Compelling Valuation, High Dividend Yield: Consider Verizon Communications

| About: Verizon Communications (VZ)

Most dividend investors look for low price-to-earnings multiples, high yields, safety, and growth. Verizon Communications (NYSE:VZ) offers all of the above.

The company ranks very highly using The 8 Rules of Dividend Investing. Verizon Communications stock is an excellent candidate for diversified, large-cap dividend stock portfolio.

This article examines the investment opportunity at Verizon Communications.

The company is generating strong free cash flow, and the dividend yield is high at 4.5%. Verizon's high dividend yield makes it Warren Buffett's 2nd (out of 20) highest dividend holding.

Verizon: Cash Flow Machine with Short-Term Headwinds

The company's free cash flow in the first quarter of 2016 was at $4.0 billion while paid dividends were at $2.3 billion. As such, the free cash flow payout ratio in the quarter was at 57.5%.

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Source: 1Q 2016 Presentation

Verizon shares are facing pressure from the strike by Verizon union workers, which may negatively impact the second quarter results. However, in my opinion, management and unions will reach an agreement sooner or later, and the strike would not have long time impact on the company's growth prospects.

According to a USA TODAY news item from May 17, Verizon and striking union officials will remain at the bargaining table in Washington this week. Senior leaders of the telecommunications giant and the Communications Workers of America and International Brotherhood of Electrical Workers met Tuesday with Labor Secretary Tom Perez and federal mediator Allison Beck and plan to continue talks.

Nearly 40,000 Verizon employees who are members of the unions went on strike April 13. The most recent labor contract expired August 1, 2015. The unions have criticized Verizon for outsourcing jobs and requiring some workers to relocate while Verizon officials say compromises on benefits are needed to tame costs.

On April 21, Verizon reported its first quarter 2016 financial results; earnings-per-share were in-line with expectations. Verizon showed earnings-per-share surprise in its previous four quarters, as shown in the table below.

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Data: Yahoo Finance

The company posted revenue of $32,171 million in the period, missing the consensus estimate of $34,406 million. Excluding the acquisition of AOL, which was not part of Verizon a year ago, revenues declined by 1.5% year over year.

The decline was due to lower wireless phone activations on device installment sales, lower upgrades, and the ongoing migration of its customer base to unsubsidized pricing. In wireline, the higher growth of Internet-only activations and smaller video bundles also pressured revenue growth.

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Source: 1Q 2016 Presentation

Verizon's First Quarter Highlights

  • Consolidated: $1.06 in earnings per share, compared with $1.02 per share in 1Q 2015.
  • Wireless: 640,000 retail postpaid net additions; continued low 0.96 percent retail postpaid churn.
  • Wireline: 5.0 percent Fios revenue growth; 98,000 Fios internet and 36,000 Fios video net additions.

In the report, Chairman and CEO Lowell McAdam said:

"Verizon's strong first-quarter results demonstrate our capacity to compete effectively, while executing on our plan of continued network leadership and seeding new growth markets in mobile video and the Internet of Things."

Verizon Wireless segment revenues of $22 billion accounted for 68.4% of the company revenues in the first quarter of 2016, and the total wireless revenue declined 1.5% year-over-year.

However, what is most encouraging, in my opinion, is the margin expansion. Segment EBITDA margin increased to 46.2% in the recent quarter from 38.4% in the prior quarter and 44.8% in the same quarter a year ago.

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Source: 1Q 2016 Presentation

Verizon's Outlook & Growth

Management reaffirmed its expectations that 2016 earnings will be comparable to 2015's level. This is due to pressures from the sale of high-margin wireline operations to Frontier Communications, the ongoing shift of the wireless customer base to device payment plans and from higher capital spending on the ramping up of new growth projects.

Verizon also indicated that given the status of labor contract negotiations, there is expected to be pressure on second-quarter earnings due to the timing of cost reductions.

In my view, Verizon is well positioned for continued growth.

The company remains committed to consistently investing in its networks for the future. Its 2015 investments have positioned it for growth and allow it to maintain its network leadership position.

