- VZ Wireless' superior network is an intriguing competitive advantage that is fueling revenue growth and margin improvement.
- Results for VZ Wireline have stabilized.
- Valuation is compelling, at less than 14x analysts' estimate for 2014 earnings.
The torrid pace of the S&P 500 in the past two years has created unrealistic price-to-earnings ratios for many companies with sound fundamentals and consistent earnings. Verizon (NYSE:VZ) is a notable exception. According to Yahoo Finance, the stock trades at less than 14x analysts' expectations for earnings for 2014, despite the growing market share of its wireless segment (VZ Wireless) and the stabilization of its wireline operations (VZ Wireline). I believe VZ's shares reflect at least a 20% discount, due to investors' uncertainty about the acquisition of 45% of VZ Wireless from Vodafone.
VZ Wireless Poised for Solid Growth in Revenue and Profits
VZ Wireless has a compelling advantage - the largest 4G LTE and 3G EV-DO networks of any service provider in the U.S. In my opinion, the network has been the catalyst behind VZ Wireless' two-point gain in market share in the past two years. According to Fiercewireless.com, VZ Wireless comprised over 35% of wireless connections in 3Q13.
In addition to increasing market share, VZ Wireless is also garnering more revenue per account. Average revenue per account (ARPU) increased to $154 in 2013 from $135 two years ago. I believe this trend reflects the growth in smartphones, which represented 86% of new activations in 2013 compared with just 44% in 20112. Regardless of the reason, the impact is clear. Both revenue and gross margin have improved significantly. Consequently, EBITDA has grown at annual rate of over 13% since 2008. I acknowledge that acquisitions have helped fuel EBITDA growth, but EBITDA margin still expanded to 45% in 2013 from 39% in 2008.
Source: Verizon 10-k filings for 2013 and 2010
VZ Wireline is clearly the less valuable of VZ's two business units. However, it is still generating significant free cash flow, and it has shown signs of stabilization. The key to the table below is that VZ Wireline's capital expenditures have moved in tandem with its EBITDA. I think that trend demonstrates management has realistic expectations for the return on investment in VZ Wireline. It is also encouraging that EBITDA and free cash flow increased modestly in 2013. VZ Wireline has been moderately successful in harnessing FiOS to offset declining revenue from landline connections.
Free Cash Flow
Source: Verizon 2013 and 2010 Annual Reports
Valuation: Where the Rubber Meets the Road
So far, I have demonstrated VZ Wireless has attractive prospects to grow revenue and profits. I have also shown that VZ Wireline should not be a drag on free cash flow growth. Valuation is the final hurdle in proving VZ is an attractive investment.
As mentioned earlier, VZ trades at less than 14x analysts' expectations for 2014 earnings. That compares favorably to a forward price-to-earnings (P/E) ratio of 16x for the S&P 500. While this comparison is encouraging, a stock could have a P/E ratio and still be overvalued for a variety reasons. Therefore, I used a simple model based on the key principles of finance to estimate VZ's value. My estimate is $67.
Below is a summary of my simple model to calculate the value of VZ:
- Calculate present value (PV) of unlevered free cash flow.
- Add PV of Debt Tax Shield.
- Subtract PV of Claims that are Senior to Shareholders.
- Divide by number of shares outstanding.
The first step is estimating the PV of VZ's unlevered free cash flow. I calculated this amount as a perpetuity of 2013 operating cash flow minus investing cash flow plus interest expense.
PV of Unlevered Free Cash Flow = (Operating Cash Flow - Investing Cash Flow + Interest Expense) / (Cost of Capital - Growth Rate)
Substituting values with dollars in millions…
PV of Unlevered Free Cash Flow = (38,818 - 14,833 + 2,667) / (10% - 3%) = 380,743
The critical variables are the cost of capital and growth rate. I selected 10% for the cost of capital. That is very conservative given VZ's beta of 0.03 and 4.2% yield on 10-year notes issued in March 2014. My growth rate of 3% represents the product of a 15% assumption for return on capital and 20% reinvestment rate. I calculated VZ's return on capital (ROC) as 19% for 2013. I defined ROC as the sum of interest expense plus net income including the portion attributable to non-controlling interests divided by the sum of debt, minority interest and equity. ROC for 2013 was above recent averages due to adjustments for its pension and other retiree obligations. Therefore, I selected 15% as a conservative estimate for the prospective ROC.
VZ has been reinvesting significantly more than 20% of its profits in recent years, and it will need to fund investments in its network in the near term. However, I expect the reinvestment rate to decline over time. Assuming a greater reinvestment would result in a greater valuation.
The second step in my valuation is estimating the value of the debt tax shield. I believe VZ's current debt is $110.5 billion. This number is comprised of $93.6 billion of debt outstanding at Dec. 31, 2013, $6.6 billion borrowed in February 2014 under long-term credit agreement and $10.3 billion of debt issued during three offerings in 2014. VZ's 10-k shows its statutory federal tax rate is 35%. The chief difference between its statutory tax rate and its effective tax rate is due to non-controlling interests, which will disappear after its deal with Vodafone. Therefore, I calculated the debt tax shield as $110.5 billion times 35%, or $38.7 billion. VZ's enterprise value is $419.4 billion.
The below table displays my estimates for non-operating claims that are senior to shareholders.
Employee Benefit Obligations
110% of Book Value at Dec. 31, 2013
200% of BV excluding VZ Wireless at Dec, 31, 2013
The final step is dividing VZ's enterprise value available to common shareholders of $276.4 billion by the number of shares outstanding. VZ's February 21, 2014 press release regarding its purchase of Vodafone's 45% stake in VZ Wireless announces the company issued 1.275 billion shares to Vodafone. Adding that number to the 2.875 billion weighted average outstanding shares assuming dilution in 4Q13 equals 4.15 billion shares, which means my model values a share of VZ at $67.
I believe a sound investment should be attractive in terms of both fundamentals and valuation. VZ satisfies both criteria. VZ Wireless is the market leader in the US wireless business. Its best-in-class network is a compelling advantage that it has monetized through revenue growth and margin expansion. Management has stabilized VZ Wireline. VZ's P/E ratio and my valuation both indicate that VZ's shares are a bargain.