Merrill: Sprint PCS mandatory would likely get maximum ratio if Sprint recombined PCS stock

By Ronda Fears

Nashville, Tenn., June 28 - If Sprint Corp. were to reincorporate the Sprint PCS tracking stock back into a single equity, the Sprint PCS mandatory would revert to a single conversion ratio, and likely at the maximum ratio, according to Merrill Lynch & Co. analysts in a report Friday.

Merrill's telecom services equity team is of the opinion that the arguments in favor of the conversion of PCS shares to FON shares now outweigh the arguments against it, particularly in light of the recent share price declines for both FON and PCS.

However, Sprint at present has no plans to recombine the two stocks, noted Merrill convertible analysts Yaw Debrah and Tatyana Hube.

If that were to happen, though, the PCS mandatory would become convertible into FON stock at a single conversion ratio that would result in a ratio adjustment until maturity, or Aug. 17, 2004.

The single conversion ratio would be based on the conversion ratio of shares for PCS into FON and the current conversion ratio on the convertible.

In considering the current convert conversion ratio, a holder of the PCS convertible would be treated as if they had settled the purchase contract underlying the mandatory immediately before the date that the PCS/FON recombination took place.

However this treatment does not make it clear which of the convertible's ratios would be applied, the maximum ratio of 1.0204 or the minimum ratio of 0.8364.

"The language of the prospectus leaves room to have the recombination treated as an early settlement, which would imply that the minimum ratio of 0.8364 would be applied to settle the contract," the analysts said.

"However, the language is also broad enough to treat the settlement as if it took place on Aug. 17, 2004. In this case, given that the current stock price is well below the lower threshold price of $24.5 under the equity unit contract, the maximum ratio of 1.0204 would apply."

According to an investor relations representative of Sprint, were the PCS common stock converted into FON common stock, it would treat the transaction as it would on Aug. 17, 2004, using the maximum ratio of 1.0204 to determine the final conversion ratio that will apply through maturity, the analysts said.

In November 1998, Sprint recapitalized its equity by creating two types of tracking stocks: FON, to reflect its wireline business, and PCS, to reflect its wireless business. Under this tracking structure, the two stocks still share the balance sheet of Sprint Corp.

"Because PCS and FON are simply different views on the same balance sheet picture, it is clear to us that concerns about PCS leverage have infected the valuation of FON," said Merrill telecom services analysts Adam Quinton and Linda Mutschler in a report.

"Originally, the shareholder segmentation thesis that drove the creation of the tracking structure was a sound one in our view.

"However, now, with growth investors fleeing wireless, because growth has slowed, and value investors concerned about FON, because they see that in reality their balance sheet risk is a function of the whole company, we're not sure that this bifurcation argument still holds.

"We suspect that the sum of the parts argument isn't working, plus the stress on PCS caused by its high leverage means it is unable to recapitalize itself through an equity issue due to the high level of dilution that would result at anything like current prices."

Recombining the components, assuming current prices and a 10% premium for the PCS shares, the analysts estimate that Sprint would currently be trading at about 19 times estimated 2002 earnings and 13.6 times estimated 2003 earnings, with a dividend yield of around 3%.

That would be more comparable to the P/E multiples of 12.4 times estimated 2002 and 12.9 times estimated 2003 for BellSouth, SBC and Verizon Communications.

Also, the equity analysts estimate a recombined Sprint would be trading at an EV/EBITDA multiple of about 4.8 times estimated 2002 earnings and 4.2 times estimated 2003 earnings, versus about 5.8 times for estimated 2002 and 5.6 times for estimated 2003 for BellSouth, SBC and Verizon Communications.

"Based on current valuations, we believe that investors are already factoring some of the risks on the PCS side into the FON valuation," analysts Quinton and Mutschler said.

"Furthermore, we think that the clarity of the capital structure would be enhanced by the conversion - as would be the company's ability to participate in M&A activity."

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