We published our report analyzing and evaluating Verizon Communication's (VZ) ability to pay its lofty 4.7% dividend yield in September. We were pleased that our report was recognized for the high level of quality analysis and research that went into it. We remembered that report because Verizon's key business unit Verizon Wireless recently announced that it was paying a special $8.5B dividend to its joint venture partners Verizon Communications and Vodafone PLC (VOD). Verizon Communications owns 55% of Verizon Wireless and consolidates Verizon Wireless's financials into its total corporate financial reports. Because Vodafone owns 45% economic interest in Verizon Wireless, Verizon Communications accounts for Vodafone's share of Verizon Wireless's profits with an income statement entry for Net income attributable to non-controlling interest as well as a line item in its Equity accounts on its balance sheet for Non-controlling interest. The bad news for Verizon is that the minority interest expense to Vodafone has rocketed upward from $216M in 2000 to $9.2B in the last twelve months. The good news for Verizon investors is that Verizon Communications is now the best way to get exposure to Verizon Wireless. Previously, we would have suggested investors buy Vodafone to get exposure to Verizon Wireless instead of Verizon Communications.
Source: Morningstar Direct
Until recently, the best way to get exposure to America's most profitable and fastest growing wireless carrier was buying shares of Vodafone. Although Vodafone was a minority owner of Verizon Wireless, it still held a significant 45% stake in the company. Vodafone also owned and operated fixed line and wireless communications networks in dozens of countries worldwide, including many emerging markets countries like India, Turkey and the Czech Republic. Vodafone had suffered through the indignity of nearly $54B in losses from 2003-2007 and had to sell off its Vodafone Japan operations to SoftBank. From 2008-2010 Vodafone regained its profitability and saw its profits reach a record in FY 2010 (£8.6B) as revenues increased by 42.5% from the end of FY 2007 to the end of FY 2010. Unfortunately for Vodafone, its revenues have been stagnant since 2010 and its profits have been sagging during this time period as the company has seen a fresh round of asset impairment costs and as well as its cost of sales growth exceeding its revenue growth. In the first half of its FY 2013, the company booked a £1.9B loss due to £5.9B in impairment losses on its Spanish and Italian operations as well as a 7.4% decline in revenues.
Source: Morningstar Direct
Although Verizon Communications was the controlling shareholder of the fastest growing wireless property in the US (Verizon Wireless) since 2000, Verizon Communications' consolidated corporate results from 2000 to 2010 were quite mediocre and inconsistent. Verizon Communications saw steady erosion of its legacy wireline business which it owned 100% and offset those losses with subscriber growth from Verizon Wireless, which it only owned 55% of. We think that explains why even though Verizon Wireless has grown its operating income from $444M in 2000 to $21.3B in the last twelve months, Verizon Communications' operating income has stagnated since 2000. Verizon was able to salvage some value from its legacy assets during this time period as it made a number of timely and deft deals to dispose of lagging legacy assets such as Hawaiian Telecom, Idearc and the Reverse Morris Trust deals involving ILEC Communications/Frontier and Verizon Northern New England/FairPoint. However, the combination of declining wireline operations and non-recurring corporate charges helped offset the sparkling growth and profitability of Verizon's Wireless crown jewel.
Source: Morningstar Direct
Based on Verizon Wireline's reduced importance to Verizon Communications and based on Vodafone's European struggles, we believe that the best way to get exposure to Verizon Wireless is through Verizon Communications. Although our expectations for US GDP have been revised downward due to recent electoral results, we believe that Verizon Wireless will continue to serve as a consistent cash cow for Verizon Communications. Despite the efforts of AT&T (T) and Sprint (S) to increase each firm's respective 4G-LTE footprint, Verizon is still the hands down leader in terms of 4G-LTE coverage. Despite the fact that its new monthly prices for postpaid smartphone customers are $10/month higher than a comparable plan at AT&T and $20/month higher than a comparable plan at Sprint, Verizon was able to expand its leading position in the US wireless industry in the most recent quarter. Verizon picked up 1.76M new customers in the most recent quarter, including 1.535M new postpaid customers. This outpaced the 678K in new customers at AT&T and the negative 423K at Sprint. Regardless of Verizon Wireless's future revenue growth, we believe that the division will be continue to expand its operating margins and cash flows as it is approaching the completion of its 4G-LTE network build-out.
Source: Verizon Wireless
Although Vodafone has a significant and well-known presence in emerging markets such as India and other countries in Asia, Africa and the Middle East these markets only provide about 30% of its revenue. The rest of its revenue comes from Europe and the European economies have been ailing due to the Eurozone debt crisis. Because Verizon does not have any operations outside the US, it doesn't have to worry about currency issues like Vodafone does. Verizon's US market is still the cleanest dirty shirt in the global macroeconomic environment. Even though Verizon Wireless has now declared two special dividends totaling $18.5B to Verizon Communications ($10.2B) and Vodafone ($8.3B), we believe that Verizon may consider increasing its stake in Verizon Wireless. At least Verizon tried to buy out Vodafone's stake in 2006 but ultimately failed. If we were Verizon's management, we would try to up Verizon Communications' stake in Verizon Wireless by at least 5%.
In conclusion, we believe that although Verizon Communications is fairly valued, it will continue to serve as a cash cow for investors and will continue to pay dividend yields near 5% due to the strength of its Verizon Wireless franchise. We also see that although Vodafone's dividend yield is about 275bp higher than VZ's yield, Vodafone has a lot more risk in its business due to its exposure to the European economies as well as risks in its Indian operations. Even though the majority of Verizon Communications' net income is allocated to Vodafone for its Minority Interest in Verizon Wireless, we believe that Verizon Communications now offers investors a better way to gain exposure to Verizon Wireless than Vodafone based on the evaluation of the recent performance and outlooks for each company.
Source: Verizon's Q3 2012 10-Q
Disclosure: I am long S.
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.