Sprint Corporation Valuation

April 1, 2005

Andrea Armenta [email protected] Brianne Braudt [email protected] David Dencklau [email protected] Kent Ewalt [email protected] Matt Milatoni [email protected]

Table of Contents

Executive Summary……………………………………………………..……. .…………3 Business & Industry Analysis...... …....6 Company Overview………………………………………………..………………….6 Five Forces Model…………………………………………………..………………...6 Competitive Strategy Analysis……………………………………..…………………9 Accounting Analysis……………………………………………………………………..11 Key Accounting Policies……………………………………………………………..11 Potential Accounting Flexibility……………………………………………………..12 Strategy Analysis…………………………………………………………………….12 Quality of Disclosure………………………………………………………………...13 Potential Red Flags…………………………………………………………………..14 Ratio Analysis & Forecast Financials……………………………………………………17 Ratio Analysis………………………………………………………………………..17 Forecasting the Financial Statements………………………………………………...25 Valuations Analysis…………………………….………………………………….……..29 Method of Comparables………………………………………………………….…..30 Discounted Dividends…………………………………………………………….….33 Cost of Equity……………………………………………………………….…...33 Discounted Free Cash Flows…………………………………………………….…...35 Cost of Debt……………………………………………………………………...35 Weighted Average Cost of Capital……………………………………….………36 Discounted Residual Income………………………………………………….…...…37 Abnormal Earnings Growth………………………………………………………….38 Long Run Average Residual Income Model……………………………………..…..39 Z-Score……………………………………………………………………………….39 Conclusion………………………………………………………………………....…40

References………………………………………………………………………………..41 Appendix…………………………………………………………………………………42

2 Executive Summary

Plan for DEBAM Investment Group Paradise

Analysis of Sprint Corp Evaluators: Andrea Armenta, Brianne Braudt David Dencklau, Kent Ewalt, Matt Milantoni

Investment Recommendation: Sell Date of Valuation: April 1, 2005

NYSE: FON $22.74 EPS Forecast For the Year 52 week price range $16.83 - $25.80 Ended: 2005 2006 2007 2008 2009 2010 2011 2012 2013 Revenue (2004) 27.43 Billion EPS (0.28) (0.28) 0.07 0.27 0.50 0.74 1.01 1.31 1.62 Market Capitalization 34.78 Billion Industry Sprint Average Shares Outstanding 1.48 Billion Valuation Ratio Comparison Trailing P/E N/A 13.53 Dividend Yield 2.11% Forward P/E 14.96 14.35 3-month Avg Daily Trading Volume 12,555,409 Forward PEG N/A N/A Percent Institutional Ownership 80.58% M/B 2.48 2.21

Book Value per Share $9.17 Valuation Estimates ROE (2004) -7.67% ROS (2004) -3.69% Actual Current Price (April 1, 2005) $22.74

Cost of Capital Estimates Beta Ke Ratio Based Valuations Ke Estimated P/E Trailing 21.76 5-year Beta 1.357 8.158% P/E Forward N/A 3-year Beta 1.898 9.781% PEG Forward N/A 2-year Beta 0.820 6.547% Dividend Yield 9.36 Published Beta 1.342 8.113% M/B 20.26 Epic Valuation 30.35 Kd 5.09% Intrinsic WACC(bt) 6.10% Valuations Discounted Dividends 6.20 Free Cash Flows 59.26 Residual Income 13.56 Abnormal Earnings Growth 13.85 Long-Run Residual Income Perpetuity 20.67

3

Sprint Corporation is in the business of global communications for both residential and business customers. They are comprised of two divisions: Sprint PCS, a 100% digital wireless communications service, and Sprint FON, the number one local fixed-line provider next to the Baby Bells. Between these two divisions, Sprint offers long-distance, local, and wireless communication services to its customers on local, national, and global levels.

Sprint currently has a market cap of 34.78 billion. In 2004, they had revenues of over 27 billion but ended up with a net loss for the year of 1 billion. This follows net income of 1.3 billion in 2003 and .6 billion in 2002. Although Sprint was able to increase its revenues in 2004, offsetting increasing in expenses and the lack of nonrecurring income items found in 2003 and 2002 resulted in a net loss for the company.

Sprint competes in a fairly competitive environment. Rivalry among existing firms is high, fueled by increasing concentration as more and more telecommunications providers merge and low switching costs for customers. Sprint also must be aware of the threat of substitute products. For its FON division, this comes from the growth of the mobile phone industry. For its PCS division, this comes from the increasing use of the Internet and e-mail to communicate as well as from high-speed internet phone companies such as Vonage. On the other hand, the threat of new entrants is relatively low due to large start- up costs and the bargaining power of both buyers and suppliers is low considering Sprint’s size.

Sprint competes by differentiating itself from its competitors. Sprint’s main strength is its ability to provide customers with tailor-made solutions by combining its wireless, wire line, local, long distance and global services. Sprint’s key success factors include its emphasis on innovation of service alternatives, customization of business solutions, cutting edge products and services, and cost efficiency.

In evaluating Sprint’s accounting policy, we found that Sprint is fairly conservative in its choice of accounting methods. We also found that the quality of disclosure for Sprint is moderate. Although some information was aggregated, Sprint was open about presenting both bad and good news with its shareholders. Sprint’s website2 proved a clear and easy to use source of information. Overall, we feel that Sprint provides the information necessary for investors to make an appropriate analysis. We also computed sale and core expense manipulation ratios for Sprint and two of its competitors. We found that Sprint’s ratios tended to be similar to those of their competitors. Based on our research, we felt that Sprint’s financial statements were accurate and did not need to be restated.

We forecasted the financial statements of Sprint Corp for the next ten years using information from the prior five years. We used pro forma financial statements of the past five years as well as liquidity, profitability, and capital structure ratios to identify trends in computing our forecasts. After considering Sprint’s sustainable growth rate, average growth rate, and other analysts’ opinions5, we calculated that Sprint’s revenue will grow at 3.2% per year. This results in revenues of 37.5 billion in ten years. Based on our

4 forecasts, we believe Sprint will grow, but only very slowly because they are not able to transfer much of their revenues to their bottom line. Forecasted net income in ten years is only 1.1 billion out of 37.5 billion in revenue.

Finally, we valued Sprint using multiple valuation models. Using the method of comparables produced mixed results. The forward P/E, Market to Book, and Price/Sales ratios came closest to Sprint’s observed price of $22.74. Three of the four intrinsic valuation models (discounted dividends, discounted residual income, and abnormal earnings models) resulted in Sprint being overvalued. The discounted free cash flows resulted in Sprint being undervalued by nearly $30. This is clearly an outlier and was discarded. The discounted residual income model and the abnormal earnings growth models both found that Sprint is overvalued by around $8.00.

We computed a cost of equity between 6.5% - 9.7% and a cost of debt for Sprint of 5.1%. This results in a weighted average cost of capital of 6.1%. Clearly, our valuation will change based on which cost of equity is used. We performed a sensitivity analysis for each valuation model to see the effect of changes in the cost of capital and the growth rate assumed for each model. Even allowing for these changes, we still found that Sprint was overvalued. Given our in-depth analysis and countless man-hours of research, we believe that Sprint is overvalued and recommend it as a sell.

5 Business and Industry Analysis

Company Overview

Sprint Corporation specializes in global communications for residential and business customers. Among their services are long-distance, local service, and wireless communications. Sprint Corporation is comprised of two divisions: Sprint PCS, a 100% digital wireless communications service, and Sprint FON, the number one local fixed-line provider next to the Baby Bells. The FON Group includes Sprint’s global market division, local division, and other business activities, including wholesale distribution of telecommunication products and operation of a transatlantic Tier 1 internet backbone network. The purpose of this report is to analyze Sprint Corporation in relation to its competitors in the industries in which it operates. We first analyze the industry using the Five Forces Model and then discuss Sprint Corporation’s competitive strategy.

Five Forces Model

The Five Forces Model provides a framework for analyzing the potential profits in a given industry. The factors that affect profitability include the degree of actual and potential competition, as measured by the rivalry among existing firms, the threat of new entrants, and the threat of substitute products, and the bargaining power in input and output markets, as measured by the bargaining power of buyers and the bargaining power of suppliers. We discuss each of these factors for Sprint Corporation in the next several pages.

Rivalry Among Existing Firms

Rivalry among existing firms is determined by several factors, including industry growth, industry concentration, the level of differentiation, switching costs, scale and learning economies, excess capacity, and exit barriers. We discuss each of these individually.

Industry Growth

The wireless communications industry has been growing quickly due to the increasing need for mobility. Switching from analog to digital wireless networks has also encouraged the rapid growth. However, with competition increasing and new customer subscriptions declining except in underdeveloped nations, price competition is becoming more prevalent. Wireless internet access may provide an important opportunity for additional growth in the industry.

6 In the fixed line industry, deregulation in the form of the Telecommunications Act of 1996 has opened the door for anyone to offer service. Growth in this industry has slowed with the increase of wireless communications as services like the internet and e-mail lessen people’s reliance on fixed line communications. With more than 90 million miles of fiber-optic cables constructed by U.S telecom companies across the nation with up to 90% unused capacity, there is plenty of opportunity for the industry to meet future demand growth for services such as broadband communications.

Concentration

The Wireless industry is dominated by several merged companies including Verizon Wireless (Verizon and Vodaphone Group), Cingular Wireless (SBC Communications, Bell South and recent acquisition, AT&T Wireless), and Sprint PCS. As a result of deregulation in 1996, there are now many smaller players in the telecommunications industry. Verizon Communications, SBC Communications, Bell South and Qwest Communications International are the four “Baby Bells” that still dominate local phone services and the roll out of DSL broadband access. With just few major companies controlling the majority of the telecommunications industry, prices are not as low as they will become as more competition develops in the future.

Differentiation/Switching Costs

With the major carriers of wireless and telecommunication companies using relatively similar technologies, there is little differentiation between competitors except for usage plans and equipment styles. The major switching costs in the wireless industry are long contracts, large penalties for early contract termination, and purchase costs for new hardware. Switching costs for the fixed line telecommunications industry are minimal, consisting of moderate setup fees and hardware costs.

Scale/Learning Economies

The sheer size and dominance of the major companies in both industries makes gaining any significant market share by newcomers difficult. With billions of dollars spent by wireless companies for third generation licenses and the debt incurred from network development, it will be difficult for new entrants to afford to compete in the wireless industry.

Excess Capacity/Exit Barriers

There is excess capacity in both the wireless and the fixed line telecommunications industries causing price competition to intensify. Also price wars will escalate as it is

7 extremely costly to exit the industries given the huge amount of money invested in capital and Research and Development.

