I reiterate my bullish stance on Verizon Communications (VZ) because the company continues to offer attractive growth prospects. VZ has a healthy dividend yield and potential for price appreciation, as discussed in my previous article on VZ. The company has decided not to expand its operations in Canada after it managed to settle a deal with Vodafone (VOD) to buy back its 45% share in VZ Wireless. The large price tag of $130 billion has raised several concerns among shareholders and potential investors, but I believe the additional cash flows generated with the complete ownership of VZ Wireless will be more than enough to cover the cost in the shape of dividends and after-tax interest expense.
Both VZ and VOD wanted this deal to happen for a long time. The delay was mainly because they were not able to settle on a price, and the concern for a huge tax bill. They finally settled on a price, and most importantly they managed to structure the deal in such a way that VOD will only have to pay $5 billion in U.S. taxes and nothing in terms of British taxes.
Benefit derived by VZ through deal
First of all, it is important for investors to realize that VZ has not undertaken this deal so it can benefit in the short term. As of now, around $60 billion of new debt and equity might not paint an encouraging outlook for the company, but over the long term, owning 100% of the wireless business is attractive, as around 67% of operating revenues and around 95% of free cash flows come from the wireless segment.
Furthermore, the telecom industry is going through a consolidation phase, as SoftBank invested in Sprint (S), Leap wireless (LEAP) was acquired by AT&T (T), and MetroPCS was acquired by T-Mobile (TMUS). So, I believe there is no better investment available then to double the share of VZ Wireless, as the segment continues to drive growth and profitability. It is true that most people in the U.S. already have smartphones and data plans, but I believe that smartphones do not spell the end of the wireless story. In fact, they will help unlock other growth opportunities, such as providing M2M solutions. M2M technologies will enable users to connect other devices with their cell phones, which will not only help reduce costs, but improve efficiency as well. Such growth opportunities are relatively new, and this particular opportunity can be a future growth driver for the company. Lowell McAdam, the chairman and CEO of VZ, is reported to have said; "It's just funny that we still talk about 90 percent, 95 percent, 100 percent penetration as a ceiling, You start adding in all your appliances and your cars and your home and your security system and all that stuff, and I think we can keep growing. That's part of our job."
Realizing this potential, VZ has already laid down the initial groundwork. One of its chip vendors, Altair, is certified to manufacture chips that can be sold to hardware makers, and then those devices can connect with VZ smartphones. Similarly, the acquisition of Hughes Telematics (which was already using M2M technology to control various devices) was also based on strengthening the company's M2M businesses.
With the 100% ownership of VZ Wireless, the company can now integrate its wireline and wireless businesses instead of operating them as separate entities. This will enable the company to offer more integrated products and services in the form of bundles, which will reduce churn rates. It will also help strengthen the wireline segment and improve its margins.
The figure below shows the 10-year treasury yield for the past year. With the passage of time, debt financing will be more expensive, as currently the yields are at the lower end, but they are on the rise. So, I believe that this is the right time for debt financing, as a one point increase in the rates will add $600 million to the interest expense.
Source: Yahoo Finance
VOD has decided that $60.2 billion worth of VZ stock will be distributed to its shareholders. Now this might cause some short-run price volatility, as most VOD investors are Europeans who are not familiar with VZ's operations and the viability of the company. Moreover, some large funds and plans are not allowed to keep American equities. So, VOD investors might sell VZ shares, which would cause some pressure on the price. Furthermore, interest rates are on the rise, which could increase the cost of financing, as the company is planning to take debt of around $60 billion.
I believe the company continues to offer bright growth prospects for the future because of favorable revenue and EPS growth, expected improvement of wireline margins and 10% accretion of the earnings per share. VZ has also managed to increase its dividends to $0.53 per share, maintaining its attractiveness with a healthy dividend yield of 4.60%. The company's management intends to pay off debt as soon as possible, which will help bring down its leverage to normal levels. I think that with 100% ownership of the wireless segment, VZ will emerge as a stronger company with significant upside potential.