Since my March 28, 2012 article on Verizon Communications (VZ), the market has begun to pay up for the value of this enterprise. The stock has returned 19.29% versus the S&P 500 returning 1.41% (not too shabby for a sleepy, dividend-centric investment). In light of the earnings "bloodbath" Friday, and with the stock down 2.94% on earnings being in-line at $0.46 per share during the second quarter, I thought it made sense to update my thoughts on the company. The bottom line here: VZ remains to me a sound long-term holding. Let's touch on some of the revelations that came out of the quarter, and hit on a few of the "insightful" points raised from the comments in the last article.
- Through the first six-months of 2012, VZ has generated a consolidated $15.3 billion of Cash Flow from Operations. When you strip out capital expenditures of $7.4 billion, VZ had $7.8 billion of Free Cash Flow to fund dividends, debt repayment and other financing/investment activities. What did the company do? VZ paid $2.6 billion in common dividends, retired $2.8 billion in debt and funded a $4.5 billion dividend to Vodafone Group Plc (VOD), the 45% owner of Verizon Wireless. The company is now headed into the back half of 2012 with the VOD dividend funded, $10.0 billion of cash on the balance sheet (down from $13.4 billion at 12/31/11, with the incremental burn coming from the VOD dividend) and the expectation of continued dividend stability and managed capital expenditures (in addition to the funding of the $3.9 billion deal to acquire AWS spectrum for LTE devices). The cash flow, and overall cash position, of the consolidated VZ remains very much stable and intact.
- Speaking of capital expenditures (and further on the point of Free Cash Flow), VZ spent $7.4 billion in the first six-months of 2012, down from $8.9 billion during the first six-months of 2011. The cuts were largely at Verizon Wireless, where the company has spent $3.9 billion during the first six-months of 2012 versus $5.4 billion during the first six-months of 2011. The company cites the capital spending discipline as the primary driver of improved Free Cash Flow during the first half of 2012 versus the first half of 2011. Discipline around spending is good, and further supports the potential for debt reduction, financial flexibility and dividend stability moving forward.
The VZ story (really, the wireless story in general) is about data. It has been well documented that there will be a slowdown in mobile adds, simply because more and more consumers have them. While VZ exceeded consensus on Retail Postpaid adds (an impressive 888,000 during the quarter, considering there was no new iPhone to sell), the more important number is the record $56.13 Retail Postpaid ARPU realized in the quarter (up from $54.12 in the second quarter of 2011 and $55.43 in the first quarter of 2012). The trend of rising ARPU in wireless is essential, as the continued ability to realize the increased use of mobile data platforms will drive top line growth for the next several years.
Net adds in FiOS weren't great (as Video and Internet are down, year-over-year), but thanks to strong Digital Voice residence connections, adds were up 604,000 in the quarter, versus 591,000 during the second quarter of 2011. More notably, the Consumer ARPU is up to $100.26, versus $92.44 during the second quarter of 2011 and $97.88 during the first quarter 2012. While growth is not robust from FiOS, adds are still positive year-over-year and, more importantly, the ARPU from the business is up considerably.
From the corporate presentation, year-over-year, operating revenues were up 3.7%, operating income grew 15.5% and EBITDA margin expanded to 34.2%. Metrics were sound, across the board, as the company continues to grow.
On the call, management indicated that the spectrum deal is expected to close during the summer 2012. The regulatory process continues to move forward. A successful close to the spectrum deal would be a positive for the VZ.
In the last article (as I want to touch on a few subjects), one of the comments discussed the risk that the VZ enterprise is levered, and as such, over time, as rates rise, will be subject to earnings erosion due to higher interest costs. This is not particularly insightful (sorry, but it isn't) and is a risk to not just VZ, but every business in the world that has any debt. And more notably, it is a huge risk to the United States and other sovereign entities that have levered within the current low environment. But, to humor the topic, in reviewing the company's capital structure, VZ is not loaded up with 2.0% and 3.0% debt for the next 15 years, despite being an A- rated credit and having a current yield on 10-year paper sub-4.0%. It would appear that the company has not been overly aggressive in calling in paper (due to redemption features) and thus, is not subject to massive funding risk, especially considering any new issuance would likely be (1) longer-dated and (2) at a lower cost than the back-end debt of (roughly 6.0% in cost). In light of the Fed commitment through 2014 to hold rates "exceptionally" low and the company's still higher than it could be if they could call paper cost of funding, the benefit of lower rates is still likely to impact the company on a go forward basis for the foreseeable future.
Another concept brought up was the underfunded pension. Yes, VZ has a $6.5 billion funding gap on the pension as of the year-end 2011. However, recent performance in the stock market (and bond market), combined with some contributions from VZ, will likely lessen the funding gap. And, to make clear, the $24.7 billion healthcare gap is a pay as you go number. Ultimately, pension issues are an overhang but, at this point, not overly relevant due to the strong cash flow and cash position of the company. When is it time to worry about pension assets crushing VZ? When disruptive technologies emerge around wireless and wireline businesses that lead to a decline in adds, revenue and cash flow for the overall business. That isn't happening now and does not appear to be in the foreseeable future.
Overall, VZ continues to chug along nicely and the quarter was fine. The dividend yield of 4.5% is attractive in light of the current market, and the company's ability to grow through wireless has been quite good. VZ remains a core holding, not to be traded but rather, held as the wireless cycle in the U.S. continues to play out.