Verizon – Consider Challenges Wisely

Today, I am going to start with the first investment analysis report for BrightHedge. I will try to follow the same structure for analysis to provide comparability and consistency in future reports. I combined public company information and my analysis in this report.

Overview

Verizon offers communications, information and entertainment products and services to consumers, businesses, and governmental agencies. The company has two reportable segments: wireless and wireline. Verizon has a workforce of approximately 155,400 employees.

The company reports its operations under two segments. Approximately 70% of its revenue coming from wireless segment. The wireless market is very competitive and its duopoly with AT&T is very closely followed by T-Mobile and Sprint. Verizon has a market share of more than 35% among wireless carriers in the US. Current and potential competitors including wireless service providers, cable companies increase the market threads for top companies in the industry. Mid and some small companies easily adapt their bandwidth speed, reduce their prices which may negatively affect Verizon. Verizon is generally highlight quality of its network, coverage of its wireless products and attracts more data traffic. The company benefits from economies of scale and generates positive operating income. However, due to competition with large-cap and mid-cap rivals, we may see potential declines of future revenues.

Competitor coverages and network qualities are improving and pressured the company’s competitive advantage. Although it has challenges, the company focus on premium plans and holding customer base with backbone investments in 5G.

Verizon declared Lowell McAdam will step down as CEO on August 1, 2018, and be succeeded by Hans Vestberg (former boss of Ericsson). Mr. Vestberg started in Ericsson’s HR unit and promoted to be CEO in 2010. However, he left the companywith serious issues, which are declining profit margins, slipping revenues and weak share performance. During his tenure at Ericsson, the company’s share performance declined by 35 percent. His strategy was to broaden the company’s penetration and focus on media and services. His prior objectives look like currently in line with Verizon’s “seamless customer experience”.

The wireless market is very competitive and its duopoly with AT&T is very closely followed by T-Mobile and Sprint.

Investment Characteristics

The company’s return on assets increased from 5.37 to 12.01; also, return on equity increased from 67.40 to 91.74, which are mostly affected by current income tax benefits. With tax reform now passed, the company reduced expected tax rate to 21% and its deferred tax liabilities decreased by more than $16.8 billion. This change clearly indicates the remeasurement effect on the financial statements, which deteriorates financial comparability. The company has a relatively stable gross margin. The rate is on 58%-62% range in the prior 10 years. The gross margin stability is in accordance with value stock characteristics. It has a relatively stable operating margin and EBITDA margin during the 2015-2017 period. However, the company’s investments in 5G infrastructure and possible fiber capacity increase pressure expected operating margin.

Verizon Wireless dominates the U.S. wireless market with duopoly partner of AT&T. These two companies penetrate approximately 70% of the total market share. Their share of industry EBITDA is at nearly 80%, which is impressive.

Verizon’s majesty contributes a considerable cost advantage. The company is able to pass through its infrastructure fixed costs to its large customer base easier than competitors.  

The company focuses on high-performing network capabilities with a goal of meeting future customer needs. The wireless network leadership help to maintain customer brand loyalty and above average price setting capabilities. The company’s retention rate assists to promote long-term relationships. However, its brand recognition is not resilient compared to the past. The competitors have bundled wireless services with other products and offer promotional pricing.

With tax reform now passed, the company reduced expected tax rate to 21% and its deferred tax liabilities decreased by more than $16.8 billion.

Valuation

Our Verizon fair value estimate is $50 per share. Our fair value estimate implies enterprise value-to-sales multiple of 2.68 times and price-to-earnings ratio of 10.5. The company’s current reinvestment rate (as a percentage of EBIT) is 56% and we expect that reinvestment rate will be 32% in the stable growth environment. Return on capital is 8.79%. After considering current capital expenditures for 5G infrastructure, our expectation for return on capital is 6.2%. The current cost of capital is 4.39%. We expect the future cost of capital of 6.45%, possible fed funds rate increase affected the cost of capital expectation. In our DCF calculation, we used free cash flow to equity and the present value of terminal value is expected to be 80.33% of the value of equity in the firm. The company’s wireless operating revenues declined by 1.9% due to the competition conditions in the wireless industry. However, Verizon’s new bundled arrangements are appropriate for securing competitive leverage in the industry.    

Risks to consider

The company had approximately $119.1 billion of outstanding debt as of March 31, 2018. Verizon’s debt level accelerated by more than 100% during the acquisition of Vodafone. The company sold $49 billion of bonds, the largest corporate debt sale in history at the time. According to the company’s annual reports, Verizon committed to returning its pre-wireless transaction credit-rating profile in the 2018 to 2019 timeframe. The wireless industry saturation levels are approaching to steady state and significant competition in a rapidly developing industry possibly will reduce profitability.

The company believes the growth in video consumption using mobile devices delivers an opportunity for revenue growth. Verizon has established IoT solutions for electric and other utilities to develop new services and create revenue growth. Through various acquisitions and investments and the launch of new consumption and IoT products and services, the company is expanding the ways to deliver content for diversification purposes. However, current profitability and revenue levels of these new activities have not generated a satisfactory level of variation to the core business line of segments, yet.

Current profitability and revenue levels of these new activities have not generated a satisfactory level of variation to the core business line of segments, yet.

Other considerations

According to WSJ’s Management Top 250 ranking, Verizon ranked second among telecom companies and No. 48 overall. Its innovation score stayed behind the AT&T and this indication clearly supports the company’s current infrastructure investments. The company’s key executive compensation levels are fairly allocated comparing to stock return and revenue generation levels of its competitors. However, we are putting reserves of the company’s investments and acquisitions in digital media and IoT solutions. These sectors include giant companies of Google and Facebook, which are capturing most of the market.

Conclusion

Verizon Stock Price as of July 2018
Source: Yahoo! Finance

Verizon’s stock price has shown a relatively stable pattern comparing to competitors. The company’s price-to-earnings ratio is relatively lower than the industry average and S&P 500. Thus, these two indications display large-cap value characteristics. However, Verizon’s price-to-sales ratio presents market value characteristics. Also, interestingly, price-to-book value is higher than both industry averages and S&P, which means more like growth stock features. We need to keep in mind that the company is the leader in the wireless industry and additional premium to book value is acceptable. Therefore, the large-cap value category is the representative level for the stock. Verizon’s expected reduction in leverage in 2019 supports the company’s future increase in free cash flows, which may create a better balance sheet. However, competition level and high infrastructure costs generate pressure into profitability and stock performance. New segmentation practices still maintain the uncertainty due to the saturated market environment.

Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.

Share on facebook
Share on twitter
Share on linkedin
Share on email
Author

Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.

Subscribe
Notify of
0 Comments
Inline Feedbacks
View all comments

Important Information

The investment information, comments and recommendations contained herein are not subject to investment advice. The comments and recommendations contained herein are based on personal views. These views may not fit your financial situation and your risk and return preferences. For this reason, based only on the information contained herein, investment decisions may not have the appropriate outcome.