Threat of New Entrants

In the past, the telecommunication industry was very hard to break in to. Now, the Telecommunication Act of 1996 has deregulated the industry. The act was passed to help stimulate competition and make it easier for new, start-up companies to jump into the mix and compete with the big boys of the industry. The large established corporations still have the upper hand against new firms entering the market. The industry requires a tremendous amount of capital that established corporations already have. New entrants would find it difficult to raise that capital and compete with the established corporations. Another problem new entrants face is getting licensed, which is costly. This process can also be very lengthy. The threat of new entrants is a possibility that Sprint Corporation must consider, but is not a major factor. Sprint has established relationships with customers and suppliers that take time to develop. They already have their research department established and are coming up with new technologies and ideas to stay one step ahead of their competition.

Threat of Substitute Products

The FON Group faces a huge threat from the continuing growth of the mobile phone. Cell phones are beginning to take the place of land lines as the primary communication device for most households. In conjunction, the Internet and e-mail are also helping with the lapse of land line phones. Meanwhile, the PCS Group is Sprint’s bread winner as the wireless communication industry continues to build.

A threat to the wireless communication industry comes from the new kid on the block: high-speed internet phoning. Companies like Vonage are potential threats to Sprint PCS because with wireless internet you could, in a sense, take your computer with you and always have a phone to make unlimited calls to anywhere. Some of Sprint’s competitors have counted on the new idea and are continuing to diversify themselves into this new technology. Verizon, for instance, is now offering this new service through what they call VoiceWing.

Bargaining Power of Buyers

Overall, the bargaining power of buyers has a low impact on Sprint Corporation. The bargaining power of buyers is composed of two factors: price sensitivity and relative bargaining power. The price sensitivity of buyers for Sprint’s products varies. On one hand, buyers are very price sensitive for commodities. One example of this is the local and long-distance telephone services provided by Sprint’s FON component. There is little differentiation among local and long-distance telephone services and switching costs

8 are low, so consumers are highly sensitive to price. On the other hand, Sprint has been able to differentiate its wireless digital PCS network by consistently offering the newest technology on the market. Buyers are not as price sensitive for these items. The relative bargaining power of buyers is also low due to the large number of buyers and the generally low volume of purchases per buyer. While there are multiple alternatives for buyers to choose from, the cost of one individual not doing business with Sprint will have little impact on the company.

Bargaining Power of Suppliers

Sprint is committed to supplier diversity, but at the same time is also trying to get the most value for its money. Even though many large companies are able to give cheaper prices, Sprint still looks out for the little guys (companies). Sprint is committed to including small, third-party certified minority, woman, and disabled veteran owned businesses2. Sprint goes about choosing suppliers by having them register a bid for the product or service that they could supply which Sprint evaluates whenever it needs a product or service. For example, when Sprint needs to purchase more landline connections in Texas they will run a query for all companies that are involved in landlines. Then they will be evaluated and chosen based on the need of the company and the price. Seeing the process that Sprint has in place to choose suppliers, it is easy to say that suppliers have low bargaining power over Sprint Corporation.

Competitive Strategy Analysis

The telecommunications industry consists of many companies. However, the main competition in the industry comes from relatively few major firms. The level of competition between these few dominant firms can be intense. In order to achieve a competitive advantage in the industry, Sprint’s main focus is the strategy of differentiation of its products and services from its closest competitors. Sprint differentiates its products from its rivals by developing and distributing state-of-the-art network technologies which include its nationwide 100% digital PCS wireless network and the first all digital, nationwide award winning fiber-optic Tier 1 internet backbone in the U.S.

To distinguish itself from competitors, Sprint focuses on several key success factors. Among these factors are Sprint’s emphasis on innovation of service alternatives, customization of business solutions, cutting edge products and services, and cost efficiency. Sprint builds the foundation for accomplishing its goals by re-aligning its internal resources in 2004 to cater to customers of two distinct groups, individuals and businesses. Their previous structure was more product-focused. By restructuring, Sprint can use its assets more efficiently to grow sales, reduce operating costs, increase employee productivity, increase innovation, and increase product and service differentiation. In order to remain competitive in the future, Sprint is growing more and

9 more toward providing one-stop communications services for all of its business customers and consumers.

Sprint’s strategy has been successful to date as their wireless customers have increased nearly 22% and DSL customers almost 60% in 2003. Sprint provides simplicity to businesses by providing tailor-made solutions which combine wireless, wire line, local, long distance and global data and voice capabilities, creating solutions across product boundaries in ways that are unmatched by competitors2. Berge Ayvazian, President of the Yankee Group, states, “…While other carriers can still compete with bundled services through wireless partnerships, none of them can achieve the same streamlined efficiency and focus of which Sprint is capable.” Sprint also forms strategic alliances with several industry-leading companies such as Cisco Systems, HP, IBM, and Nortel Networks to generate innovation and provide top notch customer solutions. Sprint is known for having some of the most advanced products and features. They achieve differentiation by being a first mover in bringing new features and technologies to market.

Accounting Analysis

10 In this section we use both qualitative and quantitative measures to evaluate the degree to which Sprint’s accounting and financial reporting capture the underlying business reality. There are six key steps in performing accounting analysis. First, we identify the key accounting policies for Sprint and assess the degree of accounting flexibility in those areas. We then evaluate Sprint’s accounting strategy and quality of disclosure and identify any potential red flags. We omit step six, undoing accounting distortions, because we believe that Sprint’s financial statements are reasonable and not distorted.

Key Accounting Policies

Key accounting policies for Sprint Corp occur in the areas of revenue recognition and related allowance for uncollectible accounts and accounting for its numerous long-lived assets, including property, plant and equipment, definite life intangibles, goodwill, and indefinite life intangibles. Research and development spending should be a key accounting policy because it is directly linked to the cutting-edge products that are one of Sprint’s key success factors. However, we were not able to evaluate this because Sprint does not provide any information on R&D spending in their 10-K. This is one example of poor accounting disclosure on Sprint’s part.

Revenue recognition methods are key accounting policies for Sprint because Sprint relies on revenues to furnish its continued growth. In the current telecommunications industry, the companies that will be successful are those that can provide a variety of services throughout the nation. Recent mergers and acquisitions reinforce the fact that only the big players will survive. Sprint must have adequate revenues to continue to grow, either through expanding its own structure or acquiring other companies. Accounting for allowance accounts is also important because any changes in them directly affect the revenue recognized for that period.

As a telecommunication provider, a significant portion of Sprint’s assets consist of long- lived assets. Property, plant, and equipment, net of accumulated depreciation, accounted for 56% of Sprint’s total assets and net intangibles accounted for nearly 20%, according its unaudited third quarter 2004 10-Q. Sprint’s property, plant and equipment consist of land, buildings, digital fiber-optic network, switching equipment, microwave radio and cable and wire facilities1. Intangibles include goodwill, licenses, patents, and trademarks1. Accounting for these is especially important to Sprint because changes in technology or the industry may cause the value of some of these assets, such as the digital fiber-optic network or goodwill, to drastically change.

Potential Accounting Flexibility

The FASB allows several accounting methods in the areas of depreciation, amortization, goodwill, inventory, retirement benefit plans, and stock-based compensation. The FASB

11 allows choices in accounting for these items so that managers can choose the method that best fits the underlying economic reality for their company. However, choice of different methods will lead similar companies to show different balances for these items, so there is some room for managers to choose a method that helps them appear more profitable than an alternative method.

Sprint records its property, plant and equipment at historical cost and depreciates these items on a straight-line basis over their estimated economic useful lives. This is in line with common accounting practices. It is also the method used by AT&T4, one of Sprint’s competitors. Sprint expenses repair and maintenance costs as they are incurred.

On January 1, 2002, Sprint adopted the Statement of Financial Accounting Standards (SFAS) No. 142, as its method for accounting for goodwill and other intangible assets1. In line with SFAS No. 142, Sprint stopped amortization of goodwill and indefinite life intangibles as of December 31, 2001. They are now on the books at their current carrying value, which is evaluated each year for impairment. Definite life intangibles are amortized over their useful lives, which at year-end 2003 averaged 10 years1. Definite life intangibles are checked for impairment whenever economic indicators suggest that it is necessary.

Sprint accounts for its inventory differently for its FON group and its PCS division. The FON group states its inventories at the lower of cost or market value using the first-in, first-out (FIFO) method. The PCS division states its inventories at the lower of historical cost, also using the FIFO method, or replacement value. Replacement value will generally be lower than market value, so this is a conservative accounting choice.

Retirement benefit plans represent a significant cost that will not be incurred until the far future. Accounting for these requires management to make numerous assumptions about future discount rates, return on assets, and health care costs. Sprint makes these assumptions based on historical experience, benchmarks, and assumptions from an independent actuary. On January 1, 2003, Sprint began accounting for stock-based compensation using the prospective method outlined in SFAS No. 123 and No. 148. Under the prospective method, Sprint expenses the fair value of stock-based compensation made on or after January 1, 2003.

Strategy Analysis

After examining Sprint’s financial statements in depth, we believe that Sprint takes a moderately conservative approach to accounting for its segments. This is illustrated in several ways.

First, Sprint recognizes its revenues as services are rendered or products are delivered in accordance with SEC Staff Accounting Bulletin No. 104. Revenues received for bundled products are allocated among the different items based on relative fair values. This is in line with its competitors. Sprint recognizes expenses as incurred. They have also adopted

12 SFAS No. 123 and No. 148 in accounting for stock-compensation plans, which requires all stock-compensation to be expensed at fair market value. This choice of accounting method will increase Sprint’s expenses and reduce their bottom line. Sprint also regularly evaluates its assets for impairments.

On the other hand, Sprint chooses to value its inventory using the FIFO method for both divisions. During periods of increasing inflation, the choice of the FIFO method will lead to lower costs, which will lead to increased gross profits. Also, in any company in any industry, managers are evaluated on the overall profitability of the company. There will always be some incentive for top management to make choices that will increase the bottom line of their company. However, we have not identified any serious areas where we believe that Sprint has manipulated its numbers or taken advantage of aggressive accounting methods.

Quality of Disclosure

The quality of disclosure for Sprint is moderate. Sprint is open about sharing both bad and good news with its stockholders. Sprint does disclose its significant accounting policies and provides information on its different segments. However, some information is difficult to find and other information, such as R&D spending, was not presented separately, making it impossible to evaluate.

In examining Sprint’s financial statements, the company provides detailed information about the recent consolidation of its two core divisions, the FON group and the PCS division, into a single stock under the ticker symbol FON. It explicitly covers what the consolidation means to both sets of previous stockholders.

Sprint had to reissue its 10-K for 2003 due to a calculation error discovered in the fourth quarter of 2003. This error resulted in the overstatement of interest capitalized during the construction of Sprint’s wireless capital assets, with a corresponding understatement of interest expense and overstatement of depreciation expense. According to Sprint, the cumulative impacts of this error as of June 30, 2004, including the related income tax effect, resulted in a $166 million overstatement of net property, plant and equipment, a $61 million overstatement of deferred income tax liability, and a $105 million overstatement of retained earnings.

Sprint presents adequate information about both its FON group and the PCS division. Operating information is generally divided between these two groups and detailed information about the segments composing these groups is provided in the Footnotes and in Manager’s Discussion and Analysis. For example, operating revenues for the FON group are broken into the major components of the FON group, including voice, data, internet, and other. The sources of operating revenues are also broken down for the PCS division.

