On January 4, 2013, I published an article suggesting investors distribute shares of Verizon (VZ) as AT&T (T) historically was the better performing company. The main points of the article are that AT&T's return distribution suggested the firm's returns are less risky; also, AT&T's profit margins and sales growth suggest it is the better firm to purchase.
Since that article, shares of Verizon stemmed their decline and advanced substantially. Further, the share price of AT&T also increased substantially. However, Verizon's share price outperformed AT&T's share price by roughly 600 basis points year-to-date. Part of the outperformance can be attributed to Verizon's higher sales growth rate the past few years; however, AT&T was the more profitable firm.
All of that said, I am going to update my analysis of Verizon and determine what investors should do with their shares. If I can accurately forecast the share price over the next few months, risk-adjusted returns will be improved.
Thus, in this report we'll discuss the financial performance of both firms. We'll also analyze Verizon's statement of financial position and statement of cash flows. Further, we'll cover the operating segments. Then, we'll move into my 2013 forecast and the valuation. Lastly, before making an investment recommendation, we'll take a look at the technicals.
Given the recent increase in the valuation of the firm, investors should reduce long-equity exposure. We'll begin by discussing the financial performance.
We'll examine Verizon's financial performance relative to AT&T's financial performance. Analysis of financial performance is an essential component of equity analysis as equity investors benefit from the growth of a firm. Verizon's sales outperformed AT&T's sales in recent years, but that hasn't always been the case.
Verizon's consolidated sales grew at a 4.5% pace in 2012; that follows a 4% increase in 2011. Between 2002 and 2012, sales grew at a compound annual rate of 6.6%. In contrast, AT&T's sales grew 2% in 2011 and 0.6% in 2012. However, between 2002 and 2012, AT&T's revenue grew at an 11.5% pace.
After contracting in 2010 and 2011, Verizon's operating income increased 2.2% in 2012. However, between 2002 and 2012, operating income grew at an annual compound rate of 0.6%. Between 2002 and 2012, net income declined substantially. Thus, Verizon's top-line growth hasn't meant increased earnings for shareholders. The operating margin and net profit margin were trending lower. In contrast, AT&T's margin trend is more favorable.
The dividend is increasing; however, the retention rate is negative. Average basic shares outstanding is trending higher.
So, Verizon's top-line growth outpaced U.S. GDP growth. However, operating income and net income lagged. Relative to AT&T, Verizon underperformed financially. For established companies, I place more emphasis on profits reaching the bottom line than on sales growth.
Next, we'll discuss the financial position and cash flows of Verizon.
Financial Position and Cash Flows
Verizon uses a substantial amount of leverage. Thus, credit analysis of the balance sheet is important. Adjustments were made to parts of the balance sheet to give a truer picture of the credit worthiness or solvency of the firm.
Verizon's liquidity position weakened between the end of 2011 and the end of 2012. That said, the solvency of the firm strengthened. The adjusted debt-to-assets ratio declined from 0.27 to 0.26; the adjusted debt-to-capital ratio declined from 0.47 to 0.46. The adjusted debt-to-equity ratio declined from 0.88 to 0.85; that said, making further adjustments to the debt-to-equity ratio, debt was 81% larger than equity. The financial leverage ratio was 2.66. The interest coverage ratio increased from 4.56 to 5.12, and the free operating cash flow to debt ratio increased from 0.25 to 0.29.
Cash flow from operations increased 6% relative to 2011; capital expenditure has been pretty much flat between 2010 and 2012. Additionally, Verizon increased spending on the acquisition of wireless licenses in 2012. Cash used in investing and financing activities is trending higher.
Verizon used about $10 billion of its cash balance in 2012. Also, non-controlling interest represent more than 50% of equity. Also, intangible assets are larger than equity; there is about $100 billion of intangible assets on the balance sheet. Thus, Verizon isn't the most solvent corporation. However, the firm generates a substantial amount of cash flow, which it is reinvesting in the business and distributing to capital providers.
Next, we'll cover the operating segments including analysis of the firm's subscribers.
Analysis of the operating segments is an important part of analyzing Verizon. We'll examine which parts of the business are performing well and which parts are a drag on the valuation of the firm. It should be noted that Verizon only owns part of its wireless business.
The growth of the wireless segment's revenue slowed to 8% in 2012 from 16% in 2011. A substantial portion of the revenue growth in 2011 came from a 41% increase in revenue from equipment and other. Wireless operating income grew 17% in 2012 after declining 1% in 2011; the operating margin was 29% at the end of 2012. The growth in wireless is coming from an increase in connections and an increase in average amount paid per account. Also, the amount of connections per account is trending higher.
Total operating revenue from the wireline segment has been declining slowly the past couple years. The wireline operating income and operating margin are low. For example, in 2012, the wireline operating margin was 0%. The voice connections are declining while total broadband connections, FiOS internet subscribers, and FiOS video subscribers are increasing.
Overall, the operating segments performance is solid; however, the decline in voice connections is weighing on the wireline segment. Next, we'll cover the 2013 forecast and forward multiplier model valuations.
2013 Forecast & Valuations
One of the most- if not the most- important part of equity analysis is forecasting the financial performance. Also, valuing the securities is critical. In this section we'll cover both.
In the first quarter of 2013, I am forecasting revenue in the $29.5 billion to $30.5 billion range; operating income in the $5.1 billion to $5.7 billion range, and net income in the $3.9 billion to $4.3 billion range. For full-year 2013, revenue should be between $114 billion and $120 billion; operating income between $12 billion and $15 billion and net income between $1 billion and $3 billion.
Using $49.01 as the current share price, the current price-sales ratio is 1.21, and the forward price-sales ratio is between 1.17 and 1.23. The current price-earnings ratio is 159.80, and the forward price-earnings ratio is between 140.66 and 46.89.
Relative to its historic price-sales valuation history, Verizon is overvalued. On an absolute basis, the price-earnings ratio suggest the firm is overvalued. Thus, the price-sales valuation is probably near a peak. Next, we'll discuss the technicals.
We'll use some technical analysis to help manage practical risk. In this section, we'll discuss the trend indicators, momentum indicators and Dow theory. We'll conclude this section with a recommendation based solely on the technicals.
The share price of Verizon is trading above the rising 50-day simple moving average and the 200-day simple moving average. Also, the momentum indicators are confirming the up-trend. On a long-term basis, the momentum indicators are forming negative divergences. Additionally, we remain in a Dow theory-defined bull market; throwbacks will probably be short lived.
The technicals are giving us some long-term warning signals as the short-term technicals confirm the up-trend. Thus, based on the technicals, investors should start reducing their long positions.
The price-sales valuation is at the highest level in several years and the technicals are giving warnings of a long-term trend change; thus, investors should reduce long-equity exposure. Investors would be locking in gains near a peak in value.
Subsequent research should continue to add depth to the industry statistics and the financial position of Verizon.
Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.