What's more, to maintain network superiority, Verizon announced on February 22, that it has signed an agreement to purchase XO Communications' fiber-optic network business for approximately $1.8 billion. According to Verizon, its ownership of XO's fiber-based IP (Internet Protocol) and Ethernet networks will help better serve enterprise and wholesale customers. Also, acquired fiber facilities will help Verizon continue to densify its cell network. The transaction is subject to customary regulatory approvals and is expected to close in the first half of 2017. Verizon expects to receive several financial benefits from the deal, including a step-up by the assets as well as operating and capital expense savings. The net present value of the operational synergies is expected to be more than $1.5 billion.

On April 6, Verizon announced that it has entered into an agreement to purchase an approximate 24.5% stake in AwesomenessTV [ATV]. Upon completion of this transaction, the ATV multi-platform media company will be valued at approximately $650 million. DreamWorks Animation (NASDAQ:DWA), which acquired ATV in 2013, will remain the company's majority stakeholder with an approximate 51% ownership of outstanding shares, while Hearst will own the remaining 24.5%. ATV is a producer and distributor of short-form digital entertainment content for teen audiences and got its start as a content provider for YouTube. ATV was also one of the original content partners when Verizon launched its go90 wireless video service last year.

Furthermore, on the first-quarter conference call, CFO Fran Shammo said that the company remains confident in its three-tier strategy for long-term growth. That is to:

  1. Lead at the network connectivity level in the markets Verizon serves
  2. Develop new business models through global platforms in video and Internet of Things
  3. Create incremental revenue opportunities in applications and content.

According to Mr. Shammo, regarding progress on this multi-tier strategy the company is focused on network leadership and operating efficiency, while it develops new ecosystems in video and the Internet of Things, leveraging its capabilities in the United States and scaling its platforms globally.

Verizon is also developing a portfolio of unique content targeted at the Millennial Generation so that it can capitalize on the opportunity transforming mobile. At the network connectivity layer the company consistently invest in its 4G LTE network to accommodate growth in data usage and enable customers to experience an unmatched level of connectivity. National studies continue to recognize Verizon as the overall 4G LTE network performance leader.

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Source: 1Q 2016 Presentation

Verizon's High Dividend

In September 2015, Verizon's board approved a 2.7% dividend increase which raises its annualized dividend to $2.26 per share.

This was the ninth consecutive year that its board approved a dividend increase, affirming their confidence in the strength of their future cash flows. Verizon has been paying uninterrupted dividends since 1983. The forward annual dividend yield is high at 4.5% and the payout ratio is at 50.9%.

The annual rate of dividend growth over the past three years was at 3.4%, over the past five years was at 3.0%, and over the last ten years was at 3.2%.

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Source: company's reports *assuming same dividend rate for the year

Verizon did not buy back shares in the first quarter of 2016. However, it repurchased $5.1 billion of its stock in 2015.

Verizon's Compelling Valuation

Since the beginning of the year VZ's stock is up 9.0% while the S&P 500 Index has increased 0.2%, and the Nasdaq Composite Index has lost 5.4%.

However, since the beginning of 2012, VZ's stock has gained only 25.6%. In this period, the S&P 500 Index has increased 62.8%, and the Nasdaq Composite Index has risen 81.9%. According to TipRanks, the average target price of the top analysts is at $52.64, an upside of 4.5% from its May 18 close price, however, in my opinion, shares could go much higher.

Verizon has compelling valuation; the trailing price-to-earnings is very low at 11.4, and the forward price-to-earnings is also low at 12.44.Furthermore, the price to cash flow is very low at 5.96, and the Enterprise Value/EBITDA ratio is also very low at 6.4.

Moreover, most VZ's Margins, Growth Rates and Efficiency parameters have been much better than its industry median, its sector median, and the S&P 500 median, as shown in the tables below:

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Source: Portfolio123

Summary of Verizon's Investment Opportunity

In my view, VZ's stock should be included in every diversified large cap dividend stocks portfolio. The company is generating strong free cash flow, and the dividend yield is high at 4.5%. While first quarter revenue was disappointing, management reaffirmed its previous forecast of flat earnings for 2016.

Verizon has compelling valuation; the trailing price-to-earnings is very low at 11.4, and the EV/EBITDA ratio is also very low at 6.4.

In my view, Verizon is well positioned for continued growth. The company remains committed to consistently investing in its networks for the future; its 2015 investments have positioned it for growth and allow it to maintain its network leadership position.

The average target price of the top analysts is at $52.64, an upside of 4.5% from its May 18 close price, however, in my opinion, shares could go much higher.