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On Monday evening, around 6:00 PM Eastern Standard Time, news leaked that the United States District Court for the Southern District of New York had decided to allow the T-Mobile/Sprint merger to go through, giving the companies a victory over a group of state attorneys general trying to block the deal.

Thomas Philippon, a professor of finance at NYU, used this opportunity to conduct a quick-and-dirty event study on Twitter:

Short thread on T-Mobile/Sprint merger. There were 2 theories:

(A) It’s a 4-to-3 merger that will lower competition and increase markups.

(B) The new merged entity will be able to take on the industry leaders AT&T and Verizon.

(A) and (B) make clear predictions. (A) predicts the merger is good news for AT&T and Verizon’s shareholders. (B) predicts the merger is bad news for AT&T and Verizon’s shareholders. The news leaked at 6pm that the judge would approve the merger. Sprint went up 60% as expected. Let’s test the theories. 

Here is Verizon’s after trading price: Up 2.5%.

Here is ATT after hours: Up 2%.

Conclusion 1: Theory B is bogus, and the merger is a transfer of at least 2%*$280B (AT&T) + 2.5%*$240B (Verizon) = $11.6 billion from the pockets of consumers to the pockets of shareholders. 

Conclusion 2: I and others have argued for a long time that theory B was bogus; this was anticipated. But lobbying is very effective indeed… 

Conclusion 3: US consumers already pay two or three times more than those of other rich countries for their cell phone plans. The gap will only increase.

And just a reminder: these firms invest 0% of the excess profits. 

Philippon published his thread about 40 minutes prior to markets opening for regular trading on Tuesday morning. The Court’s official decision was published shortly before markets opened as well. By the time regular trading began at 9:30 AM, Verizon had completely reversed its overnight increase and opened down from the previous day’s close. While AT&T opened up slightly, it too had given back most of its initial gains. By 11:00 AM, AT&T was also in the red. When markets closed at 4:00 PM on Tuesday, Verizon was down more than 2.5 percent and AT&T was down just under 0.5 percent.

Does this mean that, in fact, theory A is the “bogus” one? Was the T-Mobile/Sprint merger decision actually a transfer of “$7.4 billion from the pockets of shareholders to the pockets of consumers,” as I suggested in my own tongue-in-cheek thread later that day? In this post, I will look at the factors that go into conducting a proper event study.  

What’s the appropriate window for a merger event study?

In a response to my thread, Philippon said, “I would argue that an event study is best done at the time of the event, not 16 hours after. Leak of merger approval 6 pm Monday. AT&T up 2 percent immediately. AT&T still up at open Tuesday. Then comes down at 10am.” I don’t disagree that “an event study is best done at the time of the event.” In this case, however, we need to consider two important details: When was the “event” exactly, and what were the conditions in the financial markets at that time?

This event did not begin and end with the leak on Monday night. The official announcement came Tuesday morning when the full text of the decision was published. This additional information answered a few questions for market participants: 

  • Were the initial news reports true?
  • Based on the text of the decision, what is the likelihood it gets reversed on appeal?
    • Wall Street: “Not all analysts are convinced this story is over just yet. In a note released immediately after the judge’s verdict, Nomura analyst Jeff Kvaal warned that ‘we expect the state AGs to appeal.’ RBC Capital analyst Jonathan Atkin noted that such an appeal, if filed, could delay closing of the merger by ‘an additional 4-5’ months — potentially delaying closure until September 2020.”
  • Did the Court impose any further remedies or conditions on the merger?

As stock traders digested all the information from the decision, Verizon and AT&T quickly went negative. There is much debate in the academic literature about the appropriate window for event studies on mergers. But the range in question is always one of days or weeks — not a couple hours in after hours markets. A recent paper using the event study methodology analyzed roughly 5,000 mergers and found abnormal returns of about positive one percent for competitors in the relevant market following a merger announcement. Notably for our purposes, this small abnormal return builds in the first few days following a merger announcement and persists for up to 30 days, as shown in the chart below:

As with the other studies the paper cites in its literature review, this particular research design included a window of multiple weeks both before and after the event occured. When analyzing the T-Mobile/Sprint merger decision, we should similarly expand the window beyond just a few hours of after hours trading.

How liquid is the after hours market?