13 Sprint’s website is another way that Sprint makes information available. In its investors section, Sprint offers information about recent news, SEC filings, quarterly earnings, dividends, and FAQs2. Overall, Sprint provides the necessary information for investors to make an appropriate analysis of the company.

Potential Red Flags

In the manipulation diagnostics below, we show a five year trend for several sales and core expense performance indicators. We calculated these using information from Sprint’s financial statements5. As we mentioned earlier, we believe that Sprint’s financial statements are reasonable and not distorted.

Sales Manipulation Diagnostics

To measure the quality of Sprint’s financial disclosures with respect to sales we worked out three diagnostic ratios. We were unable to calculate two of the sales manipulation ratios because Sprint did not provide enough information about unearned revenues or warranty liabilities. These diagnostics are presented in Table 1 below.

Table 1: Sales Manipulation Diagnostics

Sprint's Sales Manipulation Diagnostics

2000 2001 2002 2003 2004 Net Sales/Cash from Sales 5.50 5.56 4.19 2.99 4.14 Net Sales/Net Account Receivable 5.86 6.85 7.09 9.03 6.60 Net Sales/Unearned Revenues N/A N/A N/A N/A N/A Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A Net Sales/Inventory 24.88 37.78 39.05 45.01 42.13

The first ratio we calculated was Net Sales/Cash from Sales. This ratio shows how much cash was received compared to total sales. Companies usually want this ratio to be close to one. This would mean that they are being paid with cash instead of credit. Sprint’s Net Sales/Cash from Sales has decreased in the past five years. This is a positive for Sprint.

The second diagnostic ratio we did was Net Sales/Net Accounts Receivable. This shows how much money Sprint is still waiting to collect. The ratio for Sprint has been unsteady. However, it also tells us that Sprint is not having problems collecting their account receivables.

14 The third diagnostic ratio we calculated was Net Sales/Inventory. This ratio shows how much inventory a company has compared to its Net Sales. The larger the number, the smaller the inventory a company is keeping, which is a positive. Sprint’s numbers have increased over the past five years from 24.88 to 42.13. This is a good thing for Sprint. This shows that Sprint is able to sell their inventory.

Core Expense Manipulation Diagnostics

To measure the quality of Sprint’s financial disclosures with respect to expenses, we also calculated three diagnostic ratios. There were three expense manipulation diagnostics we were unable to calculate because Sprint did not provide enough information. These ratios are presented in Table 2 below.

Table 2: Expense Manipulation Diagnostics Sprint's Core Expense Manipulation Diagnostics 2000 2001 2002 2003 2004 Net Sales/Assets 0.55 0.57 0.59 0.61 0.66 CFFO/OI 2.90 (0.34) 0.60 (2.18) 1.62 CFFO/NOA N/A N/A N/A N/A N/A Total Accruals/Sales N/A N/A N/A N/A N/A Pension Expense/SG&A N/A N/A N/A N/A N/A Other Employment Expenses/SG&A 0.63 0.63 0.68 0.75 0.71

The first ratio we calculated was Net Sales/Assets. This ratio shows how assets are growing in relation to sales. This ratio has remained the same over the past five years for Sprint.

The second diagnostic ratio we calculated was CFFO/OI. This ratio shows whether Sprint’s income is either in cash or receivables. On this ratio, Sprint fluctuates all over the place. We feel this is due to Sprint having negative operating income for some of the years. This is a definite negative for Sprint.

The third diagnostic ratio we calculated was Other Income Expenses/SG&A. This ratio shows what percentage of SG&A is other income expenses. Sprint’s numbers have stayed relatively constant over the past five years.

Finally, we computed the applicable sales and core expense manipulation diagnostics for two of Sprint’s competitors, AT&T and Verizon. These ratios are presented in Table 3 on the next page.

Table 3: Competitor’s Manipulation Diagnostics Competitor's Sales & Core Expense Manipulation Diagnostics

15 AT&T 2000 2001 2002 2003 2004 Net Sales/Cash from Sales 4.40 4.22 7.87 4.05 5.54 Net Sales/Net Account Receivable 4.20 5.90 5.94 7.27 7.09 Net Sales/Inventory N/A N/A N/A N/A N/A Net Sales/Assets 0.19 0.25 0.68 0.72 0.93 CFFO/OI 0.07 0.13 1.50 (5.30) 0.22 Other Employment Expenses/SG&A 0.61 0.57 0.61 0.66 0.57

Verizon 2000 2001 2002 2003 2004 Net Sales/Cash from Sales 4.09 3.40 3.06 3.01 3.27 Net Sales/Net Account Receivable 4.62 4.71 5.37 6.84 7.27 Net Sales/Inventory 33.88 34.14 45.02 52.81 28.69 Net Sales/Assets 0.39 0.39 0.40 0.41 0.43 CFFO/OI (1.48) (0.76) 0.67 (0.05) (0.12) Other Employment Expenses/SG&A N/A N/A 0.32 0.54 0.66

All of the sales manipulation diagnostics for AT&T and Verizon are relatively comparable to Sprint’s ratios. This tells us that Sprint is in line with the common practices for the telecommunications industry.

The core expense manipulation diagnostics for AT&T and Verizon are also comparable to Sprint’s ratios. Sprint’s Net Sales/Assets has remained fairly constant. It is slightly higher than Verizon’s and about equal to AT&T’s average Net Sales/Assets. Both competitors also show large fluctuations in CFFO/OI, with all companies having a negative value in 2003. Finally, Other Employment Expenses/SG&A is constant for all companies and Sprint’s values are close to its competitors’ ratios.

Ratio Analysis and Forecast Financials

16

The ratio analysis section is very important to assess how the company is performing compared to the industry average. This shows if the company has had any problems. In this section we compute Sprint’s ratios to see past and current trends as well as provide a basis to predict future performance. We took Sprint’s direct competitors, AT&T, MCI, and Verizon, and used their financial statements to compute their ratios to get a good representation of the industry average3, 4. We compared Sprint to the benchmark in its industry to judge their performance and see if they are a trend setter or just keeping up with the industry. This is a great tool to help see areas in which Sprint is either lagging behind or doing well compared to their competitors, which may be overlooked otherwise.

The following ratios also play a large role in forecasting Sprint’s future financial statements. By forecasting Sprint’s future income statement, balance sheet, and statement of cash flows we allow investors to get a better picture of how the company might look and might be performing into the future.

Ratio Analysis

Ratio analysis is broken down into three main categories: liquidity, profitability, and capital structure ratios. Each ratio is presented in a separate figure and then discussed. All of these ratios are important because they tell us what kind of condition the company and the rest of the industry are in.

Liquidity Analysis

In this section, we assessed Sprint using the current, quick asset, account receivable turnover, and account receivable turnover in days ratios. These ratios are presented in Figures 1-5 below. The tables that these graphs were derived from can be found in Appendix A.

Figure 1: Current Ratio

17 Current Ratio

2.00 1.50 Sprint 1.00 AT&T Corp

Amount 0.50 MCI 0.00 Verizon 2000 2001 2002 2003 2004 Industry Average Years

The current ratio tells how fast the company is able to get cash. Sprint’s ratio shows that they are currently above one dollar. Sprint and their competitors have had lots of debt in the past years and in forecasting for the future we know that Sprint is going have to stop acquiring liabilities in order to remain profitable.

Figure 2: Quick Asset Ratio Quick asset ratio Sprint 2.00 1.50 AT&T 1.00 Corp 0.50 MCI Amount 0.00 Verizon 2000 2001 2002 2003 2004 Years Industry Average

Another way to evaluate if a company has the ability to pay liabilities quickly is by using the quick asset ratio. This shows if Sprint is able to fill obligations if sales ceased for a short or long period. Current performance of the industry and Sprint shows that they need to do some changes. Since the industry was growing in the 1990s all of the companies acquired lots of liabilities because they thought that the market would continue to increase. But all good things must come to an end and the expectation of the industry was not the same as the market’s performance.

Figure 3: Inventory Turnover

18 Inventory turnover

30.00 20.00 Sprint 10.00 Verizon

Amount 0.00

0 2 4 0 0 0 0 0 0 2 2001 2 2003 2 Years

In this ratio neither AT&T nor MCI report inventory in their financial reports making them ineligible for comparison in this category. Verizon was created with the finalization of the merger between Bell Atlantic and GTE. Since this occurred we do not have confidence in using the data from Verizon in the year 2000 for this category comparison. The elimination of multiple competitors makes it unrealistic to form an industry average for this category. But Sprint is increasing for this ratio which could imply either strong sales or ineffective buying.

Figure 4: Accounts Receivable Turnover

Accounts Receivable turnover

12.00 Sprint 10.00 8.00 6.00 AT&T Corp 4.00 Amount 2.00 MCI 0.00 Verizon 0 2 4 0 0 001 00 20 2 20 2003 2 Industry Years Average

This ratio tells how quickly the company is able to collect money that was purchased on a credit sale. Do to lack of confidence in AT&T's accounting in this category for the year 2000 we have used a published Accounts Turnover4 in order to have a full competitor comparison. For this ratio all of the companies are performing near each other. Sprint has had a decrease from 2003-2004, an issue that the company needs to address because they having some kind of trouble which they were not having in the other years.

Figure 5: Accounts Receivable Turnover in Days

19 Account Receivable turnover - days

100.00 Sprint 80.00 60.00 AT&T Corp 40.00

Amount 20.00 MCI 0.00 Verizon

2000 2001 2002 2003 2004 Industry Years Average

When the turnover is addressed in days the return is much higher in the industry as compared to Sprint. Sprint needs to figure what is affecting the outcome of the ratio, once that is done the company will be able to measure up to the rest of the industry.

Profitability Analysis

In this section, we evaluated Sprint’s gross profit margin, operating profit margin, net profit margin, asset turnover, return on assets, and return on equity. These ratios can be found in Figures 6-11 below. The tables for these can be found in Appendix B.

Figure 6: Gross Profit Margin Gross profit margin Sprint 100.00% AT&T Corp 50.00% MCI Amount 0.00%

2 3 4 Verizon 00 01 0 0 0 0 0 2 2 20 20 20 Years Industry Average

Verizon’s reporting of Cost Goods sold differs greatly in 2000 from the following years. This is possibly due to the finalization of the merger between Bell Atlantic and GTE in which Verizon was created. For this reason we do not have confidence in using the data from Verizon in the year 2000 for this category comparison. Sprint’s Profit margin is lower than the industry average as well as the lowest overall compared to its immediate competitors. Sprint is increasing its profit margin each year by growing its revenues faster than its cost of sales. Some firms in this comparison do not include inventory in

20 their statements. The primary costs of sales include the handsets and accessories, the tower site costs, and customer and network related costs.

