I recently had the pleasure of reading The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World's Most Famous Investor by Mary Buffett and David Clark. While not everything in every investing book resonates with me, I did take particular interest in the 'Ten Points of Light' that Warren Buffett uses.
So the question being- would Warren Buffett invest in Verizon (NYSE:VZ) wireless? In this article, I'll go over the 'Ten Points of Light' and provide my responses to them. Mind you, I have no knowledge of the quantitative data about to be analyzed here so I have no bias in my computations and analyses.
Number 1. The Right Rate of Return on Shareholders' Equity
Throughout the book, the key element of a company that Buffett invests in is that the company has to have a durable competitive advantage. In regards to shareholders' equity, the company has to always show a consistently high rate of return on equity- above 12%.
Taking the calculation of net profit divided by shareholders' equity as posted on Yahoo! Finance, the following is determined:
Return on Equity
0.066 => 6.6%
0.067 => 6.7%
0.026 => 2.6%
Based on these figures alone, Warren Buffett would dismiss this based on the fact that 2012 saw a sharp decrease in ROE compared to 2010 and 2011, which Buffett considers to be below average anyway.
Number 2. The Safety Net: The Right Rate of Return on Total Capital
The return on total capital is calculated by taking the sum of net income less dividends and dividing that by the sum of debt plus equity. Buffett looks for a consistently high rate or return on total capital and return on equity.
Let's look at the some more data. Debt was determined as the total current liabilities plus long-term debt.
Net Income - Dividends
Debt + Equity
Return on Total Capital
-0.038 = -3.8%
-0.039 = -3.9%
0.17 = 17%
Based on these results, we see that 2010 and 2011 ate up capital instead of returned it. But a huge turnaround was seen in 2012.
Number 3. The Right Historical Earnings
Buffett looks for companies that produce an annual Earnings Per Share (EPS) that historically shows a strong upward trend. Nasdaq.com provided more historical information about Verizon's EPS.
The historical earnings look to be slipping dramatically.
Number 4. When Debt Makes Buffett Nervous
The book states that 'companies with a durable competitive advantage typically have long-term debt burdens of fewer than five times current net earnings.' Not factoring the massive bond issuance recently to acquire the remaining Verizon shares from Vodafone, the long-term debt as of 2012 was $47,618,000,000 versus net income of $875,000,000. This means that if all net income were applied to the long term-debt, it would take almost 54 ½ years to pay off its debt.
Number 5. The Right Kind of Competitive Product or Service
The book says to ask yourself these questions: 'Is the product the kind that stores have to carry to be in business? Would the businesses that carry this kind of product be losing sales if they didn't carry this particular brand-name product?' The idea is to find a company or product that consumers are continuously in need of, not one they buy once in their lifetime.
It's pretty obvious what Verizon does- they provide cellular and internet services. On the retail end, they sell cellular phones and phone accessories. A lot of what drives their retail sales is the addition of new phone models into their stores. Revenue streams come in two primary forms: monthly service billings and retail sales.
What makes me doubt Verizon's ability to solidify and maintain an undisputed competitive advantage is that they currently have competition that's looking to take away Verizon's market share. Some of the heavy-hitter providers such as AT&T (NYSE:T), Sprint Corporation (NYSE:S), Frontier Communications (NASDAQ:FTR), among others are also in competition with smaller regional carriers.
Number 6. How Organized Labor Can Hurt Your Investment
'Seldom will you find a durable-competitive-advantage company with an organized labor force.'
In early 2012, the Communications Workers of America went on strike, attempting to take their strike across the country. From a business perspective, labor unions do affect the bottom line in the same fashion that labor unions affect government jurisdictions' bottom lines.
Number 7. Figuring Out Whether The Product or Service Can Be Priced To Keep Abreast of Inflation
"...a business with a durable competitive advantage is free to increase the prices of its products right along with inflation, without experiencing a decline in demand. That way its profits remain fat, no matter how inflated the economy goes."
