Why Verizon Is Dead Money

Apr.25.14 | About: Verizon Communications (VZ)


We dislike debt.

Verizon will be taking on a mountain of debt as it folds in all of Verizon Wireless.

We expect the firm's dividend growth and credit rating to be compromised.

As part of our process at Valuentum, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Verizon's (NYSE:VZ) case, we think the firm is fairly valued at $56, modestly higher than where it is currently trading. That said, we have some very real concerns about Verizon that impact both its potential dividend growth and credit health.

At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):

At the methodology's core, if a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. You can read up on the academic proof of the methodology here. It's a fun read! As the methodology applies to Verizon, however, the company posts a Valuentum Buying Index score of 3, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. For relative valuation purposes, we compare Verizon to peers AT&T (NYSE:T), Centurylink (NYSE:CTL), and Sprint (NYSE:S).

Verizon's Investment Considerations

Investment Highlights

• Verizon's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.

• Verizon offers broadband, video and other wireless and wireline services to consumers, businesses, governments and wholesale customers. The firm operates one of America's fastest 4G wireless networks and provides services over one of America's most advanced fiber-optic networks.

• Verizon has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 17.6% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 61.1%.

• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.

• We continue to evaluate Verizon for addition to the portfolio of our Dividend Growth Newsletter, though we note its pursuit of Verizon Wireless has complicated matters quite a bit (given the outsize debt load it will take on).

What Keeps Us Up at Night

Verizon's decision to purchase Vodafone's (NASDAQ:VOD) stake will more than double the amount of debt on the company's balance sheet, to roughly $116 billion, driving its net debt to adjusted EBITDA to roughly 3 times (see image below). Moody's recently downgraded the firm a notch (Fitch did the same here), but we think the company's credit health will be tested if it doesn't de-lever significantly before the next downturn. In any case, management's decision to double its already large debt load has prompted us to re-evaluate the attractiveness of its dividend growth prospects. Our view is that debt holders will now be first in line to absorb additional capital that otherwise would have been available for future dividend increases. Verizon's pro forma capitalization is shown below:

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Image Source: Verizon

We do not think Verizon's elevated debt load bodes well for dividend growth investors in the near term, nor do we think it is a prudent move to add on so much debt so late in the economic cycle. We have grave concerns and think Verizon will be dead money until it frees itself from this mountain of debt.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Verizon's 3-year historical return on invested capital (without goodwill) is 6.8%, which is below the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Verizon's free cash flow margin has averaged about 12.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Verizon, cash flow from operations decreased about 6% from levels registered two years ago, while capital expenditures expanded about 22% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Verizon's shares are worth between $42.00 - $70.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $56 per share represents a price-to-earnings (P/E) ratio of about 183.2 times last year's earnings and an implied EV/EBITDA multiple of about 7.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.4%. Our model reflects a 5-year projected average operating margin of 18.4%, which is above Verizon's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Verizon, we use a 10.1% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $56 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Verizon. We think the firm is attractive below $42 per share (the green line), but quite expensive above $70 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Verizon's fair value at this point in time to be about $56 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Verizon's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $69 per share in Year 3 represents our existing fair value per share of $56 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.