By The Valuentum Team
Verizon's (NYSE:VZ) market position is one of its most attractive qualities, as it is the leading wireless provider in the US with just over 35% of total US wireless subscriptions in the first quarter of 2016. Management has stated that it expects 2016 to be a "plateau", and then in 2017 it will return to normal growth in earnings for the company. While plateauing is not ideal in an industry defined by such cutthroat competition, we are optimistic the company will be able to hold the line in terms of market share before returning to growth in 2017.
Our largest concern with Verizon is its massive debt load of $110.2 billion in total debt at the end of 2015 compared to just $4.8 billion in cash and cash equivalents. While operating cash flow has oscillated between ~$30 and ~$40 billion from 2013-2015 capital expenditures have steadily increased to $17.8 billion in 2015 from $16.6 billion in 2013 as the company continues to invest in the growth of its business, which is highly capital intensive by nature. As the demand for a wireless provider with strong high speed data for the growing existence of smart phones increases, so too does competition from other telecommunication companies such as AT&T (NYSE:T), T-Mobile (NASDAQ:TMUS), and Sprint (NYSE:S).
Despite its massive debt load, Verizon has managed to continue to grow its dividend, and it now boasts an attractive yield of ~4.5%. While we cannot ignore the accumulating debt and intensifying competition, we aren't too worried of the financial health of the company based on its strong free cash flow generating abilities and impressive market share. Recent reports have said Verizon has planned to submit a $3 billion bid to acquire "core internet assets" of Yahoo (NASDAQ:YHOO). How these assets would fit exactly into Verizon current portfolio of offerings remains to be seen, and the bidding process is not expected to be resolved for months. We're watching developments closely.
Verizon's Investment Considerations
• Verizon offers broadband, video and other wireless and wireline services to consumers, businesses, governments and wholesale customers. The firm operates one of America's fastest 4G wireless networks and provides services over one of America's most advanced fiber-optic networks. The company was founded in 1983 and is based in New York.
• Verizon's acquisition of the portion of Verizon Wireless owned by Vodafone has burdened the firm's balance sheet with more than $100 billion in debt. Though Verizon will have to invest in its network and platforms, a disciplined approach to capital spending will be necessary going forward.
• Verizon's focus on margin expansion and profitable growth is undeniable. It's hard not to like the firm's ~50% wireless segment EBITDA service margins, and a reasonable amount of its customers still don't have smartphones. This offers headroom to capitalize on the migration to tablets and other devices.
• Verizon is simply a cash cow, and while investments are often high, free cash flow generation is mighty impressive. For example, in the first quarter of 2016, free cash flow totaled ~$4 billion (which is actually a weak quarter for the firm) while dividends paid was ~$2.3 billion, suggesting nice dividend coverage with free cash flow.
• We like management's focus on cost improvements and capital efficiency, and we expect the firm to continue to generate strong free cash flow, which should drive future dividend expansion. Its massive debt load weighs heavily on its Dividend Cushion ratio, however.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Verizon's 3-year historical return on invested capital (without goodwill) is 7.3%, which is below the estimate of its cost of capital of 8.5%. As such, we assign the firm a ValueCreation™ rating of POOR.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does notconsider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.
Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
In the chart below, we show the probable path of Verizon's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. We assign the firm an attractive Economic Castle rating on a go-forward basis.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Verizon's free cash flow margin has averaged about 12.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Verizon, cash flow from operations increased about 0% from levels registered two years ago, while capital expenditures expanded about 61% over the same time period.
In the first quarter of 2016, Verizon reported cash from operations of ~$7.4 billion and captial expenditures of ~$3.4 billion, resulting in free cash flow of ~$4 billion. This represents a ~38% decrease from the first quarter of 2015.
We think Verizon is worth $50 per share with a fair value range of $40-$60. Shares are currently trading at ~$51, just above our fair value estimate. This indicates that we feel there is slightly more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Similar to management's expectations of a plateau in 2016, we are expecting slight weakness in Verizon's top line in 2016 before the firm returns to modest growth in 2017. Our earnings forecasts follow a similar pattern. We are anticipating a drawback in capital expenditures for the firm in 2016, as is management. Investments in the year will be focused on adding 4G LTE network capacity as the company works to continue to capture the growing data demands of its customers.
Our model reflects a compound annual revenue growth rate of 0.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 4.3%. Our model reflects a 5-year projected average operating margin of 25.7%, which is above Verizon's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Verizon, we use a 8.5% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $50 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Verizon. We think the firm is attractive below $40 per share (the green line), but quite expensive above $60 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Verizon's fair value at this point in time to be about $50 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Verizon's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $60 per share in Year 3 represents our existing fair value per share of $50 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.