Is Verizon Communications Overvalued?

| About: Verizon Communications (VZ)

Verizon Communications (NYSE:VZ) is a provider of various communication services to its wide range of customers, from individuals to corporate clients, as well as various governmental agencies. Verizon Communications operates through two segments, namely wireline and wireless, with the wireless segment generating almost 65% of the company's total revenues in the quarter ended June, 2012.

The company has been in the news recently, and not for any good reasons. According to a ruling by the U.S. Court of Appeals, Verizon is required to pay royalties of $2.74 for each of its FiOS TV subscribers, on a monthly basis, to a California-based company, Active Video Network Inc., whose patents the company had infringed. ActiveVideo owns inventions that aid in providing interactive TV to customers. In addition, the jury also awarded ActiveVideo $115 million in damages for the patent infringement.

The court, substantiating the jury's verdict against Verizon, said that there was ample evidence to support the decision. However, the company will still be allowed to provide services to its FiOS TV customers. Verizon ended the second quarter with almost 4.5 million FiOS TV subscribersd, which means that even if the company doesn't add any more customers to its FiOS video subscription base, it is looking at paying somewhere between $36 million to $37 million in royalties to ActiveVideo in the third quarter.

Moreover, U.S. telecom regulator, the Federal Communications Commission (FCC), has recently suspended pricing flexibility rules for broadband lines, which has been taken very positively by smaller telecom companies who blame telecom giants like Verizon and AT&T (NYSE:T) for overpricing them for access to lines. Verizon and AT&T together own nearly 70% of the wireless telecom market in the U.S. With the suspension by the FCC in place, companies like Verizon and AT&T are likely to suffer from a loss of revenues, as ownership of these lines is primarily controlled by a few telecom companies, including Verizon.

Since our last report on Verizon, the stock has lost over 3% in value, and we believe the stock doesn't have a significant price appreciation potential. The company, despite the growth in revenues and earnings in the quarter recently ended, was not able to provide any positive earnings surprise. Moreover, its wireline business continues to slip further, posting a 3.3% decline in revenues in the second quarter recently ended, as compared to the second quarter of FY2011. Overall revenue growth has slowed as well, and is reflected in the company's falling gross and operating margins. In the years ended 2009, 2010 and 2011, Verizon posted operating margins of 14.8%, 13.7% and 11.6%, respectively, which along with falling gross margins, signals the cooling in revenue growth over the years, as well as a slight weakness in its operations.

If we look at the stock performance on a YTD basis, its underperformance is visible relative to the market benchmark S&P, which is up almost 12%, while Verizon has gained 8.9%.

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This is despite the impressive second quarter results posted by the company, of course with a few exceptions relating to its wireline business.

Perhaps the reasoning behind the stock's underperformance is its high valuations. VZ is trading at 17 times its forward earnings. Moreover, the 10-year historical median forward P/E of 12.7x for VZ is also higher than the forward P/E for global telecom companies like Telecom Italia (NYSE:TI) and France Telecom (FTE). The stocks of both global telecoms are trading at extremely cheap valuations, especially when compared to Verizon. Forward P/E for TI is 5x, while for FTE it is 8x.

Verizon remains attractive from a dividend standpoint. Verizon's stock currently yields an attractive 4.5%, which is well backed by its healthy operating cash flows. However, it has a very high dividend payout ratio of almost 200%. In comparison to the yields currently offered by TI and FTE, the current of 4.5% doesn't sound too attractive. Of course, there are the tax considerations of investing overseas, but we believe the yields of 6% and 13% offered by TI and FTE are still very healthy. Moreover, investing in these foreign telecom companies will expose an investor to the high-growth markets in Latin America, the Middle East, and Asia.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Telecom Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.