AT&T Makes One Small Step For Leap

Maybe AT&T (NYSE:T) was insurmountably frustrated in its rumored attempt to buy all or part of Telefonica (NYSE:TEF), or maybe there never was any substance to that rumor. In any case, in lieu of the $150 billion or so that Telefonica would have cost, AT&T's surprising announcement Friday night that it was acquiring Leap Wireless (Nasdaq:LEAP) for $4 billion seems like a much smaller step.

This is a curious deal on multiple fronts. Leap is not a particularly strong company, and it is not as thought AT&T is badly hurting for spectrum. Instead, this may be a case of AT&T flexing its financial muscles to make life harder on its competition (especially T-Mobile (Nasdaq:TMUS) and Sprint (NYSE:S)) and deny this asset to other potential bidders.

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The Bid – Surprising, But Reasonable
AT&T announced that it reached an agreement to acquire Leap Wireless for $1.2 billion in cash, plus the assumption of $2.8 billion in net debt. For that, AT&T is getting spectrum covering approximately 137M POPs, the network assets and retail stores, and about 5 million subscribers. AT&T is also getting Leap's sizable pre-paid business, and I'll have more on this in a moment.

Leap Wireless shareholders will be getting $15 per share in cash from AT&T, but there's more to the deal than that. Once the deal has closed, AT&T will be looking to sell a 700MHz spectrum license in Chicago that it acquired from Verizon (NYSE:VZ) in 2012, and the proceeds will be passed to Leap shareholders through a non-transferable contingent value right. While there could be some challenges in selling this asset (apparently there are interference issues with DirecTV (NYSE:DTV) Channel 51), most analysts are valuing this asset at something in the neighborhood of $2.50 per Leap share.

Out of its own pocket, AT&T is paying about 8x estimated EBITDA for Leap. That's not unreasonable for the spectrum that Leap holds, but it is quite a bit more (100%-plus) than the market was willing to pay for Leap given the company's serious operating issues. In fact, that's arguably the most surprising part of the deal – the general assumption around Leap was that other companies were circling, but waiting for the company to weaken further before making low-ball bids for the spectrum.

Growing The Pre-Paid Business
Leap is all about pre-paid service, and the addition of this company will increase AT&T's prepaid customer base by more than 70%. As such, it definitely adds scale to this part of AT&T's business (which will now be about 10-12% of the business post-deal) and constitutes a real threat to the pre-paid businesses at Sprint and T-Mobile.

That strategic/competitive aspect is likely what is fueling this deal. While it's true that Leap has an under-utilized asset base, I don't believe AT&T is doing this deal because it believes it can produce major synergies from the combination. Rather, this pre-paid business gives the company a new front line for growth in the U.S. market.

This may also be a case of AT&T using its strength to do a deal that others cannot. Given recent transactions, I'm not sure Sprint and T-Mobile will be in a position to make a counterbid for Leap, though either could certainly use the asset. The bigger unknown is the perennial bridesmaid in the game of wireless musical chairs – Dish Network (Nasdaq:DISH). That Leap Wireless is really not the ideal match for Dish Network may run second to the fact that Dish is rapidly running out of options in the U.S. wireless space.

The Bottom Line
AT&T wouldn't have proposed this deal if they didn't believe they could get regulatory clearance, but I'm sure shareholders remember that the company had to abandon its bid for T-Mobile (and pay some hefty break-up fees) when it couldn't satisfy the concerns of regulators. Leap is small enough (and weak enough) that this deal may be more tolerable to regulators, but I wouldn't put the odds of regulatory objections at 0%.

All told, this looks like a relatively low-risk way for AT&T to deploy some capital in the pursuit of growth and a better competitive position. I don't see this deal being transformative for AT&T, but it's a worthwhile opportunity at this price and wouldn't preclude a larger move overseas if the right opportunity should appear.