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We previously published our report analyzing AT&T's (T) ability to pay its dividends to shareholders. We are aware of how dividends are not an ordinary and necessary business expense, which explains why such payments are not tax-deductible to the dividend-paying businesses. At the same time, dividend-paying companies have an implicit obligation to shareholders to pay dividends because such cash flows belong to the shareholders. If the company can't invest said cash flows in projects that meet or exceed the cost of equity capital, and if the company is not facing a 1929 or 2008 macroeconomic shock, then it is duty-bound to return those cash flows to shareholders. Based on the positive reception from our report evaluating AT&T's dividend-paying ability, we have decided to analyze and evaluate AT&T's former subsidiary and current competitive peer Verizon Communications (VZ).

We have seen that the telecom industry's legacy wireline business is in a mature and declining industry phase and we are starting to see signs of maturity from the wireless communications segment as well. Signs of maturity we are seeing from the wireless communications segment include decelerating revenue growth, reduced numbers of new subscribers and year-over-year reductions in capital expenditures. While this may not be the kind of news that growth investors who are primarily seeking capital appreciation want to hear, this is great news for income-oriented investors because we expect such trends to prompt companies to increase the proportion of free cash flows returned to investors in the form of dividends and share repurchases.

We saw this with AT&T this year as it has repurchased $4.25B in net share repurchases in the first six months of 2012, whereas last year it was saving its cash in order to help finance the proposed $39B cash acquisition of T-Mobile USA from Deutsch Telekom. Verizon did not repurchase any shares; however, it made a special $10B dividend distribution from its 55% majority owned subsidiary Verizon Wireless to Verizon Communications in January. 45% of that dividend ($4.5B) was paid to Verizon Wireless's 45% Minority Owner Vodafone (VOD). This dividend was declared last July by the board of Verizon Wireless and it was the first dividend declaration after a five-year hiatus on dividends from Verizon Wireless to Verizon Communications and Vodafone. Verizon also recently increased its dividend by a whopping 3% to $2.06/share annualized.

Verizon's Dividends and its Debt Position: With $52.4B in outstanding debt as of Q2 2012, Verizon is most certainly not debt free. However, we are more than aware of the fact that Verizon is the US's leading mobile communications services firm and is certainly able to access the capital markets for whatever debt or equity it requires. Verizon paid $1.4B in interest expenses in the first half of 2012 on its $52.4B in outstanding debt for a weighted average cost of 5.53%. While Verizon's growth engine Verizon Wireless is seeing its growth decelerate, we believe that the free cash flows generated by Verizon can be utilized at a rate of return well in excess of the 5.53% pre-tax (3.32% post-tax) cost of debt financing that Verizon utilizes. If Verizon can't find investment opportunities that provide a return in excess of 5.53% pre-tax, it should be returning that cash to shareholders in the form of dividends and repurchases. Plus if Verizon wanted to devote all of its operating cash flows to paying down debt (at the expense of reinvesting in its network or returning excess cash flows to investors), it could pay it off completely in less than two years due to its ability to generate $30B in operating cash flows annually since it acquired Alltel Wireless in 2009. We can conclude that Verizon generates enough cash based on its $30B in operating cash flows to service its outstanding indebtedness and to continue returning cash to shareholders through dividends and share repurchases. This includes any distributions from the Verizon Wireless business, 45% of which goes to Vodafone.

Source: Morningstar Direct

Verizon's Dividends and its Free Cash Flows: Verizon generates an average of $30B in operating cash flows annually and spends between $15B and $17.5B annually on capital expenditures. This results in annual free cash flows of between $12.5B to $15B, which can be returned to capital stakeholders in the form of debt redemptions, share repurchases and dividends. In the past 12 months, Verizon generated nearly $17B of free cash flows and paid $9.9B in dividends to shareholders (including $4.5B to Vodafone). We can see that Verizon's trailing twelve months free cash flows exceeded its dividend payments in the same period by 77% and Verizon still had $7.5B remaining to use for dividends and share repurchases during this time period. Verizon did not repurchase any shares and it issued $329M in new shares for various employee stock compensation programs during this time period. We also noticed that Verizon had steadily reduced its capital expenditures since 2007. During this time period, Verizon's annual CapEx has declined from $17.5B in 2007 to $14.8B in the last 12 months ending June 30, 2012, and we believe that Verizon Wireless' decelerating growth rates will result in Verizon's CapEx budget remaining flat, regardless of how AT&T and Verizon both protest about its low levels of network capacity.

