Verizon: A Great Buy Again

| About: Verizon Communications (VZ)

Summary

My last recommendation on Verizon, given twelve months ago, has brought a 23% return to investors (18% price appreciation + 5% dividends).

The company's significant debt load is a problem. However, Verizon can easily either refinance or repay it because the company has been generating strong cash flows.

The factors that point out Verizon’s stability are: a decrease in financial leverage, a high net profit margin, a sustainable working capital position, and far away debt repayment due dates.

My DCF and comparative analyses show that Verizon is a good buy now with an upside potential of more than 59%.

Nearly a year ago, I wrote about the 30%-50% upside opportunity for Verizon's (NYSE:VZ) stock. Since then, the stock has increased from $44.09 to $52.13 per share, or by more than 18%. Moreover, adding the accumulated dividends during this period results in a total return of 23%.

As you can see from Diagram 1, there have been several pumps and dumps during this period. However, the total trend has been positive so far. This supports the fact that the valuation given one year ago is correct.

You can read the article here.

Today I am going to give an update on my opinion and argue why I think VZ is still a buy candidate.

Diagram 1.

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(Source: Yahoo Finance)

Why Stay Long After Such Significant Growth?

This is the most popular question that each investor asks along with "Why is there so much debt in the company?". These questions are closely related to each other. Let me show you how.

As you can see from Diagram 2, during the last four years, Verizon has showed terrific returns on equity (ROE) figures. There are two main reasons why it has been growing (recall the DuPont analysis):

1. The net profit margin has increased from 0.76% in 2012 to 13.58% in 2015

2. The financial leverage increase from 6.79x to 14.89x.

The result is great. No competitor have show such a performance. The biggest competitor, AT&T (NYSE:T), had a figure of 20% in 2013 and now only has a 13.5% return on equity.

In the present time, we see the following trends:

1. The revenue has stopped growing. During FY2015, sales have fallen by more than 1%.

2. The gross profit margin has been decreasing during the last three years. However, a decrease in the GPM in 2015 was compensated by improvements in operating margin (from 15.42% to 25.12%) and, as a result, in the net profit margin (from 7.57% to 13.58%). The ROE has increased more than threefold, from 37.65% to 124.48%.

3. Financial leverage has declined during the last twelve months - it has decreased from 14.89x to 12.04x. Nevertheless, the ROE has fallen by more than 30 percentage points. So has the interest coverage ratio: from 6.74x to 6.11x. Regardless, the interest coverage of more than 6x is a sign of good financial health.

4. The working capital efficiency has increased a little (see Diagrams 3 and 4), despite the fact that accounts receivable remain the largest part of cash conversion cycle structure. Days of sales outstanding (DSO) have significantly fallen since 2014. The cash conversion cycle has decreased from almost 49 days to 46 days, which is a good development.

Diagram 2.

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(Source: Morningstar.com)

Diagram 3.

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(Source: 10-K of the Verizon)

Diagram 4.

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(Source: 10-K of the Verizon)

Financial leverage reduction is a major objective for the company in the coming years. As you can see from Diagram 5, most of the debt should be paid in 2027-2028. There are two facts that make me feel comfortable with the exorbitant debt levels:

1. The company is well-known on the Wall Street and can refinance its debt without problems;

2. Verizon generates more than $14B of free cash flows each year meaning that it can theoretically extinguish the entire debt load ($99.8B, according to books) in a bit more than seven years, or by 2023. As you can see from Diagram 5, most of the debt is due in 2025-2027. Hence, investors can be sure that the company can pay off all its debt by the deadline even if it does not generate any free cash flow for 1-2 years.

Diagram 5.

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(Source: Morningstar.com)

However, there is no doubt that Verizon is going to generate substantial cash flows in the nearest years. The main catalyst is, of course, its wireless segment with an annual growth of ~5% in 2015. The LTE advanced technology implementation is a big reason why Verizon's customer base is going to grow in the nearest future.

DCF Analysis

My DCF model is presented in Diagram 6. In Diagram 7, you can see how different metrics of the company are expected to change during this period. I have made and revised several assumptions, which can be seen in the "Assumptions" tab of my Excel file.

My model shows that, after subtracting the market value of debt, minority interest, adding back cash and investments, and other issues the market value of equity is around $389.4B in the Base scenario. Consequently, the stock's fair value is around $95.35 per share. It is more than 82% higher than the market price ($52.33 per share).

Diagram 6.

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(Source: data - Morningstar.com, DCF model by author)

Diagram 7.

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(Source: data - Morningstar.com, model by author)

Sensitivity Analysis

My DCF analysis is based on a number of assumptions, which create a certain expectation of the share price. However, we need to see the entire picture and derive a range of possible prices. A few assumptions about WACC and the Terminal EV/EBITDA multiple give us a plausible price range of $83-109 per share. It means that the stock has room to increase by 59%-109%.

Diagram 8.

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(Source: data - Morningstar.com, model by author)

Comparative Analysis

My comparative analysis is based on four key ratios: P/E, P/S, P/BV, and EV/EBITDA (see Diagram 9). Despite the fact that P/BV ratio shows a significant downside potential, recall the company's high ROE. Hence, this downside potential can easily turn into an upside opportunity, if the dynamics does not change. The P/E ratio shows a strong upside, while the P/S is ambiguous. The current EV/EBITDA multiple is 7x, which is 17% lower than industry's average of 8.42x (according to Damodaran). Hence, the stock looks undervalued.

Diagram 9.

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(Source: data - Morningstar.com, infographics by author)

Recommendation

Despite the significant debt load that Verizon bears, there are several factors that make its stock look undervalued. Strong margins, efficient operating working capital, LTE Advanced, stable cash flows, and far away debt repayment deadlines are the key strengths of the company, among others.

I recommend investors to BUY Verizon and set a target price range of $83-109 per share for the next twelve months. This translates into a 59%-109% upside potential, excluding the sizable dividends per share.

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.