Figure 7: Operating Profit Margin Operating Profit margin

100.00% Sprint

50.00% AT&T Corp

0.00% Amount Verizon -50.00% 00 01 02 03 04 20 20 20 20 20 Industry Years Average

For the reasons stated above, we omit Verizon from the year 2000 comparison due to lack of confidence in that year’s data for them. We also omit MCI due to lack of confidence in their data. Again Sprint’s margin fluctuates between 7.8% and -2.5%. There does not appear to be a clear growing or decreasing pattern with them. Sprint has higher costs of sales and non reoccurring expenses that contribute to its lower than industry average performance in this area. The accounting methods used and the complexity of this industry make it difficult to find comparable data without simply guessing to explain some competitor’s data.

Figure 8: Net Profit Margin

Net Profit margin Sprint

40.00% AT&T Corp 20.00% 0.00% MCI -20.00%

Amount 04 0 -40.00% 2000 2001 2002 2003 2 Verizon -60.00% Years Indus try Average

We omit MCI from the year 2003 comparison due to lack of confidence in that year’s data for them. They have a large inconsistency in net income for the year which their accounting disclosure does not easily explain. The fluctuations in the industry are widely dispersed. Sprint’s results, although sporadic, do not fluctuate as greatly. Most of the industry results are quite low or even negative. The intense competitive nature of the

21 telecommunications industry requires that firms employ low pricing structures in order to compete. This would explain the low margins overall.

Figure 9: Asset Turnover

Asset turnover Sprint

150.00% AT&T Corp 100.00% 50.00% MCI

Amount 0.00%

4 Verizon 01 02 03 0 0 0 2000 2 2 2 200 Years Industry Average

Due to lack of confidence in AT&T's accounting in this category for the year 2000 we have used a published Assets Turnover4 in order to have a full competitor comparison. Sprint has maintained relatively steady asset turnover from year to year, but have gone from above industry average to below industry average in the last two years. The industry shift towards higher asset turnover is most likely due to the intensifying competition between top competitors to gain market share by cutting prices.

Figure 10: Return on Assets

Return on assets Sprint

20.00% AT&T Corp

0.00% MCI -20.00% 1 3 Amount 2000 200 2002 200 2004 Verizon -40.00% Years Indus try Average

Due to lack of confidence in AT&T's accounting in this category for the year 2000 we have omitted them from that year's comparison. In addition we omit MCI from the year 2003 comparison due to lack of confidence in that year’s data as stated above. As an industry, return on assets is low. This is an indication that Sprint may have difficulty in branching out with new projects since their return on assets is less than the rate at which they would be able to borrow funds.

22 Figure 11: Return on Equity

Return on equity

40.00% Sprint 20.00% Verizon 0.00% Amount 2000 2001 2002 2003 2004 -20.00% Industry Average Years

Extreme outliers occurred in years 2003 and 2004 for MCI due to inconsistencies accounting practices. Therefore they were omitted from this category of comparison. We have also omitted AT&T from this comparison do to lack of confidence in their accounting of data required for this category. With just Sprint and Verizon left to compare we do not get enough of a representation to form an industry average. This ratio gives an indication of what stockholders are earning on their shares. Sprint’s share holders received a low return on investment in 2004. This indicates that Sprint did not generate sufficient assets for their invested dollars. There does not seem to be any consistent pattern for Sprint. Based on their 2004 results Sprint would need an increase in investments to have a positive outcome on their return on equity.

Capital Structure Analysis

The last set of ratios consist of total liabilities/total equity, times interest earned, and the debt service margin. These are presented in Figures 12-14 below. The tables can be found in Appendix C.

Figure 12: Total Liabilities/Total Equity

Total Liabilities/Total Equity Sprint 6.00 4.00 AT&T Corp 2.00 MCI 0.00 Amount (2.00) 00 01 02 03 04 Verizon 0 0 0 0 0 (4.00) 2 2 2 2 2 Years Industry Average

23 Once again we have omitted AT&T from the year 2000’s comparison due to lack of confidence in their accounting in this category for that year. Since most of the ratios for the industry are higher than 1.0, we can see that as an industry most firms tend to finance their assets with debt instead of equity. The use of debt financing also indicates that the firms in this comparison are more risky. In the last two years Sprint has lowered their debt to equity by decreasing their total liabilities and increasing owner’s equity.

Figure 13: Times Interest Earned

Times interest earned

Sprint 30.00 20.00 AT&T Corp 10.00

Amount 0.00 Verizon (10.00) 0 01 02 03 04 0 0 0 0 200 2 2 2 2 Years Industry Average

Due to inconsistencies in MCI's accounting practices, extreme outliers occurred in years 2003 and 2004. Therefore they were omitted from this category of comparison. Sprint is well below industry average in this comparison. With a ratio below 1.0 they are in jeopardy of generating enough cash flow to pay their interest expenses. In previous years, Sprint has had negative cash flow from operations. A significant increase in non recurring expenses in 2004 for Sprint gave them a negative Times interest earned. Sprint’s high expenses significantly decrease their operating cash flow.

Figure 14: Debt Service Margin

Debt service margin

2.00 1.00 0.00 Sprint

Amount (1.00) 00 02 04 (2.00) 20 2001 20 2003 20 Years

We were not able to interpret any acceptable results from the data collected for Sprint’s competitors. This was due to the inconsistent manner in which these firms reported their cash flows and payables. The results we obtained from Sprint were very low. Again

24 Sprint’s low operating income is due to high expenses. Sprint’s debt service margin of less than 1.0 indicates that Sprint may well have insufficient income to cover its debt. Based on the findings from the profitability ratios, we feel Sprint’s overall profitability is below industry average. Sprint’s profitability potential is not impressive compared to its closest competitors. However, the slow and consistent growth that Sprint shows in recent years indicates that they may be beginning to capitalize on their key success factors and that they have the potential to be competitive with the industry.

Sprint’s capital structure ratios indicate that the company’s expenses are too high and that they are currently not generating enough cash flow to meet their debt payments. Although they have shown slight improvement in recent years, Sprint will have to continue to build its cash flows and increase operating efficiency to be competitive in the future.

Forecasting the Financial Statements

Income Statement

We started our forecasting with the Income Statement and made Total Revenue our focal point. Total Revenue or Sales is the most important measure to forecast on the Income Statement because most of the other forecasts are based off of it. Although Sprint’s Total Revenue for the most part is slowly increasing, we did not recognize any trend in Sprint’s percentage growth of sales to help us forecast just how much Sprint’s Total Revenues will grow. Because there was not an identifiable trend, we chose to use the average percentage growth rate over the past four years. These calculations are shown in Table 4 below.

Table 4: Revenue Growth Percentage 2000 2001 2002 2003 2004 Total 23,613,000 26,071,000 26,634,000 26,197,000 27,330,667 Average Revenue Percentage 10.41% 2.16% -1.64% 4.33% 3.81% Growth

We came up with an average of 3.81% per year; however, other professional analysts3, believe Sprint will only grow at 3.2% per year. After consideration, we felt that our average was skewed a little high because it included the years when cell phone usage grew tremendously. Although cell phone usage is still growing, we don’t believe it will quite as fast as it has been.

We also considered the sustainable growth rate, or SGR, for Sprint in forecasting our total revenues. SGR is the rate at which a company can grow with its existing capital structure. The SGR is dependent on a company’s return on equity and dividend payout ratio. We calculated a SGR of 3.4% for Sprint. This is consistent with other analysts

25 predictions and also reconfirms that our calculated five-year average is slightly too high. For these reasons, we elected to use a growth rate of 3.2% to forecast our total revenue.

The next number we forecasted was gross profit. We did so by taking our forecasted total revenue and multiplying it by the average gross profit margin from the last five years. Sprint’s average gross profit margin is 52%. We then used our forecasted total revenue and gross profit to forecast the cost of revenue. This is a simple equation; Cost of Revenue = Total Revenue – Gross Profit.

The fourth number we forecasted on the income statement was operating income. We did so by taking our forecasted total revenue and multiplying it by our average operating profit margin from 1999 to 2003. The average operating profit margin for Sprint is only 2%.

The final number we forecasted on the income statement was net income. The net income for Sprint was hard to predict because of Sprint’s losses in prior years. We took total revenue and multiplied it by our forecasted net profit margin. We decided to use 2.5% for our forecasted net profit margin because it was the average of the last two years that had positive numbers. The forecasts for the items we have discussed here are presented in Table 5 below.

Table 5: Condensed Forecasted Income Statement 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Total 27,900 28,793 29,714 30,665 31,646 32,659 33,704 34,783 35,896 37,583 Revenues Cost of 13,392 13,820 14,263 14,719 15,190 15,676 16,178 16,695 17,230 18,040 Revenues Gross 14,508 14,972 15,451 15,946 16,456 16,982 17,526 18,087 18,666 19,543 Profit Operating 558 575 594 613 632 653 674 695 717 752 Income Net 697 719 742 766 791 816 842 869 897 1,127 Income

These are the forecasted numbers that we feel most comfortable with. Sprint has had many fluctuations in its past financial statements making it more difficult to predict future earnings and expenses. However, we feel we were as accurate as possible in our models and have tried to incorporate other analysts’ data when we felt ours was insufficient. Sprint’s forecasted income statement can be found in Appendix D.

Balance Sheet

The Balance Sheet was slightly easier to work with in making predictions because there was less volatility. After getting our core numbers done in the income statement, we were able to start on the balance sheet, specifically total assets. We were able to use the relationship between total revenue and total assets, expressed as asset turnover, to

26 forecast total assets. We calculated total assets by dividing total revenue by the asset turnover ratio. We used an asset turnover ratio that increased by 2% per year. We were able to recognize this trend from our data from the last five years. This information is summarized in Table 6 below.

Table 6: Asset Turnover Change 2000 2001 2002 2003 2004 Asset .55 .57 .59 .61 .63 Turnover Incremental +.02 +.02 +.02 +.02 Change

The next number we forecasted on the balance sheet was total current assets. We found this number by first producing a percentage of current assets to total assets for each of the past five years. We used those numbers to find the average, which was 14%. We then took the 14% and multiplied it by our forecasted total assets of each year to get our forecasted current assets.

After finding our current assets, we used its relationship with the current ratio to find our current liabilities. This was done by dividing current assets by our current ratio. We used an average of .77 for our current ratio.

Next we computed our total stockholders equity. We had to first find our stockholders equity as a percentage of total assets for the past five years. The average of these years was used, which turned out to be 30%. From here we multiplied our total assets by the 30% to come up with total shareholders equity.

The final number on the balance sheet we computed was total liabilities. We used the fundamental accounting equation, Assets = Liabilities – Shareholders Equity, to find our total liabilities. A summary of the items we have discussed here is presented in Table 7 below. Sprint’s balance sheet can be found in Appendix E.

