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Verizon Communication Inc. (VZ) and AT&T, Inc (T) are the two largest telecommunication networks operating in the U.S. VZ and T are underperforming the market and they both failed to meet analysts' expectation with surprise earnings of -10% and -4.30%, respectively. Both of these companies incur alot of capital expenditures to maintain their market leadership and satisfy the changing consumer preferences towards wireless devices.

I believe both of these companies have significant upside potential because the wireless business is relatively new and still growing. VZ and T both are well equipped to capture this opportunity. Furthermore, VZ and T drive around 66% and 54% of their total revenues from the wireless segment respectively. Another source of attractiveness is the long dividend payment history coupled with high dividend yield in the current low yield environment.

I will use a free cash flow model and P/E multiples in order to determine the intrinsic value of the two companies to show that these companies are undervalued and we can expect price appreciation.

In order to carry out the comparison and to incorporate simplicity to the model, a 30% weight will be assigned to debt and 70% weight to equity. Furthermore, same cost of equity and after-tax cost of debt is assumed for both the companies. Cost of equity and after tax cost of debt is 9.15% and 3.5%, respectively, so the required rate will be 7.45%. Moreover, terminal year growth rate is assumed to be 1%.

VZ:

in millions, U.S. dollar

Year

2013

2014

2015

2016

2017

2018

Terminal Value

Free cash flows

14486

15276

16140

16627

17045

17443

273143.61

Discount factor

0.9307

0.8661

0.8061

0.7502

0.6982

0.6498

0.6498

Present value of free cash flows

13482.28

13230.21

13010.09

12473.43

11900.55

11334.68

177488.72

  • Sum of discounted free cash flows = $252920 million

  • Total debt = $51987 million

  • Total value of equity = $200933 million

  • Public market discount = 25%

  • Public market value = $150699.75 million

  • Shares = 2857 million

  • Price = $52.74

T:

in millions, U.S. dollar

Year

2013

2014

2015

2016

2017

2018

Terminal value

Free cash flows

19590

19980

20761

21113

21599

22301

349209.45

Discount factor

0.9307

0.8661

0.8061

0.7502

0.6982

0.6498

0.6498

Present value of free cash flows

18232.4

17304.6

16765.42

158376.97

15080.4

13191.9

226916.30

  • Sum of discounted free cash flows = $465868.11 million

  • Total debt= $66358 million

  • Total value of equity = $399510.11 million

  • Public market discount = 25%

  • Public market value = $299632.58 million

  • Shares = 5581 million

  • Price = $53.68

P/E Multiple Estimate

Company

P/E Multiple

Next Year Earnings Estimate

Estimated Price

VZ

16.2x

$2.78

$45.03

T

14.1x

$2.52

$35.53

Source: Investec estimates and Nasdaq.com

Price was determined from both methods and then it was averaged out, coming to $48.86 and $44.60 for VZ and T, respectively. Both stocks are undervalued, which indicate an expected rise in share prices.

Highlights of Financial Performance:

VZ has managed to grow its 4Q'12 wireless revenues by 9.5%. The 4G LTE technology of the company was a major driving force of the wireless revenues covering around 89% of the U.S. population. VZ was able to activate 9.8 million smartphones and 30% of these smartphones were new to VZ. Retail postpaid and prepaid net advertisements also experienced a growth rate of 53.66% YoY. Wireline revenues experienced a decline of 2.2%. However, FiOS (both video and internet) was a star performer in the wireline segment that experienced a growth rate of 17.2% Y/Y.

T has reported an increase of 5.7% in wireless revenues. The wireless subscriber base was also being strengthened by 107 million subscribers in 4Q'12. The 4G LTE coverage of the company has now increased to 170 million people all over the U.S. Sales of smartphones were up by 6.4% from last year and reached to a total of 26.9 million. In the wireline segment U-verse revenue reached up to $2.6 billion, with an increase of 36.84% YoY. The company has also reported strong free cash flows of $19.4 billion this year, even though the capital expenditures remain somewhat stable- with slight decrease of 3.20% this year.

Both companies have faced major setbacks because of the superstorm Sandy, as it had destroyed their infrastructure and heavy amounts were spent on recovery efforts, e.g. VZ alone spent $135 million in this regard. Moreover, both companies have suffered with suppressed margins because of subsidies. Lastly, the telecommunication industry is primarily dependent on economic conditions and additional spending by the public is subject to economic recovery.

Conclusion
The table below shows comfortable positioning of the two large market caps among their peers. They both have among the lowest P/S multiple and PEG ratio, with the highest growth rate estimates for the next 5 years.

Companies

Dividend Yield

P/S

PEG (5 year expected)

Next 5 years Growth Rate/annum

VZ

4.60%

1.08x

2.38

6.74%

T

5.10%

1.51x

2.55

5.50%

BCE, Inc. (BCE)

5.20%

1.69x

7.84

1.80%

Chunghwa Telecom Co. Ltd. (CHT)

4.50%

3.30x

8.32

2.10%

Source: Yahoo Finance

VZ & T both have their own strengths, like VZ has a competitive advantage in 4G LTE coverage and subscriber base. On the other side, T has a high dividend yield coupled with free cash flow strength. So, it is difficult to choose between the two but they both have decent growth opportunity and deserve a position in your portfolio as they both paint an encouraging outlook.

Source: High Dividend Yields And Attractive Valuations Make Verizon And AT&T Buys