Is prepaid mobile service the next huge wave of growth for the industry…or will it bring about a negative overall trend in wireless industry pricing and profitability?  That’s the $64k question this summer, and clearly Sprint (S) has taken a stance with its buy of one of the largest prepaid service providers nationwide. 

Of course, S has been bleeding customers for more than a year now, and with this deal, is acquiring Virgin Mobile’s (VM) 5m subs for what looks to be a pretty sweet price.  But even as Dan Hesse touts the growth of prepaid and the “value-minded consumers” of the recession era, in VM’s most recent quarterly conference call, Dan Schulman waxed earnestly about his company’s new focus on what he dubbed “LTV” or Life Time Value per customer, and how the growth in its “hybrid” plans will improve profitability over the long-term.  Meanwhile, S is rumored to be shopping its Nextel (iDEN) division, even as it trumpets the recent customer growth at prepaid iDEN division Boost Mobile…

 So which is it?  It probably depends on how far out you look…there’s no doubt the cheaper prepaid options are popular in these tough times, but as VM has already learned, subscriber growth doesn’t necessarily translate directly to revenue growth, or more importantly, cash flow growth.  And the recent trend toward substitution of voice minutes with text messaging and the general market pressure that intense competition is placing on traditional post-paid plan pricing could have a seriously deleterious impact on even the strongest carriers over the long-term. 

 S investors have voted with their stock—and they don’t seem to like the outlook.  Since the day before the VM deal was announced, shares in S have fallen more than 20%.  A downgrade by long-time wireless industry analyst Chris Larson (Piper Jaffrey) further depressed the stock price, after he reduced his target to $3.50 per share (from $5) and asserted that S is unlikely to achieve the cash flow targets that many have been forecasting.

 The slide in share price has already reduced the indicated value of VM, based on the collar established in the stock for stock transaction.  We’ve run the deal multiples through our Calculator based on the announced $5.50 per VM share price, but also had a gander at what S’ newly slimmer market cap does for the look of the deal.

 First, the base case.  S said that the agreement valued VM’s total outstanding equity (including the 13.1% already owned by S) at $483m.  An additional $205m in anticipated outstanding net debt brings the implied enterprise value of VM to $688m.

 Through the first half, VM generated revenue of $645m, so that puts the estimated run-rate revenue multiple at about 0.5x.  Over the same time frame, the company generated more than $90m in adjusted cash flow, but VM guidance for the full year is only $127m-$142m.  We’ve used $140m as our estimate for run-rate cash flow, which implies an OIBDA multiple of 4.9x on the deal.  In terms of free cash flow, VM expects to generate between $45m and $55m.  We’ve gone with the top end of that range, based on first half results, implying a net cash flow multiple of 12.5x.

 S says it expects to enjoy some synergistic savings once the buy is completed, but failed to quantify those savings.  In the interest of conservativeness, we estimated that operating expenses might fall by 5%–given the 15% margin VM was already making, we’re not clear that G&A savings will amount to a large number.  That would imply savings of $55m to $60m annually, and push pro forma cash flow and net cash flow to around $200m and $115m, respectively.  Now the multiples look more like 3.4x OIBDA and 6x net cash flow.

 The most telling data point comes when the deal is examined on a per subscriber basis.  VM had just under 5m subs as of June 30.  Based on the $688m announced deal value, that implies a per sub value of just $138. Of course, considering that ARPU was less than $20 in the latest quarter, that works out to around 7x monthly revenue.

 By way of comparison, Atlantic Tele-Network (Nasdaq:ATNI) is paying $250 per subscriber for the former Alltel markets it’s buying from Verizon Wireless (VzW), which we called a cheap deal.  Of course, ATNI is picking up a network with the deal and Alltel subs historically generated closer to $60 per month in ARPU, so it actually is relatively cheaper (although we’re not sure at this point what portion of the revenues Alltel generated on a per sub basis that ATNI will realize going forward).

 Adjusting the deal value for the drop in S’ stock price implies an enterprise value for VM of $631m, or 4.5x expected cash flow and 11.5x expected free cash flow this year.

 In general, and despite some obvious unique attributes that recent larger wireless deals have had, there’s a clear trend toward lower values.  Back in November of 2008, AT&T (NYSE:T) offered to pay an estimated 3x+ revenue and nearly 8x cash flow for the U.S. operations of Centennial Communications (NYSE:CYCL).

In May of this year, T and VzW announced transactions that valued the wireless operations involved at around 2.2x revenue and 6x cash flow…but the newest two deals of size in our roster came in well under 1x revenue and even less in terms of cash flow…These last two deals aside, we’d be surprised to see an announced transaction of any size come in where the T/ CYCL deal did less than a year ago.

 Getting back to VM…shareholders are no doubt disappointed with the recent performance of S’ stock price—and the implied haircut they’re already taking off the announced $5.50 per share price.

 The share for share deal has a collar of no more than 1.3668 and no less than 1.0603 shares for each share of VM.  Following S’ recent nosedive, the implied value to a VM shareholder (as of 8/11) was just $4.85 per share, and the stock traded at a 6% discount, or $4.56 per share.  Prior to the deal’s announcement, VM had been trading in the high $3 per share range, so there’s still been some decent gains—but the stock is nevertheless well off its $5.28 per share close of 7/28.  

 Looking ahead, we like the company’s decision to focus on growing its more profitable customer base at the expense of overall subscriber growth.  Schulman asserted that the LTV on its hybrid customers is now 15x the value of its traditional pay-as-you-go (PAYG) subs, and while we can’t seem to get to that figure, the difference in overall value per sub is clear.

 Hybrid subscribers had an ARPU of $42 according to Schulman, which he indicated is about 2.5x the ARPU of PAYG subs.  We estimate that the company’s base is comprised of about 14% hybrid and 86% PAYG subs. Further, the churn on hybrid subs is said to be much lower—we pegged that at around 2.2%, in line with other carriers’ contract customers. Blended, VM reported overall churn of 5.3% per month in the latest period, and ARPU of about $19.

 By our calculations, that makes the overall lifetime revenue per subscriber about $354 presently, but the hybrid customer is likely to generate more than $2,200 whereas the PAYG customer may only bring in $276—or about one eighth that of the hybrid sub. Schulman may be looking at cash flow or net cash flow when he comes up with the “15x more valuable” claim, but no matter how you look at it, future growth in the hybrid sub group and a conscious effort to limit unprofitable PAYG subs can only improve the company’s overall economic profile…and ultimately that of S as well.

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