Table 7: Condensed Forecasted Balance Sheet 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Current 6,290 6,292 6,299 6,312 6,331 6,354 6,383 6,416 6,454 6,496 Assets Total 44,930 44,941 44,994 45,088 45,220 45,389 45,592 45,829 46,098 46,399 Assets Current 8,169 8,171 8,181 8,198 8,222 8,253 8,289 8,333 8,381 8,436 Liabilities Total 31,451 31,459 31,496 31,562 31,654 31,772 31,915 32,080 32,269 32,479 Liabilities Total 13,479 13,482 13,498 13,526 13,566 13,617 13,678 13,749 13,829 13,920 Equity

27

Cash Flows

Predicting the statement of cash flows proved to be very difficult because of Sprint’s volatile numbers. We were able to successfully forecast net income, depreciation, dividends, cash flows from operations, cash flows from investing, and cash flow from financing.

Net income was simply pulled from the income statement which we discussed above. Next, depreciation was forecasted by using a 4.5% increase from the previous year’s amount. We recognized this trend from past data. Since Sprint pays a constant dividend every year, we forecasted dividends to stay constant.

Our cash flows from operating activities (CFFO) was forecasted by first coming up with a percentage change in CFFO over the last five years. The number we calculated was 13.6%. We added one to this number and then multiplied it by the previous years CFFO to find the forecasted CFFO. We continued this process for the entire ten years. This information is summarized in Table 8 below.

Table 8: CFFO Change 2000 2001 2002 2003 2004 CFFO 4,297,000 4,691,000 6,360,000 8,748,000 6,304,000 Average Percent 9.16% 35.57% 37.55% -27.94% 13.6% Change

Cash flows from investing and cash flows from financing were forecasted similarly to CFFO. A summary of our forecasted cash flows is presented in Table 9 below. More information about the statement of cash flows is available in Appendix F.

Table 9: Condensed Forecasted Statement of Cash Flows 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Net Income 849 876 904 933 963 994 1,025 1,058 1,092 1,127 Depreciation 4,932 5,154 5,386 5,628 5,881 6,146 6,423 6,712 7,014 7,330 CFFO 7,526 8,549 9,712 11,033 12,533 14,238 16,174 18,374 20,873 23,712 CFFI (3,832) (3,851) (3,870) (3,889) (3,909) (3,928) (3,948) (3,968) (3,988) (4,007) Dividends (650) (650) (650) (650) (650) (650) (650) (650) (650) (650) CFFF (650) (650) (650) (650) (650) (650) (650) (650) (650) (650)

28 Valuations Analysis

The purpose of this section is to provide an estimate of Sprint’s value today from future estimates of performance. From providing information for potential investors to helping firm managers, the information provided from valuation aids in numerous business decisions inside the firm as well as externally. In this section we build on the accounting and ratio analysis sections to accomplish the final stage of Sprint’s valuation. We valued Sprint based on the assumption that our calculated ratios are sound and reliable evidence of the firm’s financial performance. We present the method of comparables, discounted dividends, discounted free cash flows, discounted residual income, and discounted abnormal earnings growth models. We also calculated the long run average residual income perpetuity based on the P/B ratio. After comparing the different methods of valuation we have come to the conclusion that Sprint Corp. is over valued.

Valuations

We used multiple valuation models in order to assess which method most accurately portrays our opinion of Sprint’s actual value. Since each method is based on different inputs some results may be more realistic than others. With each model we performed a sensitivity analysis in order to see which combinations of growth and discount rates came closest to matching the published stock value. In order to use the valuation models, we had to estimate the appropriate discount rates to use. We estimated the cost of debt (Kd), cost of equity (Ke), and weighted average cost of capital (WACC) for Sprint Corp. These are presented with the valuation method that they are used for. Finally, we compare the results from these models to determine which method we believe most accurately portrays Sprint’s actual value.

The estimated values per share for the major valuation methods, the Ford Epic valuation, and actual price per share are summarized in Table 10 below. Although Ford Epic shows that Sprint is undervalued, we emphasize the research and effort that we have put into this valuation. We feel strongly that our valuation is the correct one.

Table 10: Valuation Models

Estimated Value per Share Discounted Dividends $6.20 Discounted Free Cash Flows $59.26 Residual Income $13.56 Abnormal Earnings Growth $13.85

Actual Price per Share $22.74 Ford Epic Value per Share $30.35

29 Method of Comparables Valuation Model

The method of comparables is a valuation of the firm using price multiples. The method of comparables helps us to set a benchmark for the industry. We used the forward and trailing price/earnings ratios, price/book ratio, dividend/price ratio, price/EBITDA ratio, price/sales ratio, and price/FCF ratios to help us evaluate how Sprint is performing. The method of comparables allows analysts and investors to compare Sprint against the industry averages. AT&T, MCI, and Verizon1 are Sprint’s three main competitors in the industry. We used these three companies to compute the industry average.

The process involved in calculating the methods of comparables is quite simple. We took information from each competitor’s respective 2004 year-end financial statements to calculate the ratios. We then took averages for all the different ratios, except Sprint, since it is the firm we are trying to value. We used the industry average and either multiplied or divided it by Sprint’s numbers to find the expected share price. The method of comparables is not always the most accurate model to use, but it is the simplest. Our calculations are present in Tables 11-17 below.

Table 11: P/E Ratio Forward Price to Earnings Ratio Price Earnings Forward Competitors Symbol per Share per Share P/E Ratio AT&T T 18.66 1.203 15.51 Verizon VZ 35.19 2.670 13.18 MCI MCIP 25.29 0.117 215.33 Industry Average (excluding outlier of 215.33) 14.35 Sprint FON 22.74 1.52 Expected Share Price $21.76

Table 12: Trailing P/E Ratio Trailing Price to Earnings Ratio

Price Earnings Trailing Competitors Symbol per Share per Share P/E Ratio AT&T T 18.66 -8.14 N/A Verizon VZ 35.19 2.60 13.53 MCI MCIP 25.29 -12.25 N/A

Industry Average 13.53 Sprint FON 22.74 -0.71

Expected Share Price N/A

30 The price we calculated using the forward price/earnings ratio was $21.76. This is close to Sprint’s actual share price of $22.74. In the price/earnings ratio, MCI was an outlier so we did not use them to calculate the industry average. We could not calculate the PEG ratio and the trailing price/earnings because Sprint had a negative value for these particular ratios.

Table 13: M/B Ratio

Market to Book Ratio

Price Competitors Symbol per Share Book Value M/B Ratio AT&T T 18.66 8.79 2.12 Verizon VZ 35.19 13.56 2.60 MCI MCIP 25.29 13.24 1.91 Industry Average 2.21 Sprint FON 22.74 9.17

Expected Share Price $20.26

Table 14: Dividend Yield Dividend Yield Price Dividends Competitors Symbol per Share per Share Dividend Yield AT&T T 18.66 0.95 0.05 Verizon VZ 35.19 1.62 0.05 MCI MCIP 25.29 1.60 0.06

Industry Average 0.05 Sprint FON 22.74 0.50

Expected Share Price $9.36

The price we calculated using the market to book ratio was $20.26. This also is close to Sprint’s actual share price of $22.74. The price we calculated using the dividend/price ratio was $9.36. This was much lower than Sprint’s actual share price of $22.74. This does not appear to be an appropriate model to use to value Sprint.

31 Table 15: Price/EBITDA Ratio Price / EBITDA Ratio

Price Competitors Symbol per Share EBITDA P / EBITDA AT&T T 18.66 N/A N/A Verizon VZ 35.19 4.88 7.21 MCI MCIP 25.29 N/A N/A

Industry Average 7.21 Sprint FON 22.74 10.88 Expected Share Price $78.46

Table 16: P/S Ratio Price to Sales Ratio

Price Sales Competitors Symbol per Share per Share P/S Ratio AT&T T 18.66 37.32 0.50 Verizon VZ 35.19 25.50 1.38 MCI MCIP 25.29 63.23 0.40

Industry Average 0.76 Sprint FON 22.74 17.76

Expected Share Price $23.37

The price we calculated using the price/EBITA ratio was $78.46. This was much higher than Sprint’s actual share price of $22.74. It also is not an appropriate model to value Sprint. The price we calculated using the price/sales ratio was $23.37. This is close to Sprint’s actual share price of $22.74.

Table 17: P/FCF Ratio Price / Free Cash Flows Ratio

Price Competitors Symbol per Share FCF P / FCF AT&T T 18.66 0.85 21.88 Verizon VZ 35.19 1.78 19.73 MCI MCIP 25.29 9.24 2.74 Industry Average 14.78 Sprint FON 22.74 2.81

Expected Share Price $41.53

32 The price we calculated using the price/FCF ratio was 41.53. This is much higher than Sprint’s actual share price of $22.74. After completing these seven valuation ratios, we concluded that the best valuation model to use would be the forward price/earnings ratio because it is the closes to Sprint’s actual share price. The market to book ratio and price to sales ratio would also be appropriate to value Sprint.

Discounted Dividends Valuation Model

Using this model to predict Sprints price was straightforward because of Sprint’s dividend policy. Sprint is one of the companies that has paid a constant dividend for almost its entire existence. Sprint’s dividend is $.50 per share. This constant dividend made it easier on us to value them using the divided discount model.

The Cost of Equity

The appropriate discount rate for the discounted dividends model is the cost of equity (Ke). Calculating Ke involved determining the firm’s return, the S&P 500’s return, and the risk free rates of return. In order to have a large enough sample size to make our calculations accurate, we found the monthly return for each of the three factors from March 2000 through March 2005. This gave us over 60 samples with which to calculate our Beta. We found the monthly return information for Sprint and the S&P 500 from finance.yahoo.com5. We chose to use the monthly rates from a 5-year Treasury Constant Maturity Rate as our risk free rates of return. We found this information from the Federal Reserve Bank of St. Louis’ website6. The average risk free rate is 4.087%.

We used the S&P 500 and 5-year Treasury rates of return to calculate the market risk premium, which is simply the S&P 500 return less the risk free rate of return. We then used the firm’s return and the market risk premium to calculate a Beta. We calculated a 5-year, 3-year, and 2-year Beta using the slope of the firm’s return and the market risk premium for the respective periods of time. These are given in Table 18 below.

Table 18: Beta Estimates Beta Estimate:

5-year time horizon 1.3571

3-year time horizon 1.8981

2-year time horizon 0.8202

We used the estimated betas and a historical market risk premium of 3.00% to calculate the cost of equity, again for each of the three time periods. We also calculated Ke using the beta for Sprint Corp. published in finance.yahoo.com5. The cost of equity is equal to

33 the average risk free rate plus the market risk premium multiplied by Beta. Our Ke estimates are given in the Table 9 below. Calculations can be found in Appendix H.

Table 19: Ke Estimates

Ke Estimates:

5-year time horizon 8.158%

3-year time horizon 9.781%

2-year time horizon 6.547%

Yahoo published 8.113%

Another way to estimated Ke is to calculate what Ke would be required for the different valuation models to achieve the actual observed share price. We calculated these costs of equity for the three models that use Ke: discounted dividends, residual income, and abnormal earnings models. This information is summarized in Table 20 below.