Verizon's Dividends and its (Equity) Capital Position: Verizon generates an average of $12.5B-$15B annually in free cash flows and also pays about $2.8B estimated annualized bond interest expense. The company has $52.4B in outstanding debt, $37.15B in shareholders' equity attributed to Verizon Communications and $53.3B in Minority Interest in Verizon Wireless payable to Vodafone. Part of Verizon's book value is influenced by the $29.2B worth of goodwill and intangible assets on Verizon's balance sheet. We can see that Verizon Communications generates a pre-tax return on invested capital of 9.5% for 2012. If we included the Minority Interest expense and Minority Interest Payable for Vodafone's share of Verizon Wireless, Verizon would have generated an 11.7% pre-tax ROIC. We can see that Verizon has a solid capital base and generates adequate returns on invested capital in order to pay bond interest and dividends without needing severely dilutive secondary stock offerings. We expect that if the company cannot earn double-digit returns on invested capital with regards to its free cash flows, it is duty bound to return the excess cash flows to shareholders through dividends and share repurchases. Otherwise, it is likely to follow AT&T's lead in blowing $4B by bidding for broken-growth companies like T-Mobile USA.

Verizon's Dividend Yield relative to AT&T, Vodafone, S&P 500 and Barclays U.S. Aggregate: While Verizon's dividend yield of 4.59% is much lower than the 5.4% it saw in April, we can see that it certainly exceeds the 1.91% dividend yield of the S&P 500. Part of the reason why Verizon's dividend yield has moved down this year is because of the demand for any little bit of income from high-quality investments on the part of investors. Verizon's dividend yield of 4.59% also significantly exceeds the 2.35% annual yield on the iShares Barclays (U.S.) Aggregate Bond Exchange Traded Fund (AGG). While an equity investment in Verizon, AT&T or Vodafone carries more ostensible risk than investing in bonds, we believe that an investment in the trio of telecoms offers a superior risk-adjusted and tax-adjusted return prospect than the Barclays Aggregate ETF. With regards to taxes, investors outside of tax-advantaged investments accounts only have to pay a maximum tax rate of 15% on their dividends from Verizon, AT&T or the S&P 500 versus ordinary income tax rates of up to 35% on their interest income distributions from the Barclays Aggregate ETF. Investors have to pay the 35% tax rate on Vodafone because it is a foreign company not eligible for the qualifying dividends on American securities treatment. Plus we believe that the Barclays Aggregate ETF carries significant interest rate risk due to the rapidly increasing national debt. We are well aware that the Federal Reserve is holding down interest rates with its monetary easing program; however, even notable investors like Bill Gross have tried their hand at shorting T-Bonds. While we cannot predict a tipping point for if and or when interest rates will increase, we believe that 2.35% is too low a return prospect, especially when it is subject to ordinary income tax rates.

Source: Morningstar Direct

In conclusion, we can't argue with yield hungry investors who have a long position in Verizon. While Verizon is not our first choice with regards to investing in the telecom sector, we are more than aware that it is an industry leader in this industry. We can see that Verizon is able to generate a return on equity well in excess of its direct cost of debt capital and its indirect cost of equity capital and because its wireless communications business is now seeing the deceleration to growth that has already hit its old, traditional wireline business, we believe that the company will continue to pay a dividend yield that is well above what the S&P 500 pays. Verizon and its predecessor Bell Atlantic have been paying dividends since 1984 and have steadily increased or maintained its split-adjusted dividend in that time. Based on the low-interest rates on bonds, as well as the risk of interest rates increasing once the Federal Reserve ends its ridiculous monetary easing programs, we believe that Verizon offers a better risk/return prospect for income-oriented investors versus typical high-grade bonds.

Source: Verizon Dividend History

Source: Our Evaluation Of Verizon's Ability To Pay Its Dividend

Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.