The service side itself may not experience much price increases however the retail side will. Because the phones Verizon carries are manufactured by either Motorola, Apple (NASDAQ:AAPL), or Samsung- to name a few- the phone prices are determined by the phone manufacturing and shipping costs as well as Verizon's markup. Because the demand for better technology and style will never cease, manufacturers and retailers won't necessarily feel the need to keep the lowest profit margin possible to meet sales expectations. Once the manufacturer makes their pricing, then the retailer can add their pricing. Considering that if multiple retailers are selling the same model, then they'd obviously be price competing. But nonetheless, because some models of the new iPhone could be jokingly considered to be a luxury good, I believe that the product pricing can be adjusted to keep abreast with inflation.
Number 8. Perceiving the Right Operational Costs
This point considers how retained earnings is used and how much is used to maintain a durable competitive advantage. The computation used to determine this is to take the amount of retained earnings by a business for a period and measure its effect on the business's earning capacity.
The book gives this following example with H&R Block (NYSE:HRB):
In 1989, H&R Block, a company with a durable competitive advantage, earned $1.16 a share. This means that all the capital the business had accumulated until the end of 1989 produced for its owners $1.16 a share. Between the end of 1989 and the end of 1999, H&R Block paid out in dividends a total of $9.34 a share. So [f]or that ten-year period, H&R Block had retained earnings of $7.80 a share ($17.14 - $9.34 = $7.80) to add to its equity base.
The company's per share earnings increased during this time from $1.16 a share to $2.56 a share. We can attribute the 1989 earnings of $1.16 a [s]hare to all the capital invested and retained in H&R Block up to the end of 1989. We can also argue that the increase in earnings from $1.16 a share in 1989 to $2.56 a share in 2000 was due to H&R Block's durable competitive advantage and management's doing an excellent job of investing the $7.80 a share in earnings that the company retained between 1989 and 1999.
If we subtract the 1989 per share earnings of $1.16 from the 1999 per share earnings of $2.56, the difference is $1.40 a share. Thus we can argue that the $7.80 a share retained between 1989 and 1999 produced $1.40 a share in additional income for 1999, for a total return on 17.9% ($1.40 divided by $7.80 = 17.9%).
So let's work on Verizon using this set-up. Let's start with 2010:
In 2010, Verizon earned $0.90 a share. This means that the capital received until 2010 produced $0.90 per share for its owners. Between the end of 2010 and 2012, the total earnings were $2.06 per share. Of that, Verizon paid out dividends totaling $5.87 a share. Therefore, for that three-year period, retained earnings were -$3.81 per share ($2.06 - $5.87 = -$3.81). Earnings dropped from $0.90 to $0.31 during this time. If we subtract the 2010 EPS of $0.90 from the 2012 EPS of $0.31, the result is -$0.59. Therefore the retained earnings of -$3.81 between 2010 and 2012 produced -$0.59 per share, costing the business cash- leading to a loss of about 15.5%!
Number 9. Can the Company Repurchase Shares to the Investors' Advantage?
While it isn't clear what Verizon will do with the shares that it is repurchasing from Vodafone (NASDAQ:VOD), one speculation is that the shares being bought back will not be put back into the market. While the company doesn't have a history of buying back shares- as a requisite in this book- a buyback of this proportion is nothing short of epic!
In a nutshell, a stock buyback would be of benefit to shareholders by increasing the shareholders' stake in Verizon because of the newly-calculated percentage of shares, and cause for a rising EPS, and therefore a rising share price.
I'll give the benefit of the doubt here and say that this buyback could be used to help the investors.
Number 10. Does the Value Added by Retained Earnings Increase the Market Value of the Company?
"Warren believes that if you can purchase a company with a durable competitive advantage at the right price, the retained earnings of the business will continuously increase the underlying value of the business and the market will continuously ratchet up the price of the company's stock."
On December 31, 2010, Verizon had a book value of $13.64 per share and was trading at $35.78 per share. As of close of business, Thursday, September 26, 2013, Verizon has a book value of $11.90 per share and closed at $47.67. This means that the book value decreased by just under 13% and the share price increased by around 25%. The book value should be increasing while the share price increases. This could signal a number of things- the first coming to my mind is that the stock is overvalued OR that the company does not have a durable competitive advantage!
Of the 'Ten Points of Light' that I have used in the book to compare to Verizon as a company and stock, Verizon has only met two of the ten points. If Buffett were here, he'd adamantly oppose investing in Verizon. I must say that after calculating these numbers and doing this research, I am very disappointed in Verizon and would seriously consider selling here.