Table 20: Ke Required for Observed Share Price

Ke Required for Observed Share Price Residual Income 5.44% Abnormal Earnings 5.44% Discounted Dividends 2.20%

We chose to use a cost of equity of 8.113%, found by using the yahoo published beta, as the cost of equity in our valuation models. We also compared the cost of equity to Sprint’s cost of debt. A company’s cost of equity should always be higher than its cost of debt. Sprint has a cost of debt of 5.09% (as explained in the next section), so this cost of equity checks out as a realistic number.

Results

Using the discounted dividends model we came up with an expected share price of $6.20. We used our calculated Ke of 8.113% and a zero percent growth rate since we believe that Sprint will continue its constant dividend payout. This share price is much less than the actual share price of $22.74.

We performed a sensitivity analysis for this valuation model using growth rates of 0%, 3%, and 5%. This analysis can be seen in Table 21 below. The blue identifies the number that we found using our calculated Ke and g. The green is for values that come close to the observed price.

34 Table 21: Discounted Dividends

Sensitivity Analysis

g 0% 3% 5% Ke 5.000% 10.02 24.31 N/A 6.000% $8.36 $16.22 $47.67 8.113% $6.20 $9.55 $15.36 9.000% $5.60 $8.15 $11.97

The only way for the estimated share price to be close to actual is for the dividend growth rate to be greater than zero. Since Sprint has not increased its dividends at all throughout the past five years, we do not feel that this is a realistic assumption. Thus, we conclude that the discounted dividends model is not an appropriate model to use to value Sprint. The calculations for the discounted dividends model can be found in Appendix I.

Discounted Free Cash Flows Valuation Model

This model uses the weighted average cost of capital (WACC) and a stream of cash flows to predict the share price. We chose to use a before-tax based WACC so that we can get information in after-tax dollars. We use WACC in this method because we are looking at cash flows to the firm, not investors.

The Cost of Debt

In order to calculate the weighted average cost of capital, we have to know both the cost of equity and the cost debt (Kd). We calculated the cost of debt by looking at the different types of debt on Sprint’s balance sheet and their corresponding interest rates. Sprint’s costs of debt range from 1.2% for current liabilities to 10.9% for stock1. We found the interest rates for the different types of debt by looking in the notes to the financial statements1.

We calculated Kd by using a weighted average of the different types of debt and their corresponding interest rates. We found the percentage of each debt type to total debt and then multiplied those percentages by their corresponding interest rates. We calculated an average cost of debt of 5.09% for Sprint. Our calculations can be found in Appendix G.

35 The Weighted Average Cost of Capital

V V WACC = D k + E k V d V e We used the formula F F to find our weighted average cost of capital (WACC). VD is the value of debt, which is $27,553,000 according to Sprint’s 2004 balance sheet. VE is the value of equity, which is $13,768,000, also from Sprint’s 2004 balance sheet. The value of the firm, or VF, is found by adding the value of debt and the value of equity. We calculated a before-tax WACC of 6.10%.

Results

For the discounted free cash flows model, we had to first predict a stream of cash flows. We did this by using our forecasted cash flows from operations (CFFO) for years 2005 – 2014 and subtracting the cash flows from investing activities (CFFI) of the same years. This gave us the free cash flows (FCF) to the firm for each year on the 10-year basis. We then discounted this back to present day dollars using the appropriate present value factor found with our calculated WACC as the discount rate.

At this point, we set up a perpetuity starting in 2014. We then computed the present value of the perpetuity. From here we added the sum of the present values, $58,782,236 and the present value of the perpetuity, $87,479,240 to get the value of the firm, which was, $304,446,128. After this we subtracted the value of equity which was estimated to be $275,530,000 and divided this number by the shares outstanding to get an estimated share price of $59.26.

This model reveals that Sprint is undervalued by roughly $36. This valuation model throws us a curve ball, because it shows Sprint is undervalued. However, this figure may be subject to some errors. For example, our WACC is computed by using a cost of equity of 8.113%. If we change this value, it would allow for fluctuations in our estimated share price. The sensitivity analysis is presented in Table 22 below.

Table 22: Discounted Free Cash Flows Sensitivity Analysis

g

0% 1% 2% 3%

WACC 4.000% $178.54 $285.22 $498.58 1138.65 6.100% $59.26 $99.59 $159.60 258.33 7.000% $29.40 $41.19 $75.83 $125.87 8.000% $3.78 $25.79 $55.14 96.23

36 This shows that a higher WACC and a higher growth rate would get us closer to the observed price of $22.74. The calculations for the discounted free cash flows model can be found in Appendix J.

Discounted Residual Income Valuation Model

The residual income model is the difference between normal and actual income. To complete the residual income model, we used the present value of estimated residual income for the next ten years, including a terminal value. To perform this valuation we began by using the 2004 ending book value per share as the beginning value in 2005. We added to this 2005’s earnings per share and subtracted the dividends per share to give us the ending book value of equity for that year. Then we multiplied the beginning book value of equity by our calculated cost of equity to get the normal income for the year. We subtracted the year’s earnings per share from the normal income to get the residual income. We continued this process for the first nine years. We then discounted each year’s residual income back to year-one dollars and totaled the results. We used 2013’s terminal value as our perpetuity with 0% growth. We also discount the perpetuity back to year-one dollars. Finally, we added the 2004 book value of equity per share, the total present value of residual income, and the PV of our terminal value to arrive at our estimated value per share.

Results

At a cost of equity of 8.113% and zero growth we came up with an estimated share value of $13.56, which is well below the actual price per share. In order to see what combinations Sprint’s cost of equity and growth rate would need to be to come close to the actual stock price, we performed a sensitivity analysis. The closest we could come to Sprint’s actual share price with our cost of equity of 8.113% was by using a 5% growth rate to get $18.63, which is still well below the actual share price of $22.74. If we kept our zero growth rate Sprint would need a cost of equity of 5.435% to get a value of $22.74 which is identical to the actual price per share. The sensitivity analysis is presented in Table 23 below.

Table 23: Residual Income Sensitivity Analysis g 0% 1% 3% 5% Ke 6.547% $17.97 $18.01 $18.14 $18.63 8.113% $ 13.58 $ 12.28 $12.30 $10.06 8.158% $ 13.48 $13.17 $12.18 $9.94 9.781% $ 10.56 $10.17 $9.06 $7.02 5.435% $22.74

37 Through the sensitivity analysis we can see that a cost of equity of 8.113% does not produce a share value that is close to the actual price. According to this model, using our calculated cost of equity and no growth, we see that Sprint is over valued at $22.74. It takes a decrease in our cost of equity to match the actual price. With these results, we reach the conclusion that the residual income model not accurate in estimating Sprint’s value. The residual income calculations are presented in Appendix K.

Abnormal Earnings Growth Value

Through this model, the value of the firm is determined by the sum of the forecasted abnormal earnings discounted back to current dollars and the firm’s book value. Abnormal earnings take into effect the opportunity cost of equity funds used instead of paid as dividends. To calculate the abnormal earnings growth (AEG), we took the earnings per share and added it to the dividends per share invested at a cost of equity of 8.113% to get the cumulative dividends earned. We then multiplied earnings per share by 1.08113 (one plus the cost of equity) and subtracted the result from the cumulative dividends earned to get the abnormal earnings for the year. We did this for years 2006- 2013. We then found the present value for each year’s abnormal earnings and added the results together. For this model we also assumed a terminal value of zero. We then added the total present values to the beginning book value to get an average perpetuity of $1.10. Then we divided the average perpetuity by the capitalization rate of .8.113% to get a value of $13.58 as of the end of 2004. In order to make this value current, we then calculated the future value as of April 1st 2005. We ended up with a value for Sprint of $13.85 compared to the actual value of $22.74

Results

As with the residual income model, abnormal earnings indicate that the value of Sprint is lower than actual share price. With our sensitivity analysis presented in Table 24 we again use different costs of equity but continue to use zero growth. All prices in the table are valued as of April 1, 2005. With a cost of debt of 6.547% we get a value of $18.26 which is still lower than the actual price. As with the residual income model in order to match the actual share price of $22.74 we would have to use a cost of equity of 5.435%.

Table 24: Abnormal Earnings Growth Sensitivity Analysis g 0% 1% 3% 5% Ke 5.435% $23.04 N/A N/A N/A 6.547% $18.26 N/A N/A N/A 8.113% $13.85 N/A N/A N/A 9.781% $10.81 N/A N/A N/A

38 With this valuation method we are still unable to come up with a value that is close to the actual value of Sprint. By using the same changes in our cost of equity the sensitivity analysis shows that the fluctuations in value are in line with those of residual income model. According to this model Sprint is once again significantly over valued at $22.74. In conclusion, we believe that the discounted abnormal earnings model is not accurate in determining Sprint’s value. The detailed abnormal earnings growth calculations can be found in Appendix L.

Long Run Average Residual Income

The last model we used to value Sprint is the long run average residual income model based on the P/B ratio. In this model, we used the following formula to calculate share prices. P = BE * 1 + [(ROE – Ke)/ (Ke – g)]

We calculated our ROE to be .12 and the book value of equity to be 9.3 per share. We plugged these numbers into the formula. After this we used our 5, 3, and 2-year cost of equity values along with growth rates of 0, 3%, and 5% for our sensitivity analysis. The sensitivity analysis is presented in Table 25 below.

Table 25: Long Run Average Residual Income Sensitivity Analysis g 0% 3% 5% Ke 6.540% 17.06 23.64 42.27 8.113% $13.69 $16.25 $20.67 9.780% $11.41 $12.35 $42.27

Our most accurate prediction came from the 2 year Ke and a growth rate of 3%, which gave us a share price of $23.64. The 5% growth rate and Ke of 8.15% was also close to the actual price of $22.74; it yielded $20.67. All of the other values were below $18 except for one, which reached a total over $40. This shows us that Sprint may be overvalued by several dollars per share. The difference comes in when using cost of equity values and growth rates. Some variation may come into play when predicted such values. The residual income model is presented in Appendix M.

The Z-Score

Altman’s Z-Score is one model used for credit rating. It weights five variables to compute a bankruptcy score. This formula is given in Figure 15 on the following page.

39 Figure 15: Altman’s Z-Score ⎡ Working Capital ⎤ ⎡ Retained Earnings ⎤ Z − score = 1.2 ⎥ + 1.4 ⎢ ⎥ ⎣⎢ Total Assets ⎦ ⎣ Total Assets ⎦

⎡ Earnings Before Interest and Taxes ⎤ + 3.3 ⎥ ⎣⎢ Total Assets ⎦

⎡ Market Value of Equity ⎤ + 0.6 ⎥ ⎣⎢ Book Value of Liabilitie s ⎦

⎡ Sales ⎤ + 1.0 ⎢ Total Assets ⎥ ⎣ ⎦

Using this formula we calculated a Z-Score of 1.32 for Sprint. This means that Sprint is in the ‘gray area’. When a company has a Z-Score below 1.2 banks will not loan them money. A good Z-Score is equal to 1.9 or above. This reinforces our belief that Sprint is not in a good financial position.

