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by Mark Goldstein

Verizon (NYSE:VZ), the New York-based telecommunications company, is the second largest fixed telephony provider in the United States and is comprised of several divisions of varying profitability and growth opportunities. Essentially its businesses are divided between copper-wire / optical fiber line services and Verizon Wireless (of which UK-based Vodafone (NASDAQ:VOD) owns 45%). At the moment Verizon is trading near its 52 week high at just over US $40 per share.

Despite Verizon Wireless being the largest wireless communications service provider in the United States, given the market and technological dynamics facing the telecommunications sector I recommend investors "short sell" Verizon stock over this quarter and the next. True, Verizon is well known for paying a quarterly dividend but its latest quarterly profit came largely from Christmas sales of the Apple (NASDAQ:AAPL) iPhone 4S which nudged upward the average monthly bill of its wireless customers. Wireless markets in the United States remain highly competitive and the recent U.S. DOJ scuttling of the proposed AT&T (NYSE:T) merger with the T- Mobile USA unit of Deutsche Telekom has exacerbated the structural problem of "looming spectrum crunch" that threatens future growth of the sector.

Consumer adaptation to mobile devices such as smartphones and tablets is devouring existing bandwidth and, according to the FCC, network traffic by 2015 will increase 25 to 50 fold over that of 2010. Verizon President and CEO Dan Mead claims that by 2014 demand will exceed capacity unless more spectrum is added. Once the investor factors in the billions of dollars companies in the industry have spent upgrading networks to 4G, the drain on future earnings can readily be seen. After the deteriorating profitability of its landline divisions is added into the equation it is clear that Verizon must evolve its business model to achieve growth and profitability goals.

Valuation

Currently, Verizon has 2,835,524,157 shares outstanding with a market capitalization of approximately $114 billion. Its enterprise value stands at slightly below $160 billion. As alluded to above, Verizon debt-to-equity, debt-to-capital and interest coverage ratios all significantly deteriorated from 2010 to 2011. Other key indicators reflect the same downward trend - net cash provided by operating activities, operating and net income and total equity all declined during the same time period. In addition to paying shareholders $5 billion during the past three fiscal years Verizon also serviced $18 billion of debt in 2009 and 2010. Most analysts consider that currently the company is fairly valued and appreciation for its stock is very limited. By comparison, AT&T trades at 6.2 times trailing twelve month EBITDA while Verizon trades at 3.8 times; a sure indicator of which company is more profitable.

Strategy

To survive competitively, wireless providers must acquire additional airwave spectrum. In response Verizon proposes to purchase wireless spectrum from SpectrumCo (a consortium including cable providers Comcast (NASDAQ:CMCSA), Time Warner (NYSE:TWC) and Bright House Networks) and Cox Communications (a subsidiary of Cox Enterprises) for $3.6 billion. However, these acquisitions must be approved by the FCC. Given the regulatory climate after AT&T's abortive attempt to merge with T-Mobile, government acquiescence is far from a formality. In fact the FCC has found "deficiencies" in documents submitted to the agency and extended a March 22nd deadline two months to declare a final decision. With opposition to the deal from (ironically) T-Mobile, Sprint-Nextel (NYSE:S), the Rural Cellular Association and the Communication Workers of America (CWA), expect the deadline to be extended again.

In the long term, should this deal be consummated, Verizon will add more than just bandwidth. In locations where currently it does not offer FiOS (bundled telephone, internet and television services over a fiber optic network) or FTTP, Verizon will have the capability of providing Comcast and Time Warner cable services. Conversely Comcast and Time Warner will market rebranded Verizon wireless services. The same reciprocal agreement would apply to Cox Communications. This of course is a direct challenge to AT&T Mobility and U-Verse services. Again, the proposed deal would put tremendous pressure on future earnings growth by virtue of the enormous capital expenditures needed to roll out infrastructure. This would no doubt impact Verizon's balance sheet for 2012.

Just as importantly, to staunch the financial hemorrhaging from its landline divisions Verizon must strive to contain labor costs, in particular health care and wage structures. The company employs a workforce of nearly 196,000; approximately 45,000 are wireline employees in nine northeastern states and the District of Columbia represented by CWA and the International Brotherhood of Electrical Workers (IBEW) who, unlike the majority of Verizon employees, pay nothing for health insurance premiums. Many of these same workers may earn up to $91,000 a year with overtime and upward of $50,000 in benefits. With many consumers transitioning to exclusive use of wireless services and the proliferation of wireline competitors, Verizon has no choice but to implement or increase employee health care contributions, freeze pensions and reduce sick leave.

Other cost-cutting initiatives include the elimination of phone cards and DSL-only subscriptions. 89,000 Verizon subscribers terminated their DSL service during the first quarter of 2012, so the company is redirecting its focus toward FiOS, which fetches 63% of Verizon's revenue in residential wireline services. Perhaps the company's shareholders could look to reduce the compensation given to upper management - its five top executives received $258 million over the last four years.

Outlook

With the introduction of next generation LTE technology for wireless telephony, Verizon has been obliged to migrate from its legacy CDMA network. This upgrade, occurring across the United States during the past few years, entails the expenditure of billions of dollars in infrastructure investment. Hand in hand with these outlays is the quest for more wireless spectrum. Should Verizon prevail in acquiring the spectrum of SpectrumCo and Cox Communications, billions more will be spent. The continuing transition from traditional landline POTS to wireless has been painful for both Verizon's wireline hourly employees and the company's bottom line. With its share price showing very little capacity for upswing, Verizon's stock should either be left for those who are looking for investment income or, in the near-term, sold short.

Source: Verizon: Short-Term Sell-Off Could Sink Stock