More important than the length of the window, however, is the relative liquidity of the market during that time. The after hours market is much thinner than the regular hours market and may not reflect all available information. For some rough numbers, let’s look at data from NASDAQ. For the last five after hours trading sessions, total volume was between 80 and 100 million shares. Let’s call it 90 million on average. By contrast, the total volume for the last five regular trading hours sessions was between 2 and 2.5 billion shares. Let’s call it 2.25 billion on average. So, the regular trading hours have roughly 25 times as much liquidity as the after hours market

We could also look at relative liquidity for a single company as opposed to the total market. On Wednesday during regular hours (data is only available for the most recent day), 22.49 million shares of Verizon stock were traded. In after hours trading that same day, fewer than a million shares traded hands. You could change some assumptions and account for other differences in the after market and the regular market when analyzing the data above. But the conclusion remains the same: the regular market is at least an order of magnitude more liquid than the after hours market. This is incredibly important to keep in mind as we compare the after hours price changes (as reported by Philippon) to the price changes during regular trading hours.

What are Wall Street analysts saying about the decision?

To understand the fundamentals behind these stock moves, it’s useful to see what Wall Street analysts are saying about the merger decision. Prior to the ruling, analysts were already worried about Verizon’s ability to compete with the combined T-Mobile/Sprint entity in the short- and medium-term:

Last week analysts at LightShed Partners wrote that if Verizon wins most of the first available tranche of C-band spectrum, it could deploy 60 MHz in 2022 and see capacity and speed benefits starting in 2023.

With that timeline, C-Band still does not answer the questions of what spectrum Verizon will be using for the next three years,” wrote LightShed’s Walter Piecyk and Joe Galone at the time.

Following the news of the decision, analysts were clear in delivering their own verdict on how the decision would affect Verizon:

Verizon looks to us to be a net loser here,” wrote the MoffettNathanson team led by Craig Moffett.

…  

Approval of the T-Mobile/Sprint deal takes not just one but two spectrum options off the table,” wrote Moffett. “Sprint is now not a seller of 2.5 GHz spectrum, and Dish is not a seller of AWS-4. More than ever, Verizon must now bet on C-band.”

LightShed also pegged Tuesday’s merger ruling as a negative for Verizon.

“It’s not great news for Verizon, given that it removes Sprint and Dish’s spectrum as an alternative, created a new competitor in Dish, and has empowered T-Mobile with the tools to deliver a superior network experience to consumers,” wrote LightShed.

In a note following news reports that the court would side with T-Mobile and Sprint, New Street analyst Johnathan Chaplin wrote, “T-Mobile will be far more disruptive once they have access to Sprint’s spectrum than they have been until now.”

However, analysts were more sanguine about AT&T’s prospects:

AT&T, though, has been busy deploying additional spectrum, both as part of its FirstNet build and to support 5G rollouts. This has seen AT&T increase its amount of deployed spectrum by almost 60%, according to Moffett, which takes “some of the pressure off to respond to New T-Mobile.”

Still, while AT&T may be in a better position on the spectrum front compared to Verizon, it faces the “same competitive dynamics,” Moffett wrote. “For AT&T, the deal is probably a net neutral.”

The quantitative evidence from the stock market seems to agree with the qualitative analysis from the Wall Street research firms. Let’s look at the five-day window of trading from Monday morning to Friday (today). Unsurprisingly, Sprint, T-Mobile, and Dish have reacted very favorably to the news:

Consistent with the Wall Street analysis, Verizon stock remains down 2.5 percent over a five-day window while AT&T has been flat over the same period:

How do you separate beta from alpha in an event study?

Philippon argued that after market trading may be more efficient because it is dominated by hedge funds and includes less “noise trading.” In my opinion, the liquidity effect likely outweighs this factor. Also, it’s unclear why we should assume “smart money” is setting the price in the after hours market but not during regular trading when hedge funds are still active. Sophisticated professional traders often make easy profits by picking off panicked retail investors who only read the headlines. When you see a wild swing in the markets that moderates over time, the wild swing is probably the noise and the moderation is probably the signal.

And, as Karl Smith noted, since the aftermarket is thin, price moves in individual stocks might reflect changes in the broader stock market (“beta”) more than changes due to new company-specific information (“alpha”). Here are the last five days for e-mini S&P 500 futures, which track the broader market and are traded after hours:

The market trended up on Monday night and was flat on Tuesday. This slightly positive macro environment means we would need to adjust the returns downward for AT&T and Verizon. Of course, this is counter to Philippon’s conjecture that the merger decision would increase their stock prices. But to be clear, these changes are so minuscule in percentage terms, this adjustment wouldn’t make much of a difference in this case.

Lastly, let’s see what we can learn from a similar historical episode in the stock market.