Conclusion

The results of these valuations point us in a clear direction. With the exception of the discounted free cash flows model, the majority of the valuations indicate that Sprint is overvalued. This also agrees with our intrinsic valuation opinions that we have developed while researching Sprint and preparing the prior sections. The Z-Score further confirms our opinions.

Given these results from the valuation models and our opinion of Sprint developed through our research, we believe that Sprint is overvalued. Because of this, we do not recommend Sprint as an opportune investment.

40 References

1. http://edgarscan.pwcglobal.com/servlets/getCompanyDetail?Name=SPRINT+CORP

2. www.sprint.com

3. http://www.marketwatch.com

4. http://edgarscan.pwcglobal.com

5. http://finance.yahoo.com

6. http://research.stlouisfed.org/fred2/categories

41

Appendix

Appendix A: Liquidity Analysis

Liquidity Analysis 1) Current Ratio 2000 2001 2002 2003 2004 Sprint 0.75 0.49 0.78 1.02 1.45 AT&T Corp 0.82 0.89 1.29 1.11 1.03 MCI 0.55 1.00 1.30 1.40 1.47 Verizon 0.65 0.61 0.79 0.69 0.84 Industry Average 0.67 0.83 1.13 1.06 1.11

2) Quick asset ratio 2000 2001 2002 2003 2004 Sprint 0.63 0.43 0.69 0.93 1.35 AT&T Corp 0.82 0.89 1.29 1.11 1.03 MCI 0.55 1.00 1.30 1.40 1.47 Verizon 0.59 0.56 0.74 0.64 0.73 Industry Average 0.65 0.81 1.11 1.05 1.08

3) Inventory turnover 2000 2001 2002 2003 2004 Sprint 12.24 18.83 17.64 20.03 19.44 Verizon 10.44 13.30 16.98 9.32

4) Accounts Receivable turnover 2000 2001 2002 2003 2004 Sprint 5.86 6.85 7.09 9.03 6.60 AT&T Corp 5.92 5.90 7.16 8.56 9.56 MCI 5.74 7.09 5.74 6.88 7.25 Verizon 4.62 4.68 5.39 6.84 7.27 Industry Average 5.42 5.89 6.09 7.42 8.03

Accounts Receivable T/O in Days 2000 2001 2002 2003 2004 Sprint 62.26 53.28 51.49 40.43 55.30 AT&T Corp 61.66 61.87 51.01 42.66 38.19 MCI 63.63 51.52 63.62 53.09 50.37 Verizon 79.03 77.99 67.77 53.36 50.19 Industry Average 67.28 61.99 59.91 49.17 45.48

42

Appendix B: Profitability Analysis

Profitability Analysis

5) Gross profit margin 2000 2001 2002 2003 2004 Sprint 50.79% 50.16% 54.83% 55.50% 53.86% AT&T Corp 82.42% 79.57% 77.89% 77.92% 76.83% MCI 86.38% 85.87% 86.61% 87.19% 87.89% Verizon 69.21% 70.42% 67.85% 67.50% Industry Average 84.40% 78.22% 78.31% 77.65% 77.41%

6) Operating Profit Margin 2000 2001 2002 2003 2004 Sprint 2.14% -2.54% 7.88% 3.84% -1.10% AT&T Corp 66.66% 60.46% 56.77% 56.55% 55.36% Verizon 69.21% 70.42% 67.85% 37.92% Industry Average 66.66% 64.84% 63.60% 62.20% 46.64%

7) Net profit margin 2000 2001 2002 2003 2004 Sprint 0.39% -5.37% 2.37% 4.92% -3.69% AT&T Corp 9.97% 18.28% -34.58% 5.40% -21.18% MCI 10.62% -41.47% -28.50% -19.34% Verizon 18.23% 0.58% 6.06% 4.54% 10.99% Industry Average 12.94% -7.54% -19.01% 4.97% -9.85%

8) Asset turnover 2000 2001 2002 2003 2004 Sprint 54.83% 56.93% 58.80% 61.39% 66.38% AT&T Corp 39.00% 25.50% 68.23% 71.95% 93.09% MCI 39.52% 36.19% 120.28% 99.81% 121.28% Verizon 39.28% 39.06% 40.19% 40.82% 42.95% Industry Average 39.27% 33.58% 76.23% 70.86% 85.77%

9) Return on assets 2000 2001 2002 2003 2004 Sprint 0.22% -3.06% 1.39% 3.02% -2.45% AT&T Corp 4.66% -23.60% 3.89% -19.72% MCI 4.20% -15.01% -34.28% -23.46% Verizon 7.16% 0.23% 2.44% 1.85% 4.72% Industry Average 5.68% -3.37% -18.48% 2.87% -12.82%

10) Return on equity 2000 2001 2002 2003 2004 Sprint 0.68% -11.10% 5.12% 9.84% -7.48% Verizon 34.12% 1.20% 12.51% 9.19% 20.85% Industry Average 34.12% 1.20% 12.51% 9.19% 20.85%

43

Appendix C: Capital Structure Analysis

Capital Structure Analysis

11) Total Liabilities/Total Equity 2000 2001 2002 2003 2004 Sprint 2.12 2.61 2.66 2.24 2.04 AT&T Corp 2.20 3.50 2.44 3.67 MCI 0.72 0.76 (2.19) 2.09 3.03 Verizon 3.76 4.25 4.13 3.96 3.42 Industry Average 2.24 2.40 1.82 2.83 3.38

12) Times interest earned 2000 2001 2002 2003 2004 Sprint (0.51) 0.56 1.49 0.72 (0.24) AT&T Corp 20.78 17.09 14.83 16.86 21.05 Verizon 18.54 14.09 15.14 16.44 11.34 Industry Average 19.66 15.59 14.99 16.65 16.20

13) Debt service margin 2000 2001 2002 2003 2004 Sprint (0.23) (1.08) 1.26 0.95 0.37

44

Appendix D: Income Statement

Income Statement - in thousands of dollars Actual Forecasted

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Total Revenue 23,613,000 26,071,000 26,634,000 26,197,000 27,428,000 28,305,696 29,211,478 30,146,246 31,110,925 32,106,475 33,133,882 34,194,166 35,288,380 36,417,608 37,582,971

Cost of Revenue (11,620,000) (12,995,000) (12,031,000) (11,658,000) (12,656,000) (13,586,734) (14,021,510) (14,470,198) (14,933,244) (15,411,108) (15,904,263) (16,413,200) (16,938,422) (17,480,452) (18,039,826)

Gross profit 11,993,000 13,076,000 14,603,000 14,539,000 14,772,000 14,718,962 15,189,969 15,676,048 16,177,681 16,695,367 17,229,619 17,780,967 18,349,958 18,937,156 19,543,145

Operating Expense Selling General and Administrative 6,919,000 7,325,000 7,202,000 6,608,000 6,624,000

Non Recurring 238,000 1,814,000 389,000 1,951,000 3,731,000

Other 4,331,000 4,599,000 4,912,000 4,973,000 4,720,000

Operating Income 505,000 (662,000) 2,100,000 1,007,000 (303,000) 566,114 584,230 602,925 622,219 642,130 662,678 683,883 705,768 728,352 751,659

Income from Continuing Operations Total Other Income/Expenses Net (217,000) (183,000) (265,000) (110,000) (52,000)

Earnings before interest and taxes 288,000 (845,000) 1,835,000 897,000 (355,000)

Interest expense (990,000) (1,181,000) (1,406,000) (1,401,000) (1,248,000) (1,312,667) (1,312,667) (1,312,667) (1,312,667) (1,312,667) (1,312,667) (1,312,667) (1,312,667) (1,312,667) (1,312,667)

Income before Tax (702,000) (2,026,000) 429,000 (504,000) (1,603,000) Income Tax Expense 126,000 624,000 39,000 212,000 591,000 Net Income from Continuing Operations (576,000) (1,402,000) 468,000 (292,000) (1,012,000)

Non-recurring Events Discontinued Operations 675,000 159,000 1,324,000

Extraordinary Items (4,000) (1,000) 3,000 Effect of Accounting Changes (2,000) 2,000 258,000

Net Income 93,000 (1,401,000) 630,000 1,290,000 1,012,000 849,171 876,344 904,387 933,328 963,194 994,016 1,025,825 1,058,651 1,092,528 1,127,489

45 Appendix E: Balance Sheet

Balance Sheet - in thousands of dollars Actual Forecasted

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Assets

Current Assets

Cash 239,000 313,000 1,035,000 2,424,000 4,556,000

Short Term Investments 125,000

Net Receivables 4,028,000 3,806,000 3,757,000 2,902,000 4,156,000 3,931,347 4,057,150 4,186,979 4,320,962 4,459,233 4,601,928 4,749,190 4,901,164 5,058,001 5,219,857

Inventory 949,000 690,000 682,000 582,000 651,000

Other Current Assets 757,000 753,000 604,000 578,000 612,000

Total Current Assets 5,973,000 5,562,000 6,078,000 6,611,000 9,975,000 6,290,155 6,291,703 6,299,215 6,312,362 6,330,854 6,354,443 6,382,911 6,416,069 6,453,753 6,495,822

PPE 25,316,000 28,977,000 28,745,000 27,101,000 22,628,000

Long Term Investments 607,000 288,000 73,000 423,000

Goodwill 4,739,000 4,737,000 4,401,000 4,401,000 4,401,000

Intangible Assets 5,960,000 5,834,000 4,646,000 3,417,000 3,435,000

Acccum. Amortization (1,134,000) (1,509,000) (2,000) (3,000)

Other Assets 1,607,000 1,904,000 1,352,000 725,000 882,000

Total Assets 43,068,000 45,793,000 45,293,000 42,675,000 41,321,000 44,929,676 44,940,736 44,994,396 45,088,298 45,220,387 45,388,880 45,592,222 45,829,065 46,098,238 46,398,730

Liabilities

Current Liabilities

Accounts Payable 4,632,000 5,149,000 4,338,000 4,174,000 4,222,000

Short Term Debt 2,202,000 4,978,000 1,887,000 594,000 1,288,000

Other Current 1,134,000 1,309,000 1,583,000 1,708,000 1,392,000

Total Current Liabilities 7,968,000 11,436,000 7,808,000 6,476,000 6,902,000 8,169,032 8,171,043 8,180,799 8,197,872 8,221,889 8,252,524 8,289,495 8,332,557 8,381,498 8,436,133

Long Term Debt 17,154,000 18,226,000 20,130,000 18,566,000 15,916,000 18,870,464 18,875,109 18,897,646 18,937,085 18,992,563 19,063,330 19,148,733 19,248,207 19,361,260 19,487,467

Other Liabilities 3,070,000 1,962,000 2,780,000 2,548,000 2,559,000 Deferred Long Term Liability Changes 1,827,000 1,553,000 2,025,000 1,725,000 2,176,000

Total Liabilities 30,019,000 33,177,000 32,743,000 29,315,000 27,553,000 31,450,773 31,458,515 31,496,077 31,561,808 31,654,271 31,772,216 31,914,555 32,080,345 32,268,767 32,479,111

