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Sprint Highlights Future Risk

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Writedowns evidence declining profit margins.

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While my eyes are normally focused on the financial services space and the consequences of "asset deflation", I would recommend that Minyan's review yesterday's earnings announcement from Sprint Nextel (S) to better understand the consequences of "profit margin deflation".

During the fourth quarter, Sprint took an almost $30 billion charge against goodwill. (For non-accountants, goodwill generally represents the premium corporations pay in the acquisition of another company. And every period thereafter, corporations must re-evaluate whether that goodwill premium is still justifiable based on forecasted future profits.)

In Sprint's case, it concluded that future earnings could no longer support the goodwill and that, in essence, its investment needed to be written down - not based on third party "market values" but based on management's own estimates of future earnings.

As a consequence of its writedown, Sprint's equity dropped from $53 billion at the end of 2006 to $22 billion at the end of 2007. At the same time, however, total liabilities remained roughly constant (going from $44 billion to $42 billion). So as a result, in combination, Sprint's liabilities to equity ratio went from 0.83X to 1.90X.

Conventional wisdom states that what we are living through is "just a US consumer credit issue". I would beg to differ. Corporate America is coming off of record profit margins, as well as record M&A volumes. While Sprint may be an extreme example, it clearly highlights the "compounded" risks associated with a decline in future profit margins.

That Sprint felt compelled to borrow under its revolving credit facility "to provide greater financial flexibility and to mitigate any potential financing risk related to $1.25 billion in bonds that mature in November 2008, as well as the approximately $400 million outstanding under our commercial paper program, and $600 million of bonds that mature in May, 2009" suggests at least the company is concerned.
No positions in stocks mentioned.
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