The Rules of the Telecom Game: Spend Big, Win Big

This week the Federal Communications Commission (FCC) staff recommended rejection of AT&T’s (NYSE: T) proposed purchase of T-Mobile USA. The staff concluded the $39 billion deal would destroy rather than create jobs and that it wouldn’t boost wireless innovation, either.

Meanwhile, the FCC itself stated it will seek an “administrative hearing” on the deal. That wouldn’t even take place until a US Dept of Justice (DoJ) lawsuit against the merger–now in the courts–runs its course, which could put a final ruling off well into 2012 at the earliest.

An AT&T spokesman immediately called the action “disappointing.” The FCC’s position, however, is pretty much right down the line with the DoJ’s stance, making it hardly a surprise.

There’s still a possibility of a negotiated settlement between the parties. Moreover, AT&T is unlikely to go away quietly, given the hefty breakup fees. Nor is T-Mobile’s owner Deutsche Telekom (Germany: DTE, OTC: DTEGY) likely to abandon this deal, which is viewed by management as its best opportunity to walk away from a market it’s no longer interested in. At the least, however, this latest move seems certain to delay this merger until after the 2012 elections.

Ironically, whether AT&T-T-Mobile ultimately succeeds or fails matters not a whit to the evolution of the telecom industry, or, for that matter, to AT&T’s future prospects. Merger or no, larger companies will continue to become more dominant, gaining share of the wireless industry’s most profitable segments. Smaller companies, meanwhile, will become increasingly less competitive and profitable, with the weakest at growing risk of toppling into bankruptcy.

The key is communications’ unique brand of “moneyball.” As the baseball movie “Moneyball” reminds us, spending less doesn’t necessarily mean failure for sports teams. Conversely, neither does big spending guarantee success, as fans up and down the East Coast discovered painfully yet again in Major League Baseball’s 2011 post season.

The communications industry, however, is a far different story. In fact, huge capital outlays are absolutely critical to success, whether it’s assuring network quality and or extending reach at a time when demand for spectrum is soaring as never before.

Wireless “data,” for example, is in greater demand than ever. The volume of texting and downloading are projected to double between now and 2017. And, as we saw during the recession of 2008-09, traffic rises even during the worst economic contractions. Like cable television, wireless communications in its many forms has become an essential service.

The catch is, as demand for service grows so do the strains on providers’ networks. Companies have become considerably more profitable than ever before, but only if they’ve been able to meet customers’ demand for the latest devices and network speeds. Falling short on either is a formula for failure, even as the overall market continues to grow.

Meeting expectations takes money–lots of it. AT&T has it–and almost none of its rivals can match it. In the third quarter of 2011, for example, the company spent $5.3 billion on its network. That still left $5.1 billion in free cash flow for the company to pay dividends, cut debt and buy back stock.

Deutsche Telecom spent just $746 million to fund its T-Mobile USA unit, the No. 4 US wireless service provider. Moreover, it now considers T-Mobile to be “Discontinued Operations,” a pretty clear sign it won’t be funding any network upgrades beyond what’s needed to keep things running for the handoff.

Sprint (NYSE: S)–still the industry’s third-largest company–has been extremely outspoken in its condemnation of the AT&T-T-Mobile deal. CEO Dan Hesse has gone so far as to contend that his company would simply be unable to stay in business were this deal to go through. And he’s obviously got more than a few politicians to listen, including the state attorney general of Sprint’s home jurisdiction of Kansas.

Sprint, however, forked out just $760 million on its network in the third quarter and still ran up negative free cash flow of $273 million. The company earlier this month issued $4 billion in debt to fund its spending as well as pay off existing debt. It was forced to pay 9 percent for notes maturing in 2018 and a loan shark-like 11.5 percent to sell bonds maturing in 2021.

Sprint’s total debt now is nearly $24 billion, a sum more than three times its market value. The company has also committed to buy $20 billon worth of Apple’s (NSDQ: AAPL) iPhones over the next four years, a move that will also require a $10 billion to $11 billion conversion of its entire network to long-term evolution (LTE) 4G systems, abandoning an earlier venture with Clearwire (NSDQ: CLWR) in rival WiMax technology.

