Over the past twelve months, shares of Verizon (NYSE:VZ) are little changed (see chart below). While Verizon has outperformed arch-rival AT&T (NYSE:T), both firms have badly lagged the performance of the broader market. At its current level, Verizon is yielding 4.5% and is trading 13-13.5x 2014 earnings, which makes shares far cheaper than the broader market. This reasonable valuation has not brought many buyers in yet, which raises an important question. Is Verizon a value stock or a value trap? Based on the company's operating results and broader trends in telecommunications, I do not believe VZ is a value trap. In fact, it is a good buy at current levels.
(Chart from Google Finance)
Verizon essentially operates two businesses: the legacy wireline unit and higher growth wireless unit. Prior to this year, Verizon only owned 55% of Verizon Wireless with Vodafone (NASDAQ:VOD) owning the other 45%. Verizon agreed to buy out its minority partner for roughly $130 billion in stock and debt (merger details available here). To do this deal, Verizon had to issue a lot of debt, and it now carries $113.5 billion in debt (debt maturity schedule available here). It also issued 1.27 billion shares to Vodafone, which then passed those shares on to its shareholders. Now many Vodafone shareholders may not want to own Verizon, and some institutional investors were barred from owning US stocks in their investment mandate. This issuance put downward pressure on shares, though the market has now mostly absorbed them. With much of the noise around the merger entering the rear view mirror, we can now look at the fundamentals of the company.
As consumers, we are all well aware that the landline is a less useful offering in the day of the cell phone. As a consequence, most companies have seen declines in their landline subscriber base, but this does not mean the wireline business is headed to oblivion. Verizon has diversified away from the landline with internet and TV offerings, mainly under its FiOS brand. This platform has been growing its subscriber base and negating the declines in landline. In just the last quarter (financial and operating details available here), the company added 126,000 internet and 92,000 TV subscribers. There are now 5.3 million FiOS TV and 6.1 million FiOS internet subscribers. FiOS average revenue per user ("ARPU") has increased 10.8% to $117, which is good for margins going forward.
Importantly, FiOS is helping to stabilize the picture in wireline. While total revenue finished down 1.4% in 2013, consumer revenue increased 4.9% and is becoming a bigger piece of wireline. Costs also fell faster than overall revenue at -2.2%. While wireline still faces challenges, the business is stabilizing. Moreover, FiOS cap-ex should decline, which will make the business even more cash flow positive, which is important to pay down the debt. I expect wireline revenue to be roughly flat this year thanks to FiOS net-adds and higher ARPU.
Wireless continues to be an exceptional performer. The company has nearly 103 million customers, which is up 4.7% year over year. The business continues to add an average of 1 million subscribers every quarter. Consumers continually are seeking out higher speeds and more data-intensive functions, which has helped push ARPU to a record of $157, which is up 7% from a year ago. Thanks to these trends, total revenue is growing at a nearly 7% clip. Smartphones now account for over 70% of mobile phones, which suggests the segment is beginning to mature. This will likely slow ARPU and subscriber growth going forward, which is why wireless is focused on new forms of connections like machine to machine and accessories (i.e. smart watches), which will power the next leg of growth for the business.
There has been increasing concern of a price war in wireless with T-Mobile (NYSE:TMUS) and Sprint (NYSE:S) aggressively pricing their offerings. Even AT&T dramatically cut prices to match these offerings (pricing details available here). A more competitive wireless market is something that investors should be concerned about and focus on. However, there is no data to support the thesis that competitive pressures will hurt Verizon's share or margins. The company continues to add customers, and in its most recent guidance (available here), it expects to expand its EBITDA margin in 2014. While T-Mobile and Sprint may put downward pressure on pricing, smartphone subsidies are less painful now that the iPhone no longer has a virtual monopoly.
T-Mobile and Sprint are also far smaller than Verizon and AT&T, which will make it difficult for them to fight a protracted price war. There has been speculation the two firms will merge, but the FCC does not seem keen on such a deal (details available here). Ironically, I think the market would be more competitive if Sprint and TMUS merged. Currently, the market has two strong (T and VZ) and two weak (S and TMUS) players, and it would be more competitive to have three strong players by combining the two smaller firms. The FCC seems to prefer four national carriers, which will limit the margin risk for Verizon. If this stance changes, there would be more downward pressure on Verizon.
The big concern for investors has to be Verizon's massive debt burden of $113.5 billion. While it is an important concern, the debt should not deter investors. I expect Verizon to grow revenue about 4% this year to $125-$126 billion. With a 35-36% EBITDA margin, EBITDA should be roughly $44-$45 billion. Debt to EBITDA is only 2.5-2.6x, which is not that levered for a company with relatively stable cash flows. With over $20 billion in free cash flow potential, VZ can easily support the dividend, which will cost about $8.7 billion this year, and start to pay down the debt at a relatively fast pace. Thanks to the Vodafone deal, Verizon now has access to all of wireless' cash flow. While it added a significant amount of debt, this debt burden is very manageable and should not keep investors out of VZ stock.
Consider this, Verizon paid $130 billion for a 45% piece of Verizon Wireless. This suggests the total value of Verizon Wireless is $290 billion. Compare that to VZ's $195 billion market capitalization. Granted, VZ now carries over $100 billion in debt, but its wireline operations also provide a source of value especially with revenue starting to stabilize. Much of this debt does not come due for several years and is at attractive interest rates. A sum of the parts analysis suggest VZ should be worth at least $225 billion, suggesting upside to around $53-55.
In 2014, VZ should earn at least $3.50. Given the debt burden, shares should trade at a slight discount to the market, but I think 14.5-15x earnings is fair given strong cash flow generation and its ability to gradually pay down the debt over the next five years. This suggests fair value is roughly $52-$53 with a 4.5% dividend yield on top of that. Verizon is a cash flow machine with a strong operating profile. Even with the debt load, Verizon's creditworthiness is not a concern. Investors should consider buying shares here.