Since I first touted the underlying fundamentals of AT&T (T) and Verizon (VZ) ten months ago here, shareholder value has taken off like a rocket. Both appreciated by 28.3% and 22.3%, respectively - nearly doubling the return on the S&P 500 over the same time period. Sprint (S) has started to recover since mid-May and recently gained 6.4% on the closing business day Friday of last week. In my view, AT&T and Verizon continue to be compelling "buys" while Sprint is far too speculative. Over the last six months, the stock has nearly doubled in value with 32.2% growth coming in the last month. With the stock at its 52 week high and a precarious business position, Sprint has considerable risk. As telecom consolidates, there will be winners and losers. With a leading development on 3G and 4G in addition to high dividend yields, AT&T and Verizon both have more favorable risk asymmetry than Sprint does. Below, I review the fundamentals of each company.
The company recently reported strong second quarter results with record wireless margins and better-than-expected earnings. Even still, the market reacted negatively off of concerns that margins would weaken in the 2H when the new iPhone launches. The launch of the iPhone 4S in the fourth quarter of last year resulted in a 1,500 bps sequential compression of EBITDA margins, so the concern is not unfounded. With that said, capex costs have been pleasantly low and will likely amount to $19.9B in 2012.
In terms of subscribers, AT&T had a stellar 1.27M worth of net adds - more than 25% better than what was anticipated. As a result of conversions from DSL, U-verse broadband continues to be a major catalyst with 553K net adds in the second quarter. All told, consumer revenue grew 1.7% y-o-y to a strong $5.5B mainly as a result of momentum from U-verse.
Aside from margin pressure, the main risks that AT&T faces include competition, integration challenges, high debt load, and regulatory hurdles for growth. I believe that the company will effectively management new customers to prevent margin erosion. Moreover, and excellent rollout of LTE should help keep multiples elevated when the economy fully recovers. Currently, AT&T offers a 4.7% dividend yield. At 14.5x forward earnings, AT&T may not be as much as a value play it was several months ago; but, it still is an attractive defensive play.
Like AT&T, Verizon also trades at a high multiple of 15.9x forward earnings. The firm offers of 4.5% dividend yield but is nevertheless rated closer to a "sell" than a "buy" according to data from FINVIZ.com. Assuming the company grows EPS 9.1% annually over the next 5 years, 2016 EPS will come out to around $3.66. Applying a 15x multiple and discounting backwards generously by 7% yields a present value of $39.14 - below the current market assessment. Accordingly, I don't think Verizon is undervalued at this point, but it still is attractive from an income and growth perspective.
Second quarter results were strong with the company increasing market share in wireless and leading in margins. Postpaid net adds re-accelerated to 888K retail subscribers. Wireline results were a mixed bag with revenue below forecasts but margins pleasantly recovering. Verizon has a leading coverage and is generally regarded as the most popular domestic wireless network. Since the firm is ahead of its competitors by around a year in LTE deployment, Verizon merits a multiples premium.
Going forward, the company has several areas where it can create value. Smartphone penetration may yield further ARPU growth while FiOS could start gaining greater traction from a rising media market. Greater advertising for FiOS would be beneficial in help cross-selling consumers to the wireless segment. And smartphone penetration has been the weakest of the national carriers, which sets the bar low for a turnaround. Certainly, Verizon has the brand name capable of executing on a solid turnaround.
Sprint continues to be rated negatively on the Street with a rating of 2.7 out of 5 where "5" is a "sell" according to FINVIZ.com. The company is expected to lose $1.13 per share next year and, in my view, shares will likely fall in value after such a dramatic rise over the last six months. Too much execution risk lies ahead after past momentum.
On the positive side, OIBDA performance has done well with margins growing nearly 70 basis points from 2Q11. Despite postpaid gross add volume within 10% from a year ago, OIBDA margins were able to dilute investments in iPhone and Network Vision. The company has also weathered a challenging market with almost 1.5M iPhones activated from the first quarter to the second quarter. More importantly, 40% of iPhone activations came from new customers - meaningfully more than what is the case for competitors.
I believe that the market has overplayed the turnaround story. Sprint still lost $0.46 in the quarter and is burdened with $22.3B in net debt - $2.6B of which will need to be paid back in 2015. Instead of being a turnaround story, Sprint would be better classified as a "staying-alive" story. Weak domestic economic growth further will further prevent the company from recovering. Sprint will need to increase investments to prevent bankruptcy and, if the demand is simply not there, it won't have the cash flow necessary to jumpstart its revival. I recommend holding out in light of the macro uncertainty.