That move has thrown the solvency of Clearwire into doubt, which would likely exact a further financial blow on Sprint due to its ties to that company. Sprint has said it will “sell WiMax devices through 2012,” though it’s hard to see why anyone would want to buy them when the company plans to abandon the network entirely in 2013. Finally, Sprint is promising to offer “unlimited data” on its iPhones, a low-margin strategy that will almost surely raise questions about its ability to maintain quality.

In short, it’s going to take some pretty fancy math for Sprint to follow through on these plans without going bankrupt. And keep in mind that it had to borrow 10-year money at 11.5 percent at a time when corporate borrowing rates overall are at their lowest in more than half a century. No. 5 wireless provider TDS (NYSE: TDS), meanwhile, will spend just $750 million to $800 million on its rural wireless network for all of 2011.

Of all the US wireless companies, only Verizon Communications (NYSE: VZ) was able to match AT&T’s third-quarter capital spending, with a total of $5.482 billion for a combination of equipment expansion and upgrades, as well as spectrum. The company also matched AT&T’s $5.1 billion in free cash flow generation during the quarter, which covered its dividend by a huge 3.4-to-1 margin. The payout ratio was 29.4 percent.

Why is money so important? Because it’s the key weapon in locking down the wireless industry’s greatest prize: “post-paid” or contract customers.

There is also a large “pre-paid” market, which is basically pay-by-usage. But the profit margins are much lower, and the competition is increasingly fierce. And, as in other industries, companies that pursue the low end of the market are usually hit a lot harder by recessions.

As is always the case, there was a deafening amount of background noise surrounding AT&T’s third-quarter earnings announcement. But several numbers stood out in the company’s report above the clamor. One was the 18 percent growth in wireless data revenue. Another was a 319,000 gain in post-paid contract customers, along with postpaid churn of just 1.15 percent. Of the company’s now 100 million plus wireless customers, 68.6 million are under contract and more than half of them have iPhones.

Sprint cheerfully stated in its third-quarter earnings report that its new wireless customer additions were the “best in more than five years.” Reading down a bit further, however, only 32.9 million of its 53 million plus customers are now post-paid. The rest are pre-paid or from its wholesale network. The company actually lost 44,000 net postpaid customers. Sprint’s postpaid churn is 1.91 percent–nearly twice AT&T’s and deterioration from the second quarter. Pre-paid churn, meanwhile, was 4.07 percent.

If the company manages to carry off its massive transition–and assuming Google (NSDQ: GOOG) or another developer doesn’t trump the iPhone in the next four years–Sprint’s iPhone buy and complete network revamp could help stanch customer losses. Even a successful Sprint iPhone, however, it won’t offer more than a temporary respite from the company’s inability to keep up in the spending wars. In fact, it’s arguably far more likely the company’s massive debt load will eventually wipe out its shareholders in a Chapter 11 bankruptcy filing.

There is one thing federal regulators could do to change the rules of telecom moneyball and their inevitable result. That’s to find some way to stop AT&T and Verizon from spending so much money on their networks. That could take the form of some kind of punitive tax. Or US regulators could take their cue from New Zealand and force a breakup of these companies.

Unfortunately that would almost certainly suck all the life out of the US telecom industry, or at least any real investment.

Certainly any foreign carrier considering investing here is now thinking twice. That’s because by forbidding Deutsche Telekom from selling T-Mobile, the US government risks setting a precedent of being able to veto foreign company exit as well as entries. (Sorry, DT, but, like the song goes, you can check out anytime you like, but you can never leave.)

Fortunately, though they have the power to at least temporarily block this deal, there’s only so much the DoJ and the FCC can do beyond that. For one thing, they face an increasingly hostile Congress, which is in fact holding up appointments due to disagreement on several issues. Moreover, at the same time FCC Chairman Julius Genachowski announced opposition to the T-Mobile deal, he’s asked the FCC to approve AT&T purchase of Qualcomm Airwaves.

In any case, short of drastic action telecom’s haves will keep getting richer, while its have-nots diminish. Consumers and businesses won’t care nor should they. Network investment make better products possible and at faster speeds. Investors, meanwhile, will continue to receive the dominant companies’ generous dividends, as well as capital gains as share prices follow them higher.

That’s how things have been working for the past decade in US communications, easily in the front rank of successful American industries. And election year politics in Washington notwithstanding, it’s how they’re likely to keep working for some time to come.