Stockholders Equity

Preferred Stock 256,000 256,000 256,000 247,000 247,000

Common Stock 1,814,000 2,787,000 2,812,000 2,844,000 2,950,000

Retained Earnings 1,578,000 (261,000) 252,000 906,000 (586,000) (386,829) (160,485) 93,903 377,230 690,425 1,034,441 1,410,266 1,818,917 2,261,446 2,738,935

Capital Surplus 9,380,000 9,564,000 9,931,000 10,084,000 11,873,000

Other Equity 21,000 270,000 (701,000) (721,000) (716,000)

Total Stockholders Equity 13,049,000 12,616,000 12,550,000 13,360,000 13,768,000 13,478,903 13,482,221 13,498,319 13,526,489 13,566,116 13,616,664 13,677,667 13,748,719 13,829,471 13,919,619

Total Liability and Equity 43,068,000 45,793,000 45,293,000 42,675,000 41,321,000 44,929,676 44,940,736 44,994,396 45,088,298 45,220,387 45,388,880 45,592,222 45,829,065 46,098,238 46,398,730 46

Appendix F: Statement of Cash Flows

Statement of Cash Flows - in thousands of dollars Actual Forecasted 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Net Income 93,000 (1,401,000) 630,000 1,290,000 1,662,667 849,171 876,344 904,387 933,328 963,194 994,016 1,025,825 1,058,651 1,092,528 1,127,489

Operating Activities Depreciation 4,144,000 4,599,000 4,912,000 4,973,000 4,720,000 4,932,400 5,154,358 5,386,304 5,628,688 5,881,979 6,146,668 6,423,268 6,712,315 7,014,369 7,330,016 Adjustments to Net Income (385,000) 915,000 853,000 803,000 2,989,000 Changes in Accounts Receivables (640,000) 222,000 590,000 75,000 (231,000) Change in Liabilities 947,000 366,000 (741,000) (856,000) (117,000) Changes in Inventories 146,000 133,000 (31,000) 204,000 (22,000) Changes in Other Operating Activities (8,000) (143,000) 147,000 2,259,000 298,000 Total Cash Flow From Operating Activities 4,297,000 4,691,000 6,360,000 8,748,000 6,625,000 7,526,000 8,549,536 9,712,273 11,033,142 12,533,649 14,238,226 16,174,624 18,374,373 20,873,288 23,712,055

Investing Activities Capital Expenditures (7,152,000) (9,046,000) (4,849,000) (3,797,000) (3,980,000) Investments (889,000) (66,000) (334,000) 145,000 Other Cash Flows From Investing Activities 249,000 334,000 254,000 101,000 22,000 Total Cash Flow From Investing Activities (6,389,000) (8,778,000) (4,595,000) (4,030,000) (3,813,000) (3,832,065) (3,851,225) (3,870,481) (3,889,834) (3,909,283) (3,928,829) (3,948,474) (3,968,216) (3,988,057) (4,007,997)

Financing Activities Dividends Paid (448,000) (451,000) (454,000) (457,000) (670,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) Sale Purchase of Stock 281,000 611,000 3,000 12,000 1,874,000 Net Borrowings 2,196,000 3,988,000 (642,000) (2,908,000) (1,884,000) Other Cash from Financing Activities 182,000 13,000 50,000 24,000 0 Total Cash From Financing Activities 2,211,000 4,161,000 (1,043,000) (3,329,000) (680,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000) (650,000)

Change in Cash and Cash Equivalents 119,000 74,000 722,000 1,389,000 2,132,000 3,043,935 4,048,311 5,191,791 6,493,308 7,974,366 9,659,396 11,576,151 13,756,157 16,235,231 19,054,058

47 Appendix G: Cost of Debt

Cost of Debt

Percent of Computed Value Total Interest Weighted 3/30/2002 Liabilities Rate Rate

Liabilities Current Liabilities Accounts Payable 4,222,000 15.32% 1.20% 0.18% Short Term Debt 1,288,000 4.67% 6.83% 0.32% Other Current Liabilities 1,392,000 5.05% 1.20% 0.06% Total Current Liabilities $6,902,000 25.05%

Long Term Liabilities Long Term Debt 15,916,000 57.77% 6.83% 3.95% Other Liabilities 2,559,000 9.29% 6.25% 0.58% Deferred Long Term Liability Changes 2,176,000 7.90% 6.25% 0.49% Preferred Stock 247,000 0.90% 10.90% 0.10% Total Liabilities $27,553,000 100.00%

Weighted Average Cost of Debt 5.09%

48 Appendix H: Cost of Equity

Cost of Equity

Beta Estimate: Average Risk Free Rate 4.087%

5-year time horizon 1.3571 Yahoo Published Beta 1.342

3-year time horizon 1.8981 Historical Mkt Risk Premium 3.000%

2-year time horizon 0.8202 Cost of Debt 5.900%

R2 Estimate:

5-year time horizon 25.0813%

3-year time horizon 45.946%

2-year time horizon 15.189%

Ke Estimate:

5-year time horizon 8.158%

3-year time horizon 9.781% Ke = 8.113 2-year time horizon 6.547%

Yahoo published β 8.113%

49

Appendix I: Discounted Dividends

Discounted Dividends Model

2004 2005 Perp Dividends per share (perpetuity) 0.50 0.50 PV factor 0.98 Continuing (Terminal) Value 22.73 PV of Continuing (Terminal) Value 22.24

Estimated Value per Share $22.74 Sensitivity Analysis Actual Price per Share as of 4/1/2005 $22.74 g 0% 3% 5% Ke 2.20% Ke 5.000% 10.02 24.31 N/A Growth rate 0.00% 6.000% $8.36 $16.22 $47.67 8.113% $6.20 $9.55 $15.36 9.000% $5.60 $8.15 $11.97

50 Appendix J: Discounted Free Cash Flows

Free Cash Flows Valuation Model

Forecast Years 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Casg Flow From Operations 7,526,000 8,549,536 9,712,273 11,033,142 12,533,649 14,238,226 16,174,624 18,374,373 20,873,288 23,712,055 Cash Flow From Investing (3,832,065) (3,851,225) (3,870,481) (3,889,834) (3,909,283) (3,928,829) (3,948,474) (3,968,216) (3,988,057) (4,007,997) Free Cash Flow 3,693,935 4,698,311 5,841,791 7,143,308 8,624,366 10,309,396 12,226,151 14,406,157 16,885,231 19,704,058 Discount rate (WACC) 0.9425 0.8883 0.8372 0.7891 0.7437 0.7010 0.6607 0.6227 0.5869 0.5532 Present Value of FCF 3,481,560 4,173,601 4,891,025 5,636,868 6,414,315 7,226,715 8,077,595 8,970,674 9,909,884

Total Present Value of Annual Cash Flows 58,782,236 Perpituity (no growth) 550,382,090 Present Value of Perpituity 304,446,128

Value of Firm (end of 2004) 363,228,364 Book Value of Debt and Sensitivity Analysis Preferred Stock 275,530,000

Value of Equity (end of 2004) 87,698,364 g

Estimated Value per Share $59.26 0% 1% 2% 3%

Actual Price per Share (as of April 1, 2005) $22.74 WACC 4.000% $178.54 $285.22 $498.58 1138.65 6.100% $59.26 $99.59 $159.60 258.33 Shares Outstanding 1,480,000 7.000% $29.40 $41.19 $75.83 $125.87 WACC(bt) 6.10% 8.000% $3.78 $25.79 $55.14 96.23 Growth 0.00%

51 Appendix K: Discounted Residual Income

Residual Income Valuation Model

Forecast Years 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Beginning BE (per share) 24.94 24.16 23.38 22.95 22.72 22.72 22.96 23.47 24.28 Earnings Per Share ($0.28) ($0.28) $0.07 $0.27 $0.50 $0.74 $1.01 $1.31 $1.62 Dividends per share $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 Ending BE (per share) 24.94 24.16 23.38 22.95 22.72 22.72 22.96 23.47 24.28 25.40

"Normal" Income 2.02 1.96 1.90 1.86 1.84 1.84 1.86 1.90 1.97 Residual Income (RI) (2.30) (2.24) (1.83) (1.59) (1.35) (1.10) (0.85) (0.59) (0.35) Present Value of RI (2.13) (1.92) (1.45) (1.16) (0.91) (0.69) (0.49) (0.32) (0.17)

BV Equity (per share) 24.94 Sensitivity Analysis Total PV of RI (9.24) g Continuation (Terminal) Value (4.31) 0% 1% 3% 5% PV of Terminal Value (2.14) Ke 6.547% $17.97 $18.01 $18.14 $18.63 Estimated Value $13.56 8.113% $ 13.58 $ 12.28 $12.30 $10.06 Actual Price per share 4/1/05 $22.74 8.158% $ 13.48 $13.17 $12.18 $9.94 9.781% $ 10.56 $10.17 $9.06 $7.02 Ke 8.11% Growth rate 0

52 Appendix L: Abnormal Earnings Growth

Abnormal Earnings Growth Valuation Model

Forecast Years 2005 2006 2007 2008 2009 2010 2011 2012 2013 EPS ($0.28) ($0.28) $0.07 $0.27 $0.50 $0.74 $1.01 $1.31 $1.62 DPS $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 DPS invested at 8.113% $0.04 $0.04 $0.04 $0.04 $0.04 $0.04 $0.04 $0.04 Cum-Dividend Earnings ($0.24) $0.11 $0.31 $0.54 $0.78 $1.05 $1.35 $1.66 Normal Earnings ($0.30) ($0.30) $0.07 $0.29 $0.54 $0.80 $1.09 $1.42 Perp Abnormal Earning Growth (AEG) $0.06 $0.41 $0.24 $0.24 $0.25 $0.25 $0.26 $0.24 $0.00

PV Factor 0.925 0.856 0.791 0.732 0.677 0.626 0.579 0.536 PV of AEG $0.06 $0.35 $0.19 $0.18 $0.17 $0.16 $0.15 $0.13

Core EPS ($0.28) Total PV of AEG $1.38 Sensitivity Analysis Continuing (Terminal) Value $0.00 g PV of Terminal Value $0.00 0% 5% 10% 15% Average Perpetuity $1.10 Ke 8.113% $13.85 N/A N/A N/A Capitalization Rate (perpetuity) 8.11% 6.547% $18.26 N/A N/A N/A 9.781% $10.81 N/A N/A N/A Estimated Value Per Share PV 12/1/2004 $13.56 8.158% $13.75 N/A N/A N/A FV 4/1/2005 $13.83

Actual Price per share 04/01/05 $22.74

Ke 8.113% Growth rate 0% 53

Appendix M: Long Run Residual Income Model

Long Run Average Residual Income Valuation Model

ROE 0.12 Sensitivity Analysis Ke 0.0815 g g 0.05 0% 3% 5% MVE 20.67 Ke 6.540% 17.06 23.64 42.27 BE 9.3 8.113% $13.69 $16.25 $20.67 9.780% $11.41 $12.35 $42.27

54