The parallel to the 2016 presidential election

The type of reversal we saw in AT&T and Verizon is not unprecedented. Some commenters said the pattern reminded them of the market reaction to Trump’s election in 2016:

Much like the T-Mobile/Sprint merger news, the “event” in 2016 was not a single moment in time. It began around 9 PM Tuesday night when Trump started to overperform in early state results. Over the course of the next three hours, S&P 500 futures contracts fell about 5 percent — an enormous drop in such a short period of time. If Philippon had tried to estimate the “Trump effect” in the same manner he did the T-Mobile/Sprint case, he would have concluded that a Trump presidency would reduce aggregate future profits by about 5 percent relative to a Clinton presidency.

But, as you can see in the chart above, if we widen the aperture of the event study to include the hours past midnight, the story flips. Markets started to bounce back even before Trump took the stage to make his victory speech. The themes of his speech were widely regarded as reassuring for markets, which further pared losses from earlier in the night. When regular trading hours resumed on Wednesday, the markets decided a Trump presidency would be very good for certain sectors of the economy, particularly finance, energy, biotech, and private prisons. By the end of the day, the stock market finished up about a percentage point from where it closed prior to the election — near all time highs.

Maybe this is more noise than signal?

As a few others pointed out, these relatively small moves in AT&T and Verizon (less than 3 percent in either direction) may just be noise. That’s certainly possible given the magnitude of the changes. Contra Philippon, I think the methodology in question is too weak to rule out the pro-competitive theory of the case, i.e., that the new merged entity would be a stronger competitor to take on industry leaders AT&T and Verizon. We need much more robust and varied evidence before we can call anything “bogus.” Of course, that means this event study is not sufficient to prove the pro-competitive theory of the case, either.

Olivier Blanchard, a former chief economist of the IMF, shared Philippon’s thread on Twitter and added this comment above: “The beauty of the argument. Simple hypothesis, simple test, clear conclusion.”

If only things were so simple.

The Department of Justice announced it has approved the $26 billion T-Mobile/Sprint merger. Once completed, the deal will create a mobile carrier with around 136 million customers in the U.S., putting it just behind Verizon (158 million) and AT&T (156 million).

While all the relevant federal government agencies have now approved the merger, it still faces a legal challenge from state attorneys general. At the very least, this challenge is likely to delay the merger; if successful, it could scupper it. In this blog post, we evaluate the state AG’s claims (and find them wanting).

Four firms good, three firms bad?

The state AG’s opposition to the T-Mobile/Sprint merger is based on a claim that a competitive mobile market requires four national providers, as articulated in their redacted complaint:

The Big Four MNOs [mobile network operators] compete on many dimensions, including price, network quality, network coverage, and features. The aggressive competition between them has resulted in falling prices and improved quality. The competition that currently takes place across those dimensions, and others, among the Big Four MNOs would be negatively impacted if the Merger were consummated. The effects of the harm to competition on consumers will be significant because the Big Four MNOs have wireless service revenues of more than $160 billion.

. . . 

Market consolidation from four to three MNOs would also serve to increase the possibility of tacit collusion in the markets for retail mobile wireless telecommunications services.

But there are no economic grounds for the assertion that a four firm industry is on a competitive tipping point. Four is an arbitrary number, offered up in order to squelch any further concentration in the industry.

A proper assessment of this transaction—as well as any other telecom merger—requires accounting for the specific characteristics of the markets affected by the merger. The accounting would include, most importantly, the dynamic, fast-moving nature of competition and the key role played by high fixed costs of production and economies of scale. This is especially important given the expectation that the merger will facilitate the launch of a competitive, national 5G network.

Opponents claim this merger takes us from four to three national carriers. But Sprint was never a serious participant in the launch of 5G. Thus, in terms of future investment in general, and the roll-out of 5G in particular, a better characterization is that it this deal takes the U.S. from two to three national carriers investing to build out next-generation networks.

In the past, the capital expenditures made by AT&T and Verizon have dwarfed those of T-Mobile and Sprint. But a combined T-Mobile/Sprint would be in a far better position to make the kinds of large-scale investments necessary to develop a nationwide 5G network. As a result, it is likely that both the urban-rural digital divide and the rich-poor digital divide will decline following the merger. And this investment will drive competition with AT&T and Verizon, leading to innovation, improving service and–over time–lowering the cost of access.

Is prepaid a separate market?

The state AGs complain that the merger would disproportionately affect consumers of prepaid plans, which they claim constitutes a separate product market:

There are differences between prepaid and postpaid service, the most notable being that individuals who cannot pass a credit check and/or who do not have a history of bill payment with a MNO may not be eligible for postpaid service. Accordingly, it is informative to look at prepaid mobile wireless telecommunications services as a separate segment of the market for mobile wireless telecommunications services.

