Why Buffett Bought Verizon

| About: Verizon Communications (VZ)


Verizon has an economic moat by way of their network, a resource that is hard to come by.

Verizon is in good shape no matter how the rumored Sprint/T-Mobile merger plays out.

Increased competition between device makers could put downward pressure on carrier subsidies.

Verizon's brand and recent buyout of Vodafone will deliver value to shareholders over time.

A couple of months ago, Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) bought shares of Verizon (NYSE:VZ). What follows is an attempt to understand why.

Before we really dig into things, it is worth getting out of the way that Buffett generally buys companies that are financially sound. Verizon has a solid underlying business, featuring earnings per share on the upswing and a solid balance sheet. But Buffett also likes companies that have a competitive advantage - what he calls an "economic moat."

In the telecommunications sector, the key thing to know is that the frequency bands that deliver wireless transmissions over the airwaves are limited. These frequency bands are like a bridge that connects mobile devices to servers. Crossing the bridge incurs a toll, but we don't really have that many options. Companies like Verizon and AT&T (NYSE:T) control the majority of the bridges that connect our devices to servers. Because the number of these bridges are seriously limited, Verizon enjoys a well-protected consumer monopoly of sorts. It is no surprise that Verizon spends the majority of its advertising budget touting the reliability of their network. (Can you hear me now?)

Sprint (NYSE:S) has recently been rumored to buy T-Mobile (NASDAQ:TMUS). In the past, the Federal Communications Commission has said that they want to maintain at least four wireless companies. If the FCC continues to maintain this position, they could block the Sprint/T-Mobile merger from going through. Sprint is actively pursuing the merger and has a lot to gain from the potential deal. In addition to bolstering subscriber numbers, Sprint could also get their hands on more wireless spectrum, which would allow them to compete with Verizon and AT&T. On the other hand, T-Mobile has been able to grow its subscriber base by competing on price. If Sprint were to acquire T-Mobile customers, who on average pay less on their monthly bill, they would have to decide how they would handle subscriber rate discrepancies. If they raise prices for the subscribers they acquired from T-Mobile, they risk angering their new customers and driving them away to Verizon or AT&T. If the merger were approved, the American telecom industry would be dominated by three major players instead of four. Less choice is generally bad for consumers and good for companies. In other words, a merger between Sprint and T-Mobile benefits Verizon.

If a Sprint/T-Mobile merger does not go through, Verizon is still in good shape. Sprint has been struggling to compete with the larger telecom companies on its own and T-Mobile has been acquiring customers at a steep cost. While it seems like there are four major players in the telecommunications space, it may be the case that only Verizon and AT&T can realistically compete. Sprint and T-Mobile have argued that a merger is necessary if either company is to compete with the top dogs. To put it another way, Verizon is well-positioned no matter how you slice it.

Telecom companies often pay subsidies for the phones they sell to their customers. These subsidies cut into carriers' profit margin. With intensifying competition between the likes of Apple (NASDAQ:AAPL), Google (GOOG, GOOGL), and maybe even Amazon (NASDAQ:AMZN) in the near future, phone subsidies will be pressured downward. When there was only a handful of handset options, Verizon didn't have a lot of choice - the company needed to carry the iPhone to attract customers and, in turn, had to pay the toll to device makers. But now that there are more mobile device choices, wireless companies can increasingly resist paying high subsidy costs.

The last thing we need to figure out is why Buffett bought Verizon instead of AT&T. Everything covered above also applies to AT&T. Further, a number of recent studies might even suggest that AT&T's wireless network is at least on par, if not even a bit better, than the Verizon network. Couple that with a slightly more attractive P/E ratio and a higher yield at current prices and Berkshire Hathaway's purchase of Verizon becomes a bit puzzling. The first thing we need to remember is that Warren Buffett loves a good brand. When it comes to the network - the bread and butter of a successful wireless company - Verizon has the best brand. AT&T may even have a negative image regarding its network, thanks to network overcrowding that hit AT&T a few years ago when iPhone users flocked to the network and jammed up the airwaves. Even if AT&T has improved its network to be on par with Verizon's, it may take a while to convince the public that this is true. The second key reason why I believe Buffett fancies Verizon over AT&T relates to Verizon's recent buyout of Vodafone's stake in the company. Buffett likes to invest in companies that return value to shareholders via stock buybacks. Verizon's purchase of Vodafone's 45% stake is kind of like a stock buyback, except that the number of shares aren't reduced. Instead, the earnings potential of the company increases. And beyond the long-run financial benefit to shareholders, Verizon is now more free to run their business in the way they see fit, which could open the door to improved efficiencies and innovations.

Disclosure: The author is long VZ, AAPL.

Business relationship disclosure: I am a YouTube partner, which means that Google pays me for advertising that runs against my content.