We published our report analyzing and evaluating Verizon Communications' (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. Based on some information that was provided to us by our readers, we decided to follow that report with a report analyzing and evaluating Verizon against Vodafone PLC (VOD) in order to determine which firm was the best way to play Verizon Wireless's strong performance. We previously believed that Vodafone was the best way to get exposure to Verizon Wireless since Vodafone had exposure to emerging markets and Verizon Communications' wireline operations were steadily declining. Because Vodafone is seeing sluggish European performance and because Verizon Wireless now accounts for nearly 65% of Verizon's revenues and 100% of its operating income excluding corporate and administrative expenses, we felt that Verizon Communications was the best way to play Verizon Wireless. We are intrigued by recent talk of Verizon buying out Vodafone's 45% interest in Verizon Wireless because we floated that idea in October. Although Verizon's yield is now 4.8%, we believe that Verizon is still fairly valued and investors should wait for 10%-20% pullback before taking a long position in the company due to the flat 2013 performance forecasts by its CEO Lowell McAdam.
Source: Verizon's Q3 2012 10-Q
In addition to the flat performance forecasts that were issued by Verizon's CEO, Verizon also announced that it was taking $9B-$10B in non-recurring charges. Verizon announced that it was taking a pre-tax charge of approximately $7B-$7.5B for the remeasurement of pension and post-retirement liabilities due to changes in the discount rate and other actuarial assumptions and the annuitization of various pension liabilities during the quarter. We couldn't help but laugh at this considering that Verizon incurred a $3.4B after-tax charge ($6B pre-tax) for pension and other benefit plans in Q4 2011. We were surprised that Verizon had to take this charge because we thought Congress passed pension plan relief in 2012 which increased the effective interest rate that companies can use to measure pension plan liabilities. In Verizon's Q3 2012 earnings release, it announced it agreed to transfer pension assets to The Prudential Insurance Company of America by purchasing a single premium group-annuity contract to settle approximately $7.5 billion of Verizon's obligations for approximately 41,000 participants under its management pension plan. The closing of the transaction took place in December 2012. This resulted in Verizon increasing its 2012 pension plan contributions to $3.4B versus $1.3B forecasted in January 2012.
Verizon also expects to take $1B-$1.5B in pre-tax charges for early debt retirements and other restructuring activities in Q4 2012 after taking $84M in such charges during Q4 2011. Verizon also took $384M in litigation settlement charges in Q3 2012 and incurred $1B in operating expenses and CapEx replacement due to Superstorm Sandy and it estimates that approximately one-third of the total amount will be recovered by insurance.
Verizon's soft outlook and "non-recurring charges" overshadowed Verizon's strong Q4 2012 performance metrics. Verizon expects that it added 2.1M net new retail postpaid customers during the quarter and it achieved 15% increase in smartphone sales for FY 2012 versus FY 2011. 87% of Verizon's postpaid phone sales were smartphones, which increased 8% versus Q3 2012 and 17% versus Q4 2011. Even though the company devoted considerable resources to restoration of service in the wake of Superstorm Sandy, it still added 130K net new FiOS customers and ended the year with 12.94M FiOS subscribers. Verizon began selling Nokia's new Lumia 822 mid-range Windows Phone 8 smartphone device in November 2012 and it will be interesting to see how well this new phone sold during the period.
Another piece of good news is that 30% of its net customer additions were new to Verizon and we agree with Verizon's CEO that the 4G-LTE network of Verizon Wireless is unparalleled to AT&T (T) and Sprint Nextel (S). The good news is that Verizon will be completing its 4G-LTE build-out in the middle of 2013. The bad news is that AT&T and Sprint are making continuous progress in building out each firm's respective 4G-LTE footprint and will make significant progress in narrowing the lead that Verizon Wireless enjoys during FY 2013. One item of local human interest to us was that one of Verizon's new "innovation centers" will be located in the Greater Boston Area, in the city of Waltham, MA because we think it will be good for our local community.
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 would be attracted to Verizon if it was to swing a deal in which it could acquire the 45% Minority Interest in Verizon Wireless that Vodafone holds and it pays for a portion of this deal by selling its legacy Wireline division to another Incumbent Local Exchange Carrier. We believe that investors should wait for a 10%-20% pullback before taking a long position in Verizon because although Verizon Wireless is the premier telecom franchise in the world, Verizon's Wireline Division is suffering from somnolent, sclerotic, stagnating and soft performance as its FiOS digital communications services are not enough to offset the declines of its wireline and high-speed internet properties. Furthermore, we are displeased to see more "non-recurring charges" as well as a flat performance forecast by its CEO. Our last reason as to why we're waiting for a pullback is we're not excited to pay over 17.66X adjusted trailing EPS (which is near its nine-year, end of year high of 17.78X adjusted trailing EPS) for a company with flat performance forecasts and a recurring pattern of "non-recurring charges."
Source: Morningstar Direct
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.