As telecom undergoes its inevitable consolidation, the next few years are bound to make winners on losers. While I am optimistic about the prospects of AT&T (T), I am pessimistic about those of Sprint (S). As I have alerted several times, Sprint is a company whose bankruptcy concerns fail to be fully highlighted by the media. Between these two extremes is Verizon (VZ).
In this article, I will run you through my DCF model on Verizon and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to AT&T and Sprint. I find that Verizon is fairly priced right now.
First, let's begin with an assumption about the top-line. Verizon finished FY2011 with $110.9B in revenue, which represented a 4% gain off of the preceding year. I model the company's growth trending from 8% to 5.5% over the next 6-years, which is decent given the limited room for penetration at this maturity.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I expect cost of goods sold to eat 41.4% of revenue versus 30% for SG&A and 15.1% for capex. Taxes are estimated at 18% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model).
We then need to subtract out net increases in working capital. I estimate that this will hover around 3% of revenue over the projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $38.61, implying 0.6% upside. The model is fairly sensitive considering that my sensitivity analysis reveals a standard deviation of $7.71 (20% of the intrinsic value) when considering a variety of differing perpetual growth rate and WACC inputs.
All of this falls within the context of strong operating performance:
"We finished the year very strong, creating value for our shareholders in 2011 by generating a total return of 18.2% through a combination of stock price appreciation of 12.1% and our dividend payments. Our stock price appreciation outpaced our peers, as well as the S&P, Dow Jones and broader indices. For the fifth consecutive year, our Board of Directors approved a dividend increase, indicating their confidence in the sustainability of our business model, cash flows and our improving earnings profile into 2012 and beyond".
However, from a multiples perspective, Verizon, again, appears to be fairly valued. It trades at 13.8x forward earnings versus 12.5x for AT&T. Assuming a multiple of 14x and a conservative 2013 EPS of $2.75, a rough price target of $38.50 is assigned - in-line with my DCF result.
Consensus estimates for AT&T's EPS forecast that it will grow by 6.8% to $2.35 in 2012 and then by 8.1% and 7.5% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $2.49, a rough price target of $34.86 is assigned, implying 12% upside. Combined with a 5.6% dividend yield, strong brand, and plenty of growth opportunities, AT&T has attractive risk/reward. While the failed takeover of T-Mobile raises concerns, ultimately, AT&T has a track record of executing beyond the low bar that has been set for it.
Sprint, on the other hand, is flirting with disaster. I like to support winners and when Sprint was lobbying against AT&T, it really showcased how vulnerable the company is. Losses are expected to bleed even more in 2012 than in 2011 at -$1.45 per share. In fact, losses per share are expected to be more than 10% higher in 2013 than they were in 2011. Put differently, this worsening momentum will devastate the company at the ~April 2013 inflection point when the economy approaches full employment (just an estimate). Investors may consider going long AT&T and shorting Sprint to benefit from the spread.
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