Analysts: T-Mobile's smartphone upgrades, EIP programs could crimp free cash flow

T-Mobile US' (NYSE:TMUS) rising smartphone upgrades and the capital required to support equipment installment plans is a key worry on the horizon, according to a report from analysts at Macquarie Capital.

Although T-Mobile is producing strong subscriber, revenue and EBITDA growth, an underlying and troubling issue for Macquarie analysts Kevin Smithen and Will Clayton is the carrier's weak generation of free cash flow. What's holding T-Mobile back on that front is higher levels smartphone upgrades and hits the carrier is taking to working capital thanks to EIP programs.

The analysts are increasing their forecast for how much EBITDA T-Mobile will generate in 2016 to $8.87 billion, up from their previous estimate of $7.72 billion. Their increase is based on "strong Q2 margins and an expected $666 million in lease accounting benefits." However, the analysts also think T-Mobile will only increase free cash flow in 2016 by $214 million, to $1.06 billion, as working capital continues to increase with EIP plans.

"While T-Mo's sub growth remains best-in-class and its ARPU has perhaps finally reached an inflection point, we are concerned over the lack of [free cash flow] conversion in the business," they wrote.

"Rising smartphone upgrade rates are very troubling in our opinion," the analysts added. "While AT&T is seeing record low upgrade rates, TMUS' 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."

The Macquarie analysts noted that T-Mobile activated 2.3 million more smartphones in the first half of 2015 than in the first half of 2014. At around $500 per device, they note that is a $1.15 billion hit to T-Mobile's working capital during a period when a new iPhone did not launch. Furthermore, it more than offset the $666 million increase in EBITDA T-Mobile saw during the period.

"When we asked T-Mo management about the higher upgrades, it was explained to us that, 'it's not about FCF it's about what the customer wants.' We fundamentally disagree," the analysts wrote. "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. What will happen to upgrade rates during the next Apple product cycle?"

"On one hand, T-Mo is showing impressive revenue, sub and EBITDA growth relative to large-cap U.S. telco peers and a 'growth premium' could be justified," they wrote. "However, the picture isn't as pretty if we look at FCF conversion and the quality of earnings and the business model. One potential read on T-Mo's results is that the company is trying to mitigate churn risk on expiring EIP plans by offering early upgrades. In addition to funding the increased purchase of new devices, T-Mo has to figure out how to dispose of the turned in used phones at or above their residual value. This may prove difficult, in our opinion."

T-Mobile CFO Braxton Carter noted on the company's second-quarter earnings call that "very few people actually wait two years now to upgrade their phones, especially with the industry innovation that we introduced with Jump! and now the Jump! On Demand." The Jump! On Demand program lets customers lease phones, pay a monthly device fee and upgrade to a new phone as often as three times every 12 months.

T-Mobile posted a negative free cash flow of $30 million in the second quarter, compared to a loss of $493 million in the first quarter and positive free cash flow of $30 million in the second quarter of 2014. "Sequentially, the improvement in Free Cash Flow was due to higher operating income and increases from changes in net working capital, partially offset by higher cash capital expenditures," T-Mobile said in its investor factbook. "Year-over-year, the decrease was primarily due to decreases from changes in net working capital and higher cash capital expenditures, partially offset by higher operating income."

According to a Seeking Alpha transcript of his remarks, Carter noted that "the primary burn on working capital is the continued investment in EIP, which has been significantly moderating. We also paid down, and when you do a detail analysis on the [quarter], a fairly substantial reduction in accounts payable in the second quarter. But, I think the important thing here is that the EIP is a function of growth."

"So, to the extent that we continue to have the momentum in the growth here there will be some incremental burn," Carter said. "But certainly, and as we said on the year-end call, our growth aspirations were fully embedded in our EBITDA guidance, in our cash flow guidance. And we're much higher than we had originally positioned in the marketplace. And you know that we are conservative in the way that we position growth, which I think is wise given the overall environment."

For more:
- see this Seeking Alpha transcript

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