Verizon's Margins Improve As Postpaid Net Adds Surprise On The Upside

| About: Verizon Communications (VZ)

Verizon (NYSE:VZ) posted yet another set of strong Q3 2012 results on Oct. 18. The largest wireless carrier in the U.S. reported a healthy 4% year-over-year growth in revenues, bolstered by a strong adoption of smartphones and its newly launched Share Everything data plans. More importantly, however, the carrier was able to grow its operating income by more than 18% as wireless EBITDA margins improved on effective management of subsidies and other expenses. Despite a saturated wireless market, Verizon was able to add 1.5 million postpaid connections in the quarter, the highest it has reported in four years. Meanwhile, LTE adoption continued to rise as Verizon leveraged its LTE coverage lead over AT&T (NYSE:T) and Sprint (NYSE:S) to good effect.

We are in the process of updating our price estimate for Verizon’s stock based on the recent earnings.

ARPU Rises on Growing Smartphone Penetration

The biggest surprise that Verizon sprung this earnings call was the number of postpaid subscribers it managed to add during the quarter. Despite a saturated wireless market, where Verizon has added fewer postpaid subscribers year over year so far this year, the carrier managed to post its best quarter in terms of postpaid net adds in four years. Verizon said that it added more than 1.5 million net postpaid subscribers in Q3, around 74% more than the same period last year. While the figure may have been bolstered by a growing number of tablet sales, we think Verizon may have also taken market share from ailing competitors such as T-Mobile.

In addition to acquiring new postpaid subscribers, Verizon also managed to convert more of its existing base to the higher ARPU-yielding smartphones. Verizon said that about 79% of all retail postpaid phone sales this quarter were smartphones with 44% of those upgrading being first time smartphone buyers. This helped increase its smartphone penetration within the postpaid subscriber base to more than 53%, up from 50% at the end of the second quarter of 2012. Increasing smartphone penetration helped drive postpaid ARPA, as smartphone users are usually heavy data users as well. Verizon's postpaid ARPA (average revenue per account) grew 6.5% over the same period last year.

Smartphone sales may increase postpaid subscriber additions and bring in juicy data revenues, but they are also very expensive due to the huge subsidies that carriers provide in return for long-term contract plans. For example, a basic model of iPhone 4S costs around $650 for carriers who then subsidize it heavily to sell the handset for