In general, bearish sentiment surrounds Verizon (VZ) and Sprint (S). From challenged margins to intense competition, I agree that there is not enough upside for either of the firms right now. Even though the two offer high dividend yields and low margins, a double dip could have more of a magnified impact than what the market is willing to acknowledge. Sprint is so close to the edge that a decline in macro demand may waste significant advertising dollars. As telecommunications companies race to the bottom with increasing promotions, what is the future of the weakest link die?
From a multiples perspective, there is little room for expansion. Verizon trades at a respective 15.4x and 15.1x past and forward earnings. AT&T (T), meanwhile, trades at a respective dividend yield of 15.1x and 12.1x past and forward earnings while offering a dividend yield that is roughly 70 bps higher at 5.9%. In my view, AT&T stands out as being the undervalued pick given its size, which substantially reduces risk.
Sprint, on the other hand, is the midst of an attempted turnover story. At the third quarter earnings call, Sprint's CEO, Dan Hesse, noted the promise of introducing iPhone to its portfolio:
"As I have discussed with you in the past, the most tangible evidence of brand improvement is subscriber performance and a strong brand is especially critical to generating gross adds or attracting new customers. As this chart depicts, Sprint's gross adds had been declining steadily since late 2005. The brand had weakened enough that gross adds dropped for 13 of 14 quarters, the downward momentum being strong enough to blow right through seasonality, dropping by over 2 million postpaid gross adds per quarter.
We hit bottom in the second quarter of 2009 and we've been building momentum ever since. Driven by brand health, we estimate our share of postpaid gross adds increased by 170 basis points versus the previous quarter. The number one reason customers leave Sprint or churn is no iPhone, and we believe the #1 reason new customers don't try Sprint has been no iPhone.
Our early results of selling the iPhone 4 and iPhone 4S have confirmed the iPhone's ability to attract new customers".
iPhone sales thus have been strong and helped ARPU. With a greater smartphone mix, the company will also have a better ability to increase fees. Even still, Sprint is experiencing threatening churn and has received low expectations for Boost and Virgin in what should be a cyclical upswing. With no clear end to losses, simply following the innovation of other competitors and challenging merger activity is no sustainable way to create value. IDEN churn is modeled to increase in the second half of 2012, but will be offset by a decline in CDMA churn.
The picture is somewhat less bleak at Verizon. This company has incredible smartphone sales, but at the cost of greater expenses and narrowing EBITDA margins. iPhone sales more than doubled sequentially to 4.2M, while LTE device sales of 2.2 also impressed analysts. The anticipated dilution to margins is around 600 basis points. A lower discount rate will further result in higher pensions costs. Terremark and greater penetration for FiOS should, however, enhance the top-line with comparatively little expenses.
Consensus estimates for Verizon's EPS are that it will decline by 2.7% to $2.18 in 2011 and then grow by 16.5% and 13.4% in the following two years. Assuming a multiple of 15.5x and a conservative 2012 EPS of $2.47, the stock is trading at roughly fair value. Of the last 14 revisions to EPS, all have gone down for a net change of -0.6%. If marco signs worsen, it is probable that the multiple will decline to 13.5x and if 2012 EPS turns out to be 12.6% below consensus, the stock would fall by 21.9%. While this is a bear case, it nevertheless illustrates poor risk/reward. Accordingly, analysts are right to rate both Verizon and Sprint a "hold".