Verizon Communications (VZ) is the holding company of Verizon Wireless, the connector of 107.8 million wireless devices. We focus in this article on Verizon's dividend (currently yielding 4.5%), its relationship to Vodafone (VOD), and the general safety of revenues.
As to current valuation - it appears to be basically fair-valued. Given that its P/E is about 43, it may be necessary to point out why the P/E ratio's signal of overvaluation is a red herring. The biggest point of interest for us, however, is this graph -- the visual representation of their seemingly dangerous payout ratio:
Verizon Communications, when consolidated, is a massive corporation:
- Total Revenue TTM: $113 billion
- Total Assets: $226 billion
- Market Capitalization: $124 billion
Approximately 63% of its consolidated 2011 revenue came from the familiar Verizon Wireless segment. Of that segment, however, Verizon Communications only owns 55% of it -- even though it consolidates the entire thing, including Vodafone's 45% ownership into its income statement. The consolidation process is partially why its net income statement has the following large curiosity:
This 45%-55% break is also the reason that certain other authors miss the point and say that the dividend is well covered by FCF -- it is indeed covered, but not well covered.
When we look at Verizon Communications, we need to be cognizant of the fractured ownership structure beneath it. Specifically, we need to be aware of the Cellco Partnership with Vodafone. The "net income attributable to noncontrolling interest" of $7.7 billion in the table above is due to Vodafone's stake in Cellco (more on this later).
"Cellco Partnership" is the legal name of Verizon Wireless. Verizon Communications, again, owns only about 55% of it. The consolidated Cellco Partnership, in turn, represents approximately 63% of consolidated revenue:
An appropriate analysis of Verizon Communications Inc. will focus on Verizon Wireless and also its other activities in proportion. But as for its other activities, we will be brief: It is seeing more switching from landlines to mobile, it is laying down fiber optic cable like the old railroads crisscrossing the country, it is working on developing better service bundles, and it is working with and forming joint ventures with the large cable companies. But enough about its Verizon Wireline segment.
Verizon and Vodafone
It appears that Verizon Wireless hasn't needed, except recently (and earlier due to tax reasons), to disburse dividends to the juggernaut Vodafone -- that's despite the fact that Vodafone itself pays a decent 7% dividend. (In fact, once it received the dividend from Verizon Wireless, it just turned around and distributed it to its shareholders.)
The $10 billion dollar dividend from the Cellco Partnership to its owners can be seen within its respective cash flow statements. Since Verizon paying itself a dividend would be useless for an appropriate accounting of the whole organization, that portion of the dividend is eliminated during the consolidation process. That means that all you can see within the consolidated statement is the $4.5 billion ($10 billion * 45%) paid to Vodafone. The payment can be found in Verizon's Q1 2012 statement of cash flows:
Source: Verizon's First-Quarter 10-Q, p. 5.
Correspondingly (and translated from U.S. dollars to pounds), we can find it on Vodafone's cash flow statement:
Source: Vodafone's 2012 20-F, p. 97.
It can reasonably be expected that dividends like this will be issued again in the future. Such dividends to Vodafone could potentially hamper Verizon's ability to pay dividends. Such a scenario is unlikely, however, since Verizon has -- at least in the past -- had more than enough cash to take care of its needs.
As a wireless service provider, Verizon -- like its competitors -- is in possession of recurring revenue streams. This was stated in a powerful paragraph by Vodafone in its 2012 20-F (p. 21):
We generate our service revenue through the supply of calls, text messaging and data, and other services over our networks. Consumers pay for these service either via contracts (typically up to two years in length) or through buying their airtime in advance (prepaid or pay as you go). Enterprise customers often have longer contracts.
These revenue models give us excellent visibility of our business. In addition, we are not reliant on single large contracts, with the top ten biggest corporate accounts representing less than 1% of annual revenue. Secondly, the majority of our services are sold in advance--reducing credit risk and generating an attractive working capital profit. Finally, our services have become such a part of our customers everyday lives that they have become non-discretionary in nature. (emphasis added)
What is true of Vodafone here is also true of Verizon Communications. In addition to this revenue picture based on many millions of contracts, Verizon's sales mix of phones also benefits recurring revenue. As stated by Francis J. Shammo in the Q1 earnings conference call:
…72% of all retail postpaid phones sold this quarter were smartphones…Consistent with prior quarters, about 20% of our smartphone sales are gross adds or new to Verizon, and the rest are upgrades from our existing customer base. Within these upgrades, 42% are customers buying a smartphone for the first time, representing incremental recurring data revenue.
As of Dec. 31, 2011, the wireless segment's operating revenue was about $70.1 billion. Of that, about 84% was service revenue. On page 29 of its 2011 Annual Report (pdf), it is noted that:
…wireless data revenue was $23.6 billion and accounted for 40.0% of service revenue during 2011 compared to $19.6 billion and 35.1% during 2010. (emphasis added)
While it is nice that the revenues from Wireless contracts are stable and recurring, the additional increase in the revenue from data suggests two points: (1) further revenue growth measured by ARPU (average revenue per user) because, once a user have a smart phone, they have to pay for data usage; and therefore (2) increased probability of recurrent revenue -- due to the fact that people will form habits around data usage, just as they do with other activities. This is to say, the more data, the more revenue -- and I'd bet that revenue recurs.
