The Biggest Winners If T-Mobile and Sprint Merge

Markets Motley Fool

T-Mobile (NASDAQ: TMUS) and Sprint (NYSE: S) are reportedly close to agreeing on terms to merge their respective companies into one entity. The third- and fourth-place carriers have held discussions in the past, but they abandoned talks as the political environment made it unlikely a merger agreement would get approval from the FCC. Reuters reports the two companies are now close to finalizing an agreement, and it could come as soon as this month.

Continue Reading Below

The combined company would have roughly 130 million subscribers, which is barely less than AT&T (NYSE: T) (135 million) or Verizon (NYSE: VZ) (146 million). While investors in the two telecom giants may be scared of what T-Mobile CEO John Legere could do with a subscriber base that large, they may actually be some of the biggest beneficiaries of T-Mobile-Sprint merger.

Competition has been out of control

The intense competition from both T-Mobile and Sprint have destroyed some of the economics that greatly benefited Verizon and AT&T. Both of the larger companies benefit from their sizable subscriber bases. With the massive fixed costs of building out a wireless network, the more customers those costs are spread across, the better.

T-Mobile has managed to improve its network, but it didn't produce any cash flow for shareholders as it did so. All of its profits were reinvested into improving the network and offering better value to subscribers.

Sprint has been even more desperate for customers. So much so that it offered free service to new customers this summer.

Continue Reading Below

The efforts of T-Mobile and Sprint have had a negative impact on AT&T and Verizon. They've been forced to make moves like offering unlimited data plans and more value-oriented service and equipment plan options.

Ending the land grab

A sizable third-place competitor could end the land grab for customers. Canada's three largest competitors are all similarly sized, and they all offer very similar plans at very similar prices. None are particularly motivated to offer better value to customers because they all benefit from the same economies of scale already. While that's not so great for consumers, it's great for investors, who see huge and steadily growing piles of cash come in year after year.

The U.S. could experience something similar following a T-Mobile-Sprint merger. That's why the FCC might have blocked the merger in 2014 under the Obama administration. Under the Trump administration, the FCC is much more laissez-faire. And while a merger could hurt consumers somewhat, consumers have had it pretty good for the last few years with their free iPhones and free service. That level of competition is completely unsustainable.

T-Mobile is already notably starting to focus on free cash flow. Management is aiming for a compound annual growth rate between 45% and 48% between now and the end of 2019.

Investors shouldn't expect that new focus to change if it combines with Sprint. If anything, it could improve the long-term outlook for free cash flow after the necessary investments to migrate Sprint customers and repurpose Sprint's CDMA spectrum are complete.

Aside from its subscribers, Sprint brings valuable assets to the table, including its high-band spectrum, which the combined company would have enough capital to deploy. But while the company might spend money to improve its network, it won't be nearly as desperate to attract new subscribers through promotional offerings.

If T-Mobile and Sprint merge, it should reduce the pressure on Verizon and AT&T's service revenue. They're both more likely to hold onto their existing customers as well. All of that adds up to higher profits than they would generate if we remain in the hyper-competitive wireless environment of today.

10 stocks we like better than T-Mobile US
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and T-Mobile US wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of September 5, 2017

Adam Levy owns shares of Verizon Communications. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool recommends T-Mobile US. The Motley Fool has a disclosure policy.