Neutral To Bullish As Verizon Cleans Up Its Act In Both Wireline And Wireless Segments

Jul.29.14 | About: Verizon Communications (VZ)

Summary

Company has delivered strong performance in the second quarter in both segments.

VZ has proven ability to add new subscribers and maintain lower churn in competitive environment.

Management has begun to build cash to participate in upcoming low band spectrum auction.

Verizon Communications (NYSE:VZ) continues to deliver a strong financial performance for the sixth consecutive quarter. I am changing my stance from neutral to bullish, as strong subscriber growth along with improved ARPA have proved that the company could back its higher prices with better network quality. However, the company now needs to invest heavily to maintain its premium network quality. Therefore, the upcoming spectrum auction holds a key position in the company's future growth plans.

Financial Performance
In the last quarter, VZ reported double digit growth in earnings and operating income, which was primarily due to the acquisition of 45% of VZ wireless from Vodafone (NASDAQ:VOD). The company reported postpaid net adds of 1.44 million, along with a churn of 0.94%. This was primarily driven by strong tablet sales of 1.1 million in the quarter. It also turned around its phone segment's poor performance in the first quarter, as it added 304K subscribers due to marketing initiatives, which highlights its strong network quality. So, it is clear that VZ's strategy to charge premium prices and provide better network quality has worked. This is evident by the strong subscriber growth, along with the ARPA growth of 4.7% YoY.

The company also experienced a turnaround in the wireline segment, after seven years, as revenues were up 0.3% YoY. This growth was attributed to a strong performance in the consumer segment and a slowdown in the decline of wholesale and enterprise business. In the consumer segment,FiOS continued to deliver strong results. In the second quarter, FiOS added 139,000 internet and 100,000 video connections, which represent YoY growth rates of 9.3% and 7.6%, respectively. VZ also continues to increase its fiber to reduce its maintenance cost and improve the quality of its services.

Competition
However, the EDGE program failed to meet its expectations. The primary reason behind the soft performance was that the company did not market the program well enough, and as mentioned in the earnings call, a majority of the sales took place through indirect channels. VZ needs to focus on its EIP sales, as its competitor AT&T (NYSE:T) is aggressively pushing its EIP plan. Moreover, I am also expecting Sprint Corp (NYSE:S) to compete more aggressively now, as its Network Vision Plan is near completion. When S starts to gain a market share, VZ will have to bear more pressure, as they both operate the same technology.

Spectrum Auction
The recent news that S and T-Mobile US (NASDAQ:TMUS) are raising $10 billion to bid together for the upcoming low band spectrum auction has raised concerns for investors. It gives S and TMUS a better chance to match the bids of telecommunication giants.

Fran Shammo, the CFO and EVP of VZ, gave the following remarks on the spectrum auction, "So I'm not going to talk about how we think we're going to pay for that auction because I'm not going to give anybody information of how much I'm willing to spend for the auction. So I think we'll just wait there. As I said, the strategy is to build cash, prepare for the auction and we'll execute accordingly."

I believe there are three reasons why the management is keen to participate in the auction and they would compete aggressively with other participants. Firstly, low bandwidth spectrum holds a key position due to its superior coverage in rural and urban centers. Secondly, although the company is not disclosing how much it is willing to spend, but VZ has started to plan and raise money to participate in the auction. Thirdly, the NY Post reported last month that VZ is interested in buying spectrum from DISH Network (NASDAQ:DISH), which means VZ wants to add more spectrum to its arsenal.

Dividends
The company has a long history of increasing dividend payments. The company raised its dividends in September and investors are expecting the same this year. Although the company has sufficient cash on its balance sheet, I believe it might restrain from increasing its dividend payments this year.

There are some important events coming up and the company needs to save cash. First of all, the company is eager to participate in the spectrum auction, as mentioned above. Its competitors S and TMUS are jointly bidding and raising $10 billion for the auction. Similarly, T has put up $9 billion for the bid. It is clear that VZ will be planning a number similar to the aforementioned bids. Secondly, a decision is pending with the Senate on the extension of the bonus depreciation bill, which might increase cash taxes for the company. Lastly, VZ is highly leveraged, so the management might prefer to payout debt to regain its superior credit rating.

Valuation
I have used a discounted free cash analysis to determine the target price. In the model below, I assumed a growth rate of 1% to determine the terminal value. Free cash flows are discounted using a WACC of 7%.My price target comes out to be $51.81, which means modest price appreciation of 1.7%. So, with a dividend yield of 4.30%, the total return comes out to be 6%.

 

2015

2016

2017

Terminal Value of FCF

Estimated Free Cash Flow

$15,222

$17,456

$20,975

$353,079

Discount Factor

0.9346

0.8734

0.8163

0.8163

Present Value

$14,226

$15,246

$17,121

$288,218

Click to enlarge

Total Value to firm = 14,226+15,246+17,121+288,218=$334,813 million
Total Debt= $120,285 million
Total Value to firm - Total Debt = Total Equity value
$334,813 - $120,285= $214,528 million
Share Outstanding = 4,140 million

Target Price = Total Equity Value/Share Outstanding
$51.81 = $214,528/4,140

Conclusion
The company has delivered strong performance in the second quarter in both wireline and wireless segments. VZ has proved that it has the ability to add new subscribers and maintain lower churn in the competitive environment, which has convinced me to change my stance to bullish. VZ's management has not revealed the exact numbers for the bidding, but it has started to build cash to participate in the auction.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.