Shares of Verizon Communications (VZ) have returned 17.7% over the past 12 months. At $44.31, the stock is now trading near its 52-week high of $48.77 attained in October 2012 and offers an attractive dividend yield at 4.6%. Is a buy rating warranted by the company's current fundamentals and the stock price level? In this article, I will elaborate on the stock valuation analysis which may assist you in formulating an appropriate investment decision.
Sell-side analysts on average predict Verizon's revenue, EBITDA, and EPS to grow at solid CAGRs of 4.0%, 7.3%, and 15.4%, respectively, over the current and next years (see comparable chart below). Those consensus estimates considerably outperform the averages of 2.8%, 3.9%, and 7.9%, respectively, for a group consisting of Verizon's primary telecom peers. Similarly, the company's EBITDA margin is forecasted to expand by 2.2% over the same horizon, compared to the peer average estimate of just 0.5%. On the profit side, although Verizon's EBITDA, EBIT, and net income margins as well as its ROIC metric are below the par, the company was able to generate above-average gross margin and ROE. The firm is almost the least leveraged in the group as reflected by its below-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Verizon was able to maintain a healthy interest coverage ratio due to its low debt level. Both the company's current and quick ratios are somewhat below the par, but they still reflect a healthy corporate balance sheet on an absolute basis.
To summarize the financial comparisons, Verizon's below-average profitability would be the primary drag on the stock valuation. However, given the company's superior growth potential, relatively low leverage, and its solid market share in the US telecom sector, I believe the stock's fair value should command a modest premium over the peer-average level. Nevertheless, the current valuations at 5.5x forward EBITDA, 15.9x forward EPS, and 1.7x PEG together represent an average discount of 5.4% to the peer-average trading multiples (see chart above), suggesting that Verizon shares are modestly undervalued on a relative basis.
From a market perspective, Verizon's forward P/E multiple at 15.9x is currently trading at 10.1% premium over the same multiple of the S&P 500 Index, which now stands at 14.5x (see chart below). In my view, this relative valuation level should justify a buy decision provided that 1) Verizon's P/E market premium averaged about 18.0% in the past 12 months; 2) the company's long-term estimated earnings growth rate of 9.2% is notably above the average estimate of 8.2% for the S&P 500 companies; 3) Verizon has a solid and growing market share in the US telecom space and an industry-leading LTE platform; and 4) the stock offers a high dividend yield of 4.6%, which is overwhelmingly above the average yield at 2.2% for the S&P 500 Index.
Now, let's take a dividend perspective to test the stock valuation's margin of safety. Verizon has a track history of raising dividend. Since 2010, the company has raised the dividend per share 3 times by 2.7%, 2.5%, and 3.0%, consecutively. As it appears that Verizon has been trying to maintain a modest dividend growth rate, I expect the company would have sufficient cash capacity to sustain the current pace of the dividend growth given that Verizon has recently reduced its debt load. In addition, under the current low-interest environment, which will likely continue for a while, strong investor demand for quality high-yield assets would weigh on Verizon's dividend yield. From a chart shown below, the stock's dividend yield is closely correlated to the yield of the 10-year US Treasury Bond yield, and the 3-year daily correlation is measured to be 0.7, which is at a significant level. As the treasury yield is unlikely to rise substantially soon, it is fair to expect no significant uptrend for Verizon's dividend yield.
As such, assuming a target dividend yield ranging from 4.3% to 5.5% (Verizon's yield has never reached this level over the past 12 months), and supposing that the annualized dividend per share would be raised by 2.5% from the current level at $2.06 to $2.11 in January 2014 payment period, this conservative scenario would suggest a target stock value ranging from $38.39 to $49.68, or a favorable rate of return from -8.8% to 16.7% after considering the 4.6% dividend income.
In a February research note, Christopher Larsen, a research analyst at Piper Jaffray, raised his rating on Verizon to overweight based on the following rationale, which I tend to agree on (sourced from Thomson One, Equity Research):
"Our upgrade is based on a number of factors that bode well for 2013 results: Verizon's best-in-class wireless network continues to help the company win share even with a price premium, the weaker 4Q print could set the company up well to beat reset 2013 expectations, we expect the company to have financial flexibility (read: returning cash to shareholders) in 2013, and wireline margins could improve."
Thomaz Seitz at Jefferies also shared a similar opinion (Thomson One, Equity Research):
"We believe continued impressive market share gains and industry-leading LTE sales should result in stronger revenue growth in 2013. VZ expects wireless margins to revert to the 49-50% range in 2013, while any help from wireline margins and/or share buybacks could add further to our forecasted double digit EPS growth in 2013."
Bottom line, Verizon shares appear to offer a solid value in the light of the stock's modestly cheap valuation as well as the company's strong fundamentals and growth potential. As the sustainable dividend yield significantly enhances the investment's risk/reward profile, I recommend acquiring the shares at the current price level.
All charts are created by the author and all financial data shown in the article and the charts is sourced from Capital IQ unless otherwise specified.
Disclosure: I am long VZ.