In anticipation of Apple Inc.'s (AAPL) announcement of an LTE-capable iPhone 5 by the fourth quarter of 2012, Verizon Communications (VZ) recently announced that it was planning to modify the terms-of-service on its legacy unlimited wireless data plans.
Verizon stopped offering unlimited data plans in 2010, at around the same time that its competitor AT&T Inc. (T) did. Beyond the desire to increase revenues per user, it had become apparent to wireless operators like Sprint Nextel Corporation (S) and AT&T that the explosion of mobile data use would require massive capital investment to complete the timely rollout of 3G and 4G networks capable of delivering bandwidth-consuming Internet data.
Related to this, Verizon itself expended capital to the tune of a combined $49.6 billion from 2009 to 2011, largely on the rollout of its 3G and 4G/LTE networks.
Indeed, despite measures to put soft limits on data use by raising prices and throttling bandwidth, networks continue to lay out massive amounts of capital to expand their capacity, with AT&T CEO Randall Stephenson expressing his regret at having offered unlimited data plans when the iPhone first launched in 2007.
Previously, Verizon customers on existing unlimited data plans could upgrade to new handsets and retain their data plans with no penalty. Not any longer: customers wishing to enjoy the full subsidy on pricey handsets like the iPhone would have to move to Verizon's new tiered data plans - or forfeit the subsidy.
Sophisticated devices such as Apple's iPhone and devices from HTC, Samsung (OTC:SSNLF) and Nokia (NOK) running either Google's (GOOG) Android OS or Microsoft's (MSFT) have spurred the growth of mobile data traffic. Indeed, mobile data traffic has more than doubled each year since 2009 and by 2016 data traffic is expected to 18 times its level in 2011, according to a study by Cisco Networks.
Verizon clearly sees a massive opportunity in all this. When it began offering its customers the iPhone in 2011, it was assumed that it was only a matter of time before an LTE version of the iPhone emerged. Unfortunately, the first Verizon iPhones were not capable of LTE-speeds and that, no doubt, resulted in the poor returns from its initial offering of the device. Indeed, Verizon has already experienced much greater success with the LTE-equipped new iPad.
To be sure, Verizon users already have a selection of LTE-capable Android phone - but iPhones remain the best-selling handsets in the United States - and that might ultimately be the reason Verizon is modifying its data plans ahead of the launch of the iPhone 5: it's an opportunity to take market share from the likes of AT&T, which still retains over 20 million iPhone users. Indeed, while Verizon activated 4.3 million iPhones in the fourth quarter of 2011 and a further 3.2 million in the first quarter of 2012, it has not succeeded as well as it would like.
Of course, beyond just attracting new users, the challenge for Verizon is retaining them. That will require it to deliver reliable 4G/LTE wireless connections - and that means acquiring bandwidth.
To do so, Verizon recently entered a deal to acquire bandwidth from SpectrumCo, a consortium of cable companies, which has drawn criticism and questions from the FCC, for $3.6 billion. If completed, the deal promises to enable Verizon to deliver more efficient and reliable 4G/LTE speeds to its customers.
On top of that investment, Verizon will have to continue expending capital on its wireless broadband rollout; it's not inconceivable that it will spend another $13 billion to $16 billion in 2012 on top of the $49.5 billion spent the past three years. I estimate that, at an Average Revenue Per User (ARPU) rate of $850 per annum, Verizon will have to attract close to 18.9 million new users to break-even on its capital expenditures.
That number of new users is close to 20% of AT&T's customer base and equivalent to around 90% of its iPhone user portfolio. That's a number that Verizon is unlikely to poach; as AT&T's experience has shown, phone subscribers have been unusually loyal to their existing wireless providers - and not just because they're locked in. For all the talk of Verizon being America's fastest mobile network, tests have shown that AT&T is faster - if not as reliable.
In any case, at the level of data usage that Cisco is forecasting, Verizon will have to continue to expend capital at similar rate for the next two to three years - meaning that, all things being equal, Verizon will have to either increase its user base by 60% or increase its Average Revenue Per User by 14% to pay for its expansion. Alternatively, Verizon could also reduce subsidies on its premier mobile devices, thereby removing the discount to its revenues.
Ultimately, the need to pay for its expansion may be the chief impetus behind Verizon's pricing and subsidy machinations. In fact, it has begun shifting its key metric from Average Revenue Per User to Average Revenuer Per Account, a move that is likely to be emulated across the Wireless space. The simple logic is that migrating its user base to shared data plans among families and/or friends will allow Verizon to top-up fees faster.
Verizon has continued to dominate the Wireless space, but its lead over AT&T is certainly not unassailable. That said, Verizon has proven capable of beating market expectations, exceeding analyst estimates in three of the past four quarters. In fact, it surprised the market by posting a 16% rise in revenues in the first quarter.
Moreover, the discipline that Verizon plans to impose on its pricing regime is welcome to the extent that it will allow it to expand its margins, mitigating the need for costly new account acquisitions and helping to pay for its sizable capital expenditures.
Going forward, I expect to see less dominant "middle" quarters for Verizon as users anticipate the iPhone 5 in the fourth quarter. That said, from a value perspective, Verizon continues to be solid: it's forward Price-Earnings (P/E) ratio of 14.8 is favorable compared to the S&P 500's 21, about even with Domestic Carriers' P/E of 14.7 and shows just a little bit of a premium over the Dow's P/E of around 13.6.
I see a price target of $55 per share or an upside of 33% against current levels, reachable by 2013.