Claims that prepaid services constitute a separate market are questionable, at best. While at one time there might have been a fairly distinct divide between pre and postpaid markets, today the line between them is at least blurry, and may not even be a meaningful divide at all.

To begin with, the arguments regarding any expected monopolization in the prepaid market appear to assume that the postpaid market imposes no competitive constraint on the prepaid market. 

But that can’t literally be true. At the very least, postpaid plans put a ceiling on prepaid prices for many prepaid users. To be sure, there are some prepaid consumers who don’t have the credit history required to participate in the postpaid market at all. But these are inframarginal consumers, and they will benefit from the extent of competition at the margins unless operators can effectively price discriminate in ways they have not in the past, and which has not been demonstrated is possible or likely.

One source of this competition will come from Dish, which has been a vocal critic of the T-Mobile/Sprint merger. Under the deal with DOJ, T-Mobile and Sprint must spin-off Sprint’s prepaid businesses to Dish. The divested products include Boost Mobile, Virgin Mobile, and Sprint prepaid. Moreover the deal requires Dish be allowed to use T-Mobile’s network during a seven-year transition period. 

Will the merger harm low-income consumers?

While the states’ complaint alleges that low-income consumers will suffer, it pays little attention to the so-called “digital divide” separating urban and rural consumers. This seems curious given the attention it was given in submissions to the federal agencies. For example, the Communication Workers of America opined:

the data in the Applicants’ Public Interest Statement demonstrates that even six years after a T-Mobile/Sprint merger, “most of New T-Mobile’s rural customers would be forced to settle for a service that has significantly lower performance than the urban and suburban parts of the network.” The “digital divide” is likely to worsen, not improve, post-merger.

This is merely an assertion, and a misleading assertion. To the extent the “digital divide” would grow following the merger, it would be because urban access will improve more rapidly than rural access would improve. 

Indeed, there is no real suggestion that the merger will impede rural access relative to a world in which T-Mobile and Sprint do not merge. 

And yet, in the absence of a merger, Sprint would be less able to utilize its own spectrum in rural areas than would the merged T-Mobile/Sprint, because utilization of that spectrum would require substantial investment in new infrastructure and additional, different spectrum. And much of that infrastructure and spectrum is already owned by T-Mobile. 

It likely that the combined T-Mobile/Sprint will make that investment, given the cost savings that are expected to be realized through the merger. So, while it might be true that urban customers will benefit more from the merger, rural customers will also benefit. It is impossible to know, of course, by exactly how much each group will benefit. But, prima facie, the prospect of improvement in rural access seems a strong argument in favor of the merger from a public interest standpoint.

The merger is also likely to reduce another digital divide: that between wealthier and poorer consumers in more urban areas. The proportion of U.S. households with access to the Internet has for several years been rising faster among those with lower incomes than those with higher incomes, thereby narrowing this divide. Since 2011, access by households earning $25,000 or less has risen from 52% to 62%, while access among the U.S. population as a whole has risen only from 72% to 78%. In part, this has likely resulted from increased mobile access (a greater proportion of Americans now access the Internet from mobile devices than from laptops), which in turn is the result of widely available, low-cost smartphones and the declining cost of mobile data.

Concluding remarks

By enabling the creation of a true, third national mobile (phone and data) network, the merger will almost certainly drive competition and innovation that will lead to better services at lower prices, thereby expanding access for all and, if current trends hold, especially those on lower incomes. Beyond its effect on the “digital divide” per se, the merger is likely to have broadly positive effects on access more generally.

The debates over mobile spectrum aggregation and the auction rules for the FCC’s upcoming incentive auction — like all regulatory rent-seeking — can be farcical. One aspect of the debate in particular is worth highlighting, as it puts into stark relief the tendentiousness of self-interested companies making claims about the public interestedness of their preferred policies: The debate over how and whether to limit the buying and aggregating of lower frequency (in this case 600 MHz) spectrum.

A little technical background is in order. At its most basic, a signal carried in higher frequency spectrum doesn’t travel as well as a signal carried in lower frequency spectrum. The higher the frequency, the closer together cell towers need to be to maintain a good signal.

600MHz is relatively low frequency for wireless communications. In rural areas it is helpful in reducing infrastructure costs for wide area coverage because cell towers can be placed further apart and thus fewer towers must be built. But in cities, population density trumps frequency, and propagation range is essentially irrelevant for infrastructure costs. In other words, it doesn’t matter how far your signal will travel if congestion alleviation demands you build cell towers closer together than even the highest frequency spectrum requires anyway. The optimal — nay, the largest usable — cell radius in urban and suburban areas is considerably smaller than the sort of cell radius that low frequency spectrum allows for.

