Sprint Nextel 2007 Fair Value and Impairment Earl K. Stice PricewaterhouseCoopers Professor of Accounting Brigham Young University 3 August 2008.

Sprint Nextel 2007Fair Value and Impairment

Earl K. SticePricewaterhouseCoopers Professor of Accounting

Brigham Young University

3 August 2008

Topics Covered in the Case

6 questions address

• Impairment analysis and asset valuation (Questions 1 and 2)

• Fair value disclosures (Question 3)

• Valuation sensitivity analysis (Questions 4, 5, and 6)

Developments During 2007

• Operating income in each quarter in 2007 was down compared to the same quarter in 2006. Total decrease of 63%.

• Average revenue per user (ARPU) declined during each quarter in 2007 compared to the same quarter in 2006.

• The market value of the company dropped from $55 billion to $37 billion.

Impairment Analysis of PPE

Land $ 277 Network equipment 30,764 Buildings and improvements 4,054 Non-network software, office equipment 2,844 Less: Accumulated depreciation (18,545) 19,394 Construction in progress 3,488 Property, plant, and equipment, net 22,882


Estimated

Annual Lease Payment Land $ 30 Network equipment 2,840 Buildings and improvements 299 Non-network software, office equipment 437 Construction in progress* 1,073 *This estimated annual lease payment is for a completed asset. Construction in progress is 60% complete.


• According to SFAS No. 144, par. 18, “the remaining life of an asset group shall be based on the remaining useful life of the primary asset of the group.”

• For the property, plant, and equipment of the Wireless segment, this asset is the network equipment.

• Remaining useful life = 8 years


• Estimated annual lease payment = $4,250

• $34,000 = 8 years × $4,250 per year.

• $34,000 > $22,882

The Wireless segment’s property, plant, and equipment is NOT impaired.


Where should students have questions about the data?

• What is the source of the lease payment data?

• 8 years? Not 10 years? Not 5 years?

Impairment Analysis of Goodwill

• Step 1 – fair value of Wireless segment greater than book value?

• Step 2 (if necessary) – estimate fair values of all Wireless segment assets and liabilities.

• Step 3 (if necessary) – recompute goodwill.


Indirect Valuation

“We [reduce] our stock price by the estimated value per share of our Wireline reporting unit and then [add] a control premium, as permitted by FASB guidance, to determine an estimate of the equity value of the Wireless reporting unit.”


Indirect Valuation

Market

Capitalization (in billions)

January 1, 2007 $ 54.2 March 31, 2007 53.8

June 30, 2007 58.8 September 30, 2007 54.1 December 31, 2007 37.4


Indirect Valuation

Market Operating Cap. Revenues EBITDA* Qwest $8.29 $13.73 $4.61 Level 3 4.96 4.31 0.76 Embarq 6.79 6.35 2.67 Windstream 6.00 3.26 1.67 Centurytel 3.80 2.70 1.37 Sprint Nextel Wireline segment ??? 6.46 1.07


Indirect Valuation

• Price-to-revenue multiple:

1.21 × 6.46 = $7.8 billion

• Price-to-EBITDA multiple:

3.45 × 1.07 = $3.7 billion

• The average of these two estimates is $5.8 billion = estimate of value of Wireline segment.


Indirect Valuation

Sprint Nextel

Market Capitalization Wireless Segment Plus 5%

(in billions) Only Control PremiumJanuary 1, 2007 $54.2 $48.4 $50.8March 31, 2007 53.8 48.0 50.4

June 30, 2007 58.8 53.0 55.7 September 30, 2007 54.1 48.3 50.7

December 31, 2007 37.4 31.6 33.2


Indirect Valuation

Book value of Wireless segment as of December 31, 2007:

$52.8 billion

Estimated market value of Wireless segment as of December 31, 2007:

$33 billion

Yes, goodwill may be impaired.


Indirect Valuation


• In this case, they should realize that the market value of the Wireless segment is substantially less than its book value no matter what assumptions are made.


Direct Valuation

Sprint Nextel also estimates the market value of the Wireless segment through an income approach which involves the computation of the present value of an estimate of the cash flows to be generated by the segment.


Direct ValuationRisk-free rate on 31 Dec 2007 4.0%Historical equity premium 7.0%Average industry Beta 1.55

Equity cost of capital 14.9%

Amountsof Debt

and EquityAfter-tax debt cost of capital 42.1 4.3%Equity cost of capital 37.4 14.9%

79.5 9.3%


Direct ValuationDiscount rate 9.3% FORECAST

HISTORICAL OIBDA Growth 13.0% GrowthCapex Growth 10.0% 6.0%

2005 2006 2007 2008 2009 2010 2011 2012 TerminalSegment earnings 6,932 11,678 9,914 11,203 12,659 14,305 16,165 18,266 Taxes (38%) 2,634 4,438 3,767 4,257 4,810 5,436 6,143 6,941

OIBDA 4,298 7,240 6,147 6,946 7,849 8,869 10,022 11,325

Capital expenditures 3,545 5,944 5,067 5,574 6,131 6,744 7,419 8,160

Free cash flow 753 1,296 1,080 1,372 1,718 2,125 2,603 3,164 95,891

Discounted cash flow 1,255 1,438 1,627 1,824 2,029 61,472

Sum of discounted cash flow 8,173PV of Terminal value 61,472Total present value of cash flows 69,645Less liabilities 36,046

Value of equity 33,599


Step 1 – Yes, goodwill may be impaired.

