Can Verizon Maintain Its Industry Lead?

| About: Verizon Communications (VZ)

When new technology emerges, companies that want to capitalize often have to be lucky in choosing the technology that will ultimately become the norm. Consider the companies that wrongly believed Betamax would defeat VHS when home video players came into vogue.

As its competitors bet on other wireless technologies, Verizon (NYSE:VZ) correctly opted for 4G-LTE (long-term evolution), which has become the dominant and preferred platform. Verizon got a full year head start over its chief wireless competitor, AT&T (NYSE:T), on deploying LTE. Therefore, Verizon has the largest 4G-LTE network in the U.S., extending it to 476 markets as of the fourth quarter of 2012. AT&T is in only 200 markets with its 4G LTE network.

Yet that expansion has come at a price. As with most of the industry, Verizon is spending large amounts of capital to expand its infrastructure, yet the payoff may be limited because of customer expectations about what they should get in return for their monthly bill.

During its fourth-quarter 2012 earnings announcement, the company reported a loss of $4.23 billion, or $1.48 a share, a year after suffering a quarterly loss of $2.02 billion, 71 cents a share.

Though the recent earnings were negatively impacted by one-time charges for pension liabilities and other expenses, the company still only earned 38 cents a share excluding those items. Analysts, on the other hand, anticipated earnings of 50 cents a share.

Shares of Verizon are trading around $45, about 17.5% higher than this time a year ago.


Verizon has all of the same problems as its main competitors in the industry, yet analysts see it as having more upside potential than those other players.

Those problems mainly stem from carriers' balance sheets and management ratios.

The company blew through cash in 2012, starting the year with more than $13 billion but ending it with just over $3 billion. Furthermore, its net operating cash flow fell by 18.62% in the fourth quarter compared with the previous year.

Verizon has roughly $48 billion in long-term debt, which given its earnings history, would take more than seven years to pay off if the company used all of its profits on debt repayment.

Like its telecom peers, Verizon also has a paltry return on assets of 3%, meaning it's not making a lot of money on its existing asset base. It has a fairly low return on equity of 7.3%. Also like its peers, Verizon has a high debt-to-equity ratio of 1.56, whereas analysts are more comfortable if that ratio is under 1. A higher ratio means the company has to finance operations with more debt and less by its profits.

Versus The Competition

Verizon's chief competitor is AT&T. While AT&T has a slightly more favorable balance sheet, analysts believe Verizon's growth prospects are stronger. In fact, Verizon's five-year projected growth rate is 9%, versus 6.3% for AT&T.

Because of its massive head start, it's plausible that Verizon will be able to reduce its capital expenditures on 4G LTE deployment and enjoy the return on that investment sooner while its competitors continue to spend heavily to catch up.

Retail service revenues for Verizon's wireless division grew by 8.4% in the fourth quarter of 2012, aided by increased smartphone penetration and positive reception for its Share Everything data plan. This despite the fact that its cheapest smartphone plan costs $20 more per month than Sprint's Unlimited Data plan.

Verizon is leading the way in retaining customers as well. Its churn rate last year was 0.95% for its wireless division and 1.24% for its overall retail customer base. Churn rate is the percentage of an existing customer base who leave the company during a given period. Therefore, Verizon lost less than 1% of its wireless customers and only 1.24% of its overall customers during the fourth quarter of 2012.


Verizon activated 3.6 million new Android smartphones and 6.2 million new iPhones, half of which were iPhone 5. New iPhone activations increased from 4.3 million in the prior-year period, versus 44% in the third quarter of 2012 and 40% in the second quarter.

Over the last two years, Verizon has been steadily converting its customers from low-end, low-margin basic mobile plans to high-end smartphone contracts. In the first quarter of 2010, only 19% of its customers had smartphones; at the end of 2012 that portion had grown to 58%. About 42% of all new smartphone sales in the fourth quarter of 2012 were to first-time smartphone customers.

However, Verizon did trade short-term gain for these long-term prospects, in the form of costly subsidies it provided to encourage iPhone transition. Management believes that investment will pay off. Because smartphone customers use more data to watch video, stream music and surf the web, they have higher monthly bills than non-smartphone customers. The average monthly bill for Verizon customers increased year-over-year by 6.6%.

In addition to the Apple iPhone, Verizon also just announced the release of a new Samsung smartphone, the ATIV Odyssey, which will run on Microsoft's Windows 8 and cost $50, much less than an iPhone. Analysts see this as a smart move by Verizon because, while iPhones remain popular, they are becoming too pricey for a large segment of the buying public. By staking a major claim on the cheaper type of product while still keeping a hand in servicing Apple's newest iPhones, Verizon can try pushing U.S. consumers toward other phone offerings in an attempt to decrease its reliance on iPhone subsidies.

Verizon is credited with focusing efforts on its wireless business before companies like AT&T. It now boasts 100 million wireless subscribers, and a strong brand, in addition to the greater 4G coverage already mentioned.

The company has also rewarded investors with sizable share buybacks and with a healthy dividend that currently yields 4.6%.

The Tortoise and The Hare?

Yet despite its obvious advantages, there are emerging signs that its competitors are catching up. Most notably, Verizon's year-over-year revenue growth of 5.7% trailed the industry average of 8.6% during the fourth quarter of 2012.

Being the first out of the gate doesn't always equate to winning in the end. History is filled with tortoises who overtook complacent hares, and time will tell if Verizon can hang on to its lead or if its size and balance sheet deficiencies cause it to lag behind its competitors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.

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