Share price of Verizon Communications (NYSE:VZ) has been riding on a downtrend since October 2013 and is currently trading just slightly above its 6-month low ($46). Given the reasons described below, the recent price weakness appears to be a buying opportunity for long-term investors.
Valuation looks compelling…
Owing to the price decline, Verizon shares now trade at 13.8x forward P/E multiple, which is 10% below the same valuation multiple of S&P 500 Index (see chart below). I am of the view that this discount magnitude presents a buy signal because 1) the stock's forward P/E multiple used to trade above the market level by as much as 25% in April 2013; 2) Verizon's consensus long-term earnings growth estimate of 7.6% is not far away from the average estimate of 8.5% for S&P 500 companies; 3) the stock offers a dividend yield of 4.5%, which is substantially above the average of the S&P 500 Index at just 1.9%; and 4) Verizon holds a leading market position in the US wireless sector with significant market share and superior margin performance.
Verizon shares also trade on a discounted valuation relative to that of AT&T (NYSE:T). The stock's forward EV/EBITDA multiple is 13% below AT&T's (see chart below). Although Verizon's forward P/E ratio is 7% higher, the shares' PEG ratio of 1.7x is 18% below AT&T's 2.1x after considering Verizon's higher consensus long-term earnings growth estimate. Given Verizon's superior profitability and free cash flow conditions as well as its more liquid balance sheet, I believe investors should buy on the stock's discounted PEG ratio.
Concerns on Verizon Wireless transaction have likely been priced in…
Verizon announced that the company agreed to purchase 45% of Verizon Wireless from Vodafone (NASDAQ:VOD) for $130B in September 2013. I believe the market's concern on this potential deal mainly comes from the following uncertainties:
- According to management, part of the transaction value will be financed through issuance of approximately 1.2B new shares, which will dilute current shareholders. However, the amount of the share issuance is subject to change according to market conditions prior to deal closing in February 2014.
- Management did not provide detailed Q4 2014 financial guidance in the Q4 2013 earnings call. This has intensified investors' concern on whether the potential Verizon Wireless deal will meet the original EPS accretion target at 10%.
Since October 2012, the beginning of the current price downtrend, Verizon's share price has dropped by 6%, compared to a positive return of 2% for S&P 500 Index. In addition, following the company's Q4 2013 earnings call, Verizon's share price traded off 1.3%, compared to a positive 0.3% performance for S&P 500 Index, as the lack of detailed 2014 guidance weakened investors' sentiment even though the company delivered an above-expectation quarterly performance. Further, Verizon's forward P/E multiple traded at an average premium of 14% over that of AT&T in the past 6 months and the premium has steadily dropped to just 7% by far (see chart below). As such, given the weak share price performance relative to the market and the discounted stock valuation relative to S&P 500 and AT&T (in terms of EBITDA multiple and PEG ratio), I am of the view that a majority of the company-related negativity has been priced in.
There are upside catalysts…
Going forward, I believe the stock price upside will likely be driven by the following developments:
- In 2013, Verizon's wireless service revenue grew at above-industry rate of 8.3% and achieved a superior EBITDA margin of 49.5%, which exceed market expectations. Given the company remains in the process of smartphone plan penetration and cost cutting as well as management's track record of reliable strategy execution, I expect Verizon's wireless business to continue outgrow the industry and produce solid margin in 2014.
- The company's wireline business experienced mediocre performance in 2014 due to weak telecom and government spending. However, provided that management has been taking initiatives to improve margin performance though process improvement, migration from copper to fiber lines, and cost cutting, I believe this segment's performance to rebound modestly in 2014 as customer spending recovers.
- Given my view that Verizon's current valuations have factored in most of the negative aspects for the Verizon Wireless transaction, I expect that any positive outcome will likely drive up the stock price.
In summary, Verizon's current discounted valuation should provide investors a fair margin of safety. In light of a few upside catalysts as mentioned above, a buy rating is warranted for Verizon on the current price weakness.
All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ unless otherwise specified.
Disclosure: I am long VZ, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.