Verizon Communications (VZ) has been one of the favorite stocks of dividend investors. It does offer an attractive dividend yield of 4.5%. However, the stock has rallied more than 14% this year and currently trades near its 52 week highs. It is trading at expensive valuations when compared against its historical average as well as its peers. The patent wars will also erode earnings and there is a big risk of margin erosion because of higher smartphone sales. We recommend that investors should wait for the price to correct in order to lock in even a higher dividend yield.
Verizon has agreed to pay over $250 million to settle its ongoing patent dispute with Tivo Inc (TIVO). TiVo, through its DVR set-up boxes, provides software and technology that enables searching and accessing content through various sources, including television and broadband video. The dispute between TiVo and VZ was over Verizon's FiOS TV features that contribute significantly to the company's wireline revenues. For the quarter ending on June 30, 2012, Verizon reported a total of 4.5 million FiOS TV connections, which was a 15% improvement over the same quarter of the previous year. The popularity of its FiOS services can be judged from the fact that it accounted for approximately 65% of the company's wireline revenues. TiVo claimed that VZ infringed on three patents, one of which was the time-warp program that allows users to store television programs, while they simultaneously watch other programs.
The settlement includes a $100 million initial cash payment, with the rest of the amount to be paid in quarterly installments until July 2018. On top of that, VZ will also be required to pay TiVo a monthly license fee for every DVR customer. TiVo reached a similar kind of agreement with AT&T (T) in January over patent infringements, which set AT&T back by over $200 million. A ruling against Verizon in the trial could have meant the possible suspension of its FiOS TV services, which, as mentioned before, is a major wireline revenue contributor for the company. It would have been a significant blow to the company, which is already struggling from a weakening wireless business, like most other telecom operators. Therefore, the settlement is likely in the interest of VZ as it was being expected that it would lose the lawsuit, for which both companies were scheduled to go to trial in a few days time.
Previously, Verizon had a dispute with a cloud TV company, ActiveVideo Networks Inc., over patent infringement. ActiveVideo had filed a lawsuit against VZ claiming that the company's FiOS TV infringed four of its patents, including its video on demand services. The U.S. Court of Appeals decreed that VZ pay royalties to ActiveVideo of $2.74 per month for each of its FiOS TV subscribers, along with $115 million in damages for patent infringement. In addition to the sum of $260 million, VZ also agreed to pay an unspecified amount to end the patent fight with ActiveVideo.
In last quarter's earnings announcement, VZ announced that it was on track for double digit percentage growth in its full year earnings. However, after its recent patent wars, the company may have to revise its earnings forecast. This may hurt its stock price, which is currently trading close to a 52-week high.
Even though VZ has produced sound results across both its segments in the recently concluded quarter, its FiOS customer additions were weaker than expected, and it has already revised its estimates down for FiOS TV growth. Moreover, we will have to wait and see what effect the launch of the iPhone 5 is going to have on the company's margins. Verizon, under the terms of agreement with Apple, is paying billions to be able to offer the phone to its customers at a competitive price. It is estimated that Verizon will be paying almost $650 for the phone while offering it to its customers for only $200. Even though the company will be able to recover these costs over a longer period of time through increased data usage, the subsidies will have a dampening effect on its margins in the short term and since the iPhone 5 has gone on sale in the later half of the year, estimates for earnings might have to be revised down. To add to the worries of telecom companies including Verizon are the reports that Samsung flagship smartphone Galaxy S3, which carries the same amount of subsidies, is also selling like hot cakes. Already, some analysts have cut their estimates on AT&T and Verizon based on the margin erosion caused by selling these smartphones. The latest estimate cut came from Stifel Nicolaus, expecting Verizon's earnings per share to drop by 6 cents.
VZ is trading around its 52-week high of $46 and it is overvalued based on all its multiples compared to historic averages as well as multiples for its rivals Sprint (S) and AT&T. VZ trades at almost 16 times its forward earnings which is a significant premium to its historic average of 12x. Price to sales of 1.12x is also higher than sprint's 0.4x. Based on its valuation, we believe there is limited upside potential for VZ.