers can replenish some of that cash by borrowing against the receivables.
Simply put, if a carrier sells you a $600 phone for $200 with a contract, the carrier’s income statement shows a net expense of $400. If a carrier leases you the same phone, the income statement shows a small positive amount that month: the amount of your first payment. The money the carrier spent to buy that phone impacts the balance sheet, but not the all-important income statement.
“As you transition from one accounting to the other accounting you create a very, very serious distortion during the period of transition, where you are effectively double counting,” said Moffett. “We tend to prefer the old [accounting] because it is a better match to free cash flow and therefore the accounting creates less of a distortion versus the real economics, which in my mind is always the cash economics.”
The impact of device leasing
Leasing takes the accounting distortions a step further, according to Moffett. The smartphone becomes an asset that the carrier depreciates, meaning its cost hits the income statement over time as a depreciation expense, but never impacts EBITDA.
“Your total lifetime EBITDA for leasing is nearly double what you get under the subsidy model and under equipment installment plans,” said Cathy Yao, senior research associate at MoffettNathanson. “In surveys that we’ve seen customers tend to be typically indifferent or ignorant towards the differences [between leasing and installment plans], so in our view leasing is really something that carriers are pursuing to make their EBITDA numbers look better, rather than something that is actively preferred by customers.”
“Sprint’s guidance has, per our calculations, over $6 billion in EBITDA distortions from leasing,” said Yao. “The fact that your handset cost completely bypasses the income statement helps inflate your first period EBITDA and continues to inflate that EBITDA over the lifetime of the customers. … So even though the cash lifetime profile is unchanged, the fact that you have the accelerated lease option helps you completely distort your EBITDA recognition.”
Sprint was the first U.S. carrier to create a smartphone leasing plan. The carrier can maximize the value of smartphones that come back to Sprint at the end of a lease because it has a unique relationship with Brightstar, which calls itself the world’s largest device distributor. Brightstar was founded by Sprint CEO Marcelo Claure, and is majority-owned by SoftBank, the Japanese carrier that also owns Sprint.
Sprint’s leasing vehicle started out as a separate financial entity, but during its most recent earnings call Sprint said it would bring the leasing company back onto its balance sheet. This boosted Sprint’s EBITDA projections for the coming quarters.
The bigger picture
Not all of Sprint’s positive projections can be attributed to accounting. Analyst Jennifer Fritzsche of Wells Fargo expects the stock to outperform the market, and while she acknowledges the impact of accounting changes on Sprint’s financials, she says that’s just part of the picture.
“This is not the only reason driving EBITDA improvement,” said Fritzsche. “Also helping year-on-year EBITDA improvement between [financial year 2015] and [financial year 2016], in our view, is stable services revenue, increasing equipment revenue and continued cost containment.”
But Fritzsche also describes Sprint as a “liquidity story at this point” and is keeping a close eye on the company’s cash flow.
One positive for Sprint from a cash flow perspective is its strong spectrum position. Among the nationwide carriers in the U.S., Sprint is the only one that does not plan to bid in the upcoming 600 MHz spectrum auction, meaning it will not be spending billions on spectrum and will have more cash available to build out its network and service its debt.
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