One can see the wireless segment operating results below. They represent about 63% of Consolidated Revenue:
As noted by Vodafone, cell phones are not considered luxury items anymore; they are as important as air conditioning. With time, the same might be said of smartphones. The distribution of income across a huge quantity of contracts allows for a bedrock of stability -- or as Vodafone put it, "These revenue models give us excellent visibility of [the] business."
Besides these obvious advantages, Verizon Wireless ranks the highest in customer satisfaction of all the telecom companies (according to JD Power and Associates).
Some Notes About Cash Flow
Free-cash-flow (FCF) is a better -- less "touched up" -- version of earnings. For countless reasons -- such as consolidation, accrual, and imperfections in depreciation -- it provides a more accurate picture of the operations of a going concern than GAAP earnings. When looking at FCF for the purpose of article writing, I generally use the following definition:
FCF = Operating Cash Flow - Capital Expenditures
There are other, better, definitions where one adjusts certain expenses out of the net income figure to arrive at the "free-cash flow" figure. For articles, however, that is too complex to explain and frequently the differences are too small to justify -- particularly if they tell the same story.
This formula works well most the time. In Verizon's case, however, we need to take into account the consolidation process, otherwise we will not get a representative FCF figure. For instance, in its 2011 10-K, their cash from operations line and capital expenditure line look as follows:
The above indicates that their consolidated FCF is about $13,536 million. But these are consolidated numbers, meaning they include income attributable to other parties besides common stock shareholders. Given that this is written for current or prospective Verizon stock holders, what percentage of that $13.5 billion is attributable to common shareholders?
If that total was attributable to the common equity, Verizon shares would be undervalued -- and furthermore, their dividend would be well protected given that $5.5 billion was paid out in 2011. It is seems that other a couple other authors on this site got this far and quit, assuming that the dividend was perfectly safe.
So of the $13.5 billion in FCF, about $5.5 billion was sent immediately to common shareholders -- or, rather, about 40% of the total consolidated FCF was paid out to equity holders.
But, of its consolidated earnings, only 23.5% of their income was attributable to shareholders. Therefore, the question becomes how safe is Verizon's dividend given that a portion of its free-cash flow legally belongs to other parties -- namely, Vodafone?
The most recent financial statements of Cellco Partnerships (i.e., "Verizon Wireless") can be found here. It ceased filing with the SEC on Dec. 3, 2010. Since 2010 is our most recent year with available data, let us look at that year as an example.
In 2010, Verizon Communications had consolidated cash from operations of $33.3 billion. That includes the consolidated Cellco Partnership, which had about $25.5 billion in cash from operations according to its documents cited above. Using free-cash flow:
- Consolidated Verizon FCF: $16,905 million
- Cellco Partnership FCF: $17,109 million
- Vodafone's interest in Cellco's FCF: $7,699 million
Verizon Communication shareholders' approximate claim to consolidated FCF:
- $16,905 - $7,699 = $9,206
This is to say that approximately $9.2 billion dollars of Verizon Communications consolidated FCF is was available to Verizon Communication shareholders in 2010. It is just a coincidence that Vodafone's portion of free-cash flow is nearly equal to its portion of consolidated GAAP earnings -- but it's a useful shortcut that I'll use next.
Given that 2012 consolidated Verizon Communications FCF was approximately $13.5 billion, and assuming that GAAP earnings are a good approximation of FCF, then with Vodafone's proportionate share at about $7.8 billion, Verizon Communications has about $5.7 billion in FCF that it can distribute to common shareholders. Here is the math again:
- Verizon Communications Consolidated FCF is $13.5 billion
- Less: Vodafone's portion of Verizon Wireless earnings of $7.8 billion
- $13.5 - $7.8 ~= $5.7 billion in FCF available for Verizon stockholders
Presently, it pays out about $5.4 billion -- $300 million of wiggle room is not much for a corporation doing $110.8 billion in sales. That being said, management -- speaking through Shammo -- is determined to maintain the dividend:
…our dividend policy is extremely important to us, and Lowell and I have said very strongly that we will continue to the policy of our dividend. (Q1 earnings conference call)
Also, Verizon indicates that capital expenditures can be slowed down, if there was any need of cash flow.
Valuation and Conclusion
Verizon's P/E ratio hints at overvaluation. With FCF attributable to Verizon Communication shareholders at about $5.7 billion for last fiscal year, its P/FCF is about 21.7.
For some that might still be a little pricey but given the overall position of the company the current valuation is not unjustified. It is the market leader in one of the richest countries of the world; it experiences low political risk; there are regulatory barriers to entry; there possibly is an argument to make that it hasn't needed to pay dividends to Vodafone much, thereby leaving more cash in the coffers; and not to mention all those features within a society where cell phones are no longer a want, but a need.
Verizon's dividend only has limited room for growth in the short term, but its dividend -- and market position -- is protected overall. There will be further dividend increases, but they are most likely to be similar to the small dividend increase last week.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.