Investment analysts at Macquarie Capital are concerned about how T-Mobile US will deal with rising smartphone prices and the capital required in order to fund equipment installation plans. Currently, T-Mobile US has strong subscriber, revenue and earnings growth, but the analysts are concerned about the relatively poor cash generation from the business. Equipment upgrade plans have been very well received by customers, but the carrier must pay for the hardware from capital and effectively fund it for the customer. The more customers upgrade and use the EIP programs, the more hits T-Mobile’s capital takes: T-Mobile US is becoming a victim of its own success. The high rate customer growth, which the business is enjoying, has to be paid for in one way.
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Nevertheless, the analysts are increasing their forecast EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, for 2016 to $8.87 billion from $7.72 billion. This increase is based on “strong Q2 margins and an expected $666 million in lease accounting benefits.” Free cash flow will increase by only $214 in 2016 to $1.06 billion, being dragged down by equipment installation plans. On the subject of rising smartphone prices, the analysts said: “[T-Mobile US’] upgrade rates have risen [year-over-year] to 9 percent in Q215 and 8 percent in Q115 from 8 percent and 7 percent in Q2 and Q1 ’14, respectively, even as T-Mo has added 4 million postpaid phone subs over the past four quarters.” T-Mobile US activated 2.3 million more smartphones in the first half of 2015 compared with the first half of 2014 and their capital took a $1.15 billion hit, as the average cost of replacement hardware is around $500 a device.
What is interesting is that when T-Mobile’s management were questioned about the higher costs of upgrades they stated that their business was not about free cash flow but instead about what the customer wants. This sort of behavior is considered outlandish by Wall Street, because a business is favoring customers over stakeholders is unusual. T-Mobile US is working to reduce churn, that is the number of customers leaving the network for a competitor, by offering early upgrades to existing customers. In the words of the analysts, “Unless T-Mo can arrest the pattern of a shortening upgrade cycle, it will fail to grow [free cash flow] rapidly enough to justify the stock’s current valuation, in our opinion.” T-Mobile US also needs a way of disposing of returned devices for at least their market value, which has proven difficult; their Jump! On Demand scheme allows customers to upgrade devices up to three times a year. This means that T-Mobile has large numbers of devices being returned by customers and no easy way to realize their value. Certainly, the T-Mobile US business is not without its problems and it’s clear the company is working hard to grow its customer base. But the Uncarrier really is behaving like an uncarrier, by putting customers first.