It is important to note, of course, that signal distance isn’t the only propagation characteristic imparting value to lower frequency spectrum; in particular, it is also valuable even in densely populated settings for its ability to travel through building walls. That said, however, the primary arguments made in favor of spreading the 600 MHz wealth — of effectively subsidizing its purchase by smaller carriers — are rooted in its value in offering more efficient coverage in less-populated areas. Thus the FCC has noted that while there may be significant infrastructure cost savings associated with deploying lower frequency networks in rural areas, this lower frequency spectrum provides little cost advantage in urban or suburban areas (even though, as noted, it has building-penetrating value there).

It is primarily because of these possible rural network cost advantages that certain entities (the Department of Justice, Free Press, the Competitive Carriers Association, e.g.) have proposed that AT&T and Verizon (both of whom have significant lower frequency spectrum holdings) should be restricted from winning “too much” spectrum in the FCC’s upcoming 600 MHz incentive auctions. The argument goes that, in order to ensure national competition — that is, to give other companies financial incentive to build out their networks into rural areas — the auction should be structured to favor Sprint and T-Mobile (both of whose spectrum holdings are mostly in the upper frequency bands) as awardees of this low-frequency spectrum, at commensurately lower cost.

Shockingly, T-Mobile and Sprint are on board with this plan.

So, to recap: 600MHz spectrum confers cost savings when used in rural areas. It has much less effect on infrastructure costs in urban and suburban areas. T-Mobile and Sprint don’t have much of it; AT&T and Verizon have lots. If we want T-Mobile and Sprint to create the competing national networks that the government seems dead set on engineering, we need to put a thumb on the scale in the 600MHz auctions. So they can compete in rural areas. Because that’s where 600MHz spectrum offers cost advantages. In rural areas.

So what does T-Mobile plan to do if it wins the spectrum lottery? Certainly not build in rural areas. As Craig Moffett notes, currently “T-Mobile’s U.S. network is fast…but coverage is not its strong suit, particularly outside of metro areas.” And for the future? T-mobile’s breakneck LTE coverage ramp up since the failed merger with AT&T is expected to top out at 225 million people, or the 71% of consumers living in the most-populated areas (it’s currently somewhere over 200 million). “Although sticking to a smaller network, T-Mobile plans to keep increasing the depth of its LTE coverage” (emphasis added). Depth. That means more bandwidth in high-density areas. It does not mean broader coverage. Obviously.

Sprint, meanwhile, is devoting all of its resources to playing LTE catch-up in the most-populated areas; it isn’t going to waste valuable spectrum resources on expanded rural build out anytime soon.

The kicker is that T-Mobile relies on AT&T’s network to provide its urban and suburban customers with coverage (3G) when they do roam into rural areas, taking advantage of a merger break-up provision that gives it roaming access to AT&T’s 3G network. In other words, T-Mobile’s national network is truly “national” only insofar as it piggybacks on AT&T’s broader coverage. And because AT&T will get the blame for congestion when T-Mobile’s customers roam onto its network, the cost to T-Mobile of hamstringing AT&T’s network is low.

The upshot is that T-Mobile seems not to need, nor does it intend to deploy, lower frequency spectrum to build out its network in less-populated areas. Defenders say that rigging the auction rules to benefit T-Mobile and Sprint will allow them to build out in rural areas to compete with AT&T’s and Verizon’s broader networks. But this is a red herring. They may get the spectrum, but they won’t use it to extend their coverage in rural areas; they’ll use it to add “depth” to their overloaded urban and suburban networks.

But for AT&T the need for additional spectrum is made more acute by the roaming deal, which requires it to serve its own customers and those of T-Mobile.

This makes clear the reason underlying T‑Mobile’s advocacy for rigging the 600 MHz auction – it is simply so that T‑Mobile can acquire this spectrum on the cheap to use in urban and suburban areas, not so that it can deploy a wide rural network. And the beauty of it is that by hamstringing AT&T’s ability to acquire this spectrum, it becomes more expensive for AT&T to serve T‑Mobile’s own customers!

Two birds, one stone: lower your costs, raise your competitor’s costs.

The lesson is this: If we want 600 MHz spectrum to be used efficiently to provide rural LTE service, we should assume that the highest bidder will make the most valuable use of the spectrum. The experience of the relatively unrestricted 700 MHz auction in 2008 confirms this. The purchase of 700 MHz spectrum by AT&T and Verizon led to the US becoming the world leader in LTE. Why mess with success?

[Cross-posted at RedState]