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Regulatory Risks in Sprint and T-Mobile Deal Outweigh Stretched Finances

NEW YORK (TheStreet) - If Sprint's (S) majority-owner SoftBank tries to push the telecom's merger with T-Mobile (TMUS - Get Report), creating a third wireless carrier in the United States with at least 100 million subscribers, the regulatory risks inherent in a deal could outweigh financial risks. That's the case even though a combined Sprint and T-Mobile would become third most indebted junk-rated company in the U.S., requiring "flawless" execution to get to a point of financial stability, according to Moody's Investor Service.

Moody's believes the risks of a merger start the day the deal is announced because both companies are in the midst of network upgrades and M&A can dent operational performance. Meanwhile, the prospect of a lengthy regulatory review and the likelihood that antitrust regulators stand their ground on an effort to have four nationwide wireless carriers could prove an insurmountable challenge for Sprint and T-Mobile.

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A large breakup fee if a transaction were blocked by either the Department of Justice or the Federal Communications Commission means there is also the risk that T-Mobile continues to be the asset that proves too hard to buy for competitors like AT&T, Verizon and Sprint. AT&T's failure to buy T-Mobile for $39 billion in 2011, after all, sparked a multi-year run of consolidation in the telecom industry.

Mark Stodden, a senior analyst at Moody's Investor Service, said in a Tuesday telephone interview he gives Sprint and T-Mobile less than 50% odds of successfully completing a deal.

Ultimately, antitrust issues inherent in the merger make it a roll of the dice and, perhaps, one SoftBank is keen to make. The risks inherent in a merger may be outweighed by potential benefits that would come from as successful combination of the nation's third and fourth largest wireless carriers. Moody's in a special comment on Monday, called the long-speculated upon transaction a "high risk, high return proposition."

A deal has yet to be formally announced, however, media reports indicate Sprint may look to pay $40 a share for T-Mobile, giving the company an equity value of about $32 billion. Sprint spokesperson Scott Sloat declined to comment, citing the company's policy not to comment on rumors and speculation.

Projected Finances of Combined Company

If a deal were given a 50% cash and 50% stock split, that would ultimately mean Sprint might finance $16 billion of the transaction. Add T-Mobile's $23 billion in existing debt and Sprint's $33 billion in debt, and the combined company would have a total debt load of about $72 billion, rated at Ba3 or lower, according to Moody's calculations.

At $72 billion in debt, the combined company would have debt of roughly five times earnings before interest, taxes, depreciation and amortization (EBITDA) following the close of merger. Those debt-to-EBITDA ratios would be roughly double AT&T (T) and Verizon (VZ), putting the company at a financial disadvantage. Meanwhile, according to Moody's analysis, the debt load will go against expectations of negative free cash flow through 2018.

Clearly, there would be small margin for financial missteps. However, if a large junk-rated debt load is a financial risk for the company, ultimately, Stodden concludes that both companies could be financially better off for pursuing a merger.

Cost Structure Can Improve Dramatically

If Sprint's owner SoftBank has flawless execution in the merger, the deal could generate over $3 billion in annual expense savings. Overall, the combined company is forecast by Moody's to have $18 billion in annual sales, general and administrative expense, equating to roughly 28% of sales. Were that ratio to fall to 25% of sales and costs of goods sold falling to 45% of sales, it could free up about $3 billion annually.

Those cost savings, combined with the prospect of lower capital expenditure needs in coming years, give the merger its high-reward nature. Large hedge fund shareholders in Sprint and T-Mobile such as Paulson & Co., Omega Advisors, Owl Creek Management and Glenview Capital Management likely anticipate the benefits of consolidation. A wave of mergers among also-ran carriers in recent years has proven that wireless consolidation has financial merit.

The fear of similar technological issues that happened with Sprint's disastrous acquisition of Nextel with T-Mobile may be overstated. The integration of Sprint and T-Mobile's contrasting networks may also prove less of a headache than many expect, particularly, if the merger is subject to a long regulatory review.

Barely Better Than a Duopoly?

All told, Sprint's possible merger effort with T-Mobile could underscore the extent that the telecom industry may be coming full circle. AT&T and Verizon stood as a virtual duopolies at the dawn of the smartphone age, and after tens of billions spent on wireless spectrum, capital projects and mergers, the industry may only expand by one carrier.

Still, were a merged Sprint and T-Mobile to become a viable and price-competitive alternative to AT&T and Verizon, it might also prove that years of industry realignment has created more choice for customers. Such a conclusion, however, would require a dramatic change of heart in Washington.

-- Written by Antoine Gara in New York.

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