There is often a battle on Wall Street between the short-term and the long-term. How long should investors wait for growth? How much time do companies get to turn things around? These are questions for which there is no one correct answer. Recently, AT&T (T) and Verizon (VZ), the 2 largest wireless carriers in the United States, were placed in the middle of such a debate. And it is one that we believe sets up a buying opportunity for long-term, dividend-oriented investors.
On Friday, September 15, Stifel Nicolaus cut its ratings on both AT&T and Verizon. In its downgrade, Stifel argued that, "while we continue to believe both Verizon and AT&T will dominate the U.S. telecommunications sector, with market share gains in wireless growing ever wider, we also believe that given current valuation levels, the two mega-caps could be used as a near-term source of funds for investors as EPS numbers get adjusted because of a strong iPhone 5 launch and as the QE3/risk-on trade becomes more prevalent." While we admit that margins may come under pressure in the short term due to a wave of upgrades at both AT&T and Verizon, it is exactly what is needed to ensure the long-term success of both companies. Friday was a positive day for most of the market, yet AT&T and Verizon both fell over 2% due to this downgrade. We, however, believe that long-term investors should see Friday's 2%+ drop in America's largest wireless companies as buying opportunities, and we lay out the case for doing so below.
The Past-Year's Performance is Not Indicative of the Long-Term Trend
AT&T and Verizon have had banner a solid run over the last 12 months, with AT&T rising over 35%, and Verizon rising over 24%, compared to a 24% rally in the S&P 500.
(click to enlarge)But, the past year has been a market where unconventional policy has driven down yields across a variety of asset classes, which has driven people to dividend stalwarts such as AT&T and Verizon. Yet, if we turn the clock back 30 years, we will see that the long-term trend is for both AT&T and Verizon to rise and fall alongside the market, but with lower volatility, as well as lower capital appreciation.
(click to enlarge)Both AT&T and Verizon have delivered decent capital appreciation over the past 29 years. But both lagged the S&P 500. That is to be expected. After all, telecommunications is not a sector that is filled with growth. But it is a sector filled with stability, as well as dividends, something that this chart fails to take into account. As of Friday's close, AT&T yields 4.7234%, while Verizon yields 4.5812%.
Frankly, it is rare to see companies with AT&T and Verizon's growth and dividend profile have double digit rallies within the span of a year. But these are no ordinary markets. And while some may think that the rally that these 2 companies have seen over the past year makes them overvalued, we believe that both AT&T and Verizon still have plenty to offer investors.
Valuations: More than Meets the Eye
The current consensus estimates for 2012 call for AT&T to earn $2.40 per share, and for Verizon to earn $2.49 per share.
(click to enlarge)(click to enlarge)Based on consensus estimates, AT&T trades for 15.525x 2012 earnings, and Verizon trades for 17.884x 2012 earnings. While that may seem expensive, given the projected growth rates for 2013 of just 7.0833% for AT&T and 13.253% for Verizon, simply taking growth and P/E into account is the wrong way to value these stocks. We believe that the PEGY ratio (price-to-earnings-to-growth-to-dividend yield) is a far better way to value AT&T and Verizon, for it takes into account the primary reason most investors buy shares of these 2 companies.
Utilizing these companies' 2012 P/E ratios, dividend yields, and 2013 growth rates, we arrive at a PEGY ratio of 1.32 for AT&T and of 1 for Verizon (readers can calculate their own PEGY ratios here). In general, ratios of 2-3 are considered adequate, and anything below 1 is considered undervalued. A stock with a ratio of between 1-2 is also a good buy, although certainly not as good as a stock with a ratio below 1. That being said, there is a case to be made that AT&T and Verizon deserve a premium PEGY ratio, given their solid track record of dividend increases.
Stifel's Downgrade: Forgetting the Long-Term and Who Owns These Companies
In its downgrade, Stifel cut its 2012 and 2013 earnings estimates for both AT&T and Verizon, due to wireless margin pressure related to the iPhone 5 upgrade cycle. For AT&T, 2012/2013 EPS was cut to $2.34/$2.58, down from $2.44/$2.68 (interestingly, Stifel is still above consensus for AT&T's 2013 earnings, even after this estimate cut). For Verizon, 2012/2013 EPS estimates were cut to $2.45/$2.78, from $2.51/$2.81. We are not disputing that earnings and margins may be pressured in the short-term due to the iPhone 5 upgrade cycle. But, what we dispute is that this will matter in the long-term. Smartphone users, especially iPhone users, come with higher revenues than feature phone users, and a migration to smartphones, especially iPhones, will benefit both AT&T and Verizon in the long run, for it will lead to higher cash flows, which can then be used to both continue growing the dividend, as well as invest in their networks.
We believe that Stifel is forgetting to take into account the investor base of these 2 companies. In general, people do not invest in AT&T and Verizon with the expectation that they will post stellar growth. They invest with the expectation that AT&T and Verizon will continue to raise their dividends for many years to come, and for the relative stability that these stocks bring (Verizon has a beta of 0.5, and AT&T has a beta of 0.57). And higher smartphone utilization is what these companies need to continue raising their dividends. In our view, what matters more to the investors of these companies is their dividend. While earnings certainly do matter, short-term fluctuations in earnings are not that relevant to the AT&T and Verizon "story." At the end of Q2 2012, 61.9% of AT&T's postpaid customers used smartphones, and their ARPU was twice that of feature phone users. For Verizon, 50% of their postpaid customers used smartphones at the end of Q2, and postpaid ARPU grew 3.7% to $56.13 (Verizon's financials do not breakdown smartphone vs. feature phone ARPU). These ARPU gains drive cash flow, which in our view is far more important in the long-term than earnings per share. If AT&T and Verizon do not have the cash needed to invest in their networks, fund pension plans, and service their debt, then their dividends will be at risk, something we believe is far more serious than wireless margin pressure.
We believe that Stifel Nicolaus' downgrade of AT&T and Verizon should be seen as a buying opportunity for investors who want to own stocks with proven track records of paying and raising dividends. While earnings may indeed come under pressure as subscribers upgrade to the iPhone 5, it is what is needed in the long-term to ensure continued dividend growth. AT&T and Verizon have proven that they can provide a reliable income stream for their investors, and in the long-term, higher smartphone usage will help solidify their ability to not only maintain, but also grow that income stream.