So, on to Step 2 which is estimating the fair values of all Wireless segment assets and liabilities.

Valuation of FCC Licenses

“Relief from royalty” method

• Use market royalty rates charged for the use of similar licenses.

• The fair value of the licenses is the present value of the after-tax royalties that Sprint Nextel is avoiding by owning the licenses.


“Relief from Royalty” Method

Search in a proprietary royalty rate database

• Rates ranging from 2% to 8%

• Average rate of 4.2%

The royalty is based on revenue, before the subtraction of any expenses.



Discount rate 9.3%Royalty rate 4.2%Monthly ARPU 58$ ARPU annual growth rate -1.0%Dec 31, 2007 customers 40751Customer # growth rate 13.0%Income tax rate 38%


“Relief from Royalty” MethodGrowth

Discount rate 9.3% 6.0%2008 2009 2010 2011 2012 Terminal

Number of customers (in millions) 46,049 52,035 58,799 66,443 75,081 Monthly ARPU $57 $57 $56 $56 $55Total annual revenue (in millions) 31,729 35,496 39,709 44,422 49,695Pre-tax royalty (4.2%) 1,333 1,491 1,668 1,866 2,087Taxes (38%) 506 567 634 709 793After-tax royalty 826 924 1,034 1,157 1,294 1,294

Discounted cash flow 756 774 792 811 830 39,214

Sum of discounted cash flow 3,962PV of Terminal value 25,139

Total present value of cash flows 29,100



Estimated fair value of FCC licenses:

$29.100 billion

Book value of FCC licenses:

$21.123 billion




• Royalty rate

• Customer growth rate

• Terminal year

• Post-terminal year growth rate

• Discount rate

Valuation of Customer Relationships

Excess cash flow valuation

• Assume that other assets earn a normal return.

• “Other assets” includes the fair values of both recognized and unrecognized assets.

• Exclude goodwill.


Discount rate 9.3%Monthly churn rate 2.3%Beginning monthly ARPU $58ARPU annual growth rate -1.0%Variable cost as a percent of revenue 42.2%Income tax rate 38%


Assets EmployedWireless reported assets (less $30,664 goodwill) $58,190Extra license value (above book value $21,123) 7,977 Fair value of non-goodwill assets employed $66,167

Annual Capital PresentAverage # of Monthly Contribution Charge After-tax Value

Customers ARPU Margin (Assets x 0.093) Excess (on 12/31/07)For the year 2008 35,144 $57.42 $13,997 $6,154 $4,863 $4,449For the year 2009 26,582 56.85 10,481 6,154 2,683 2,246For the year 2010 20,106 56.28 7,848 6,154 1,051 805For the year 2011 (ignored because negative) 15,207 55.71 5,877 6,154 (172) (120)

Fair value of Customer Relationships $7,499



• Interesting question… we’ll see more about this in a moment.

New Computation of GoodwillFair Value of Identifiable Assets and Liabilities

Current assets $7,414PPE 22,882Licenses 29,100Customer relationships 7,499Other intangibles 1,835

Less liabilities (36,046)

Fair value ofnet identifiable assets $32,685

New Computation of GoodwillEstimated equity value $33,599(direct valuation)

Less fair value ofnet identifiable assets 32,685

Implied goodwill value $914

Recorded goodwill $30,664Revised goodwill 914

Goodwill impairment loss $29,750

New Computation of GoodwillGoodwill Sensitivity Analysis (assets AND liabilities AND indirect valuation)

8.8% 9.3% 9.8%Current assets $7,414 $7,414 $7,414PPE 22,882 22,882 22,882Licenses 34,332 29,100 25,245Customer relationships 7,348 7,499 7,520Other intangibles 1,835 1,835 1,835

Less liabilities (36,847) (36,046) (35,271)

Fair value ofnet identifiable assets $36,964 $32,685 $29,626

New Computation of GoodwillGoodwill Sensitivity Analysis (assets AND liabilities AND indirect valuation)

8.8% 9.3% 9.8%Estimated equity value $33,970 $33,970 $33,970(indirect valuation)

Less fair value ofnet identifiable assets 36,964 32,685 29,626

Implied goodwill value ($2,994) $1,285 $4,344

Recorded goodwill $30,664 $30,664 $30,664Revised goodwill 0 1,285 4,344

Goodwill impairment loss $30,664 $29,379 $26,320

New Computation of Goodwill

What is the AUDITOR’S responsibility with respect to this goodwill impairment number?

SFAS No. 157 Disclosure

Fair Value Measurements at Reporting Date Using Quoted Prices in Active Significant Markets for Other Significant Identical Observable Unobservable Total Assets Inputs Inputs Gains Description Total (Level 1) (Level 2) (Level 3) (Losses) Goodwill $914 $914 ($29,750)

SFAS No. 157 Disclosure

FCC licenses:• Book value = $21.123 billion• Fair value = $29.100 billionCustomer relationships:• Book value = $4.203 billion• Fair value = $7.499 billion

Why no fair value disclosure?

Points to Remember

• Our accounting students need to understand valuation models.

• Experience with valuation models will teach our accounting students where the pressure points are.

• Teaching about fair value is much more than teaching SFAS No. 157 disclosures.

[email protected]

Email me if you want soft copies of this material.

Sprint Nextel 2007 Fair Value and Impairment Earl K. Stice PricewaterhouseCoopers Professor of Accounting Brigham Young University 3 August 2008.

Documents

disclosure slide

estimate of value

estimated value

present value

equity value

book value of wireless

book value of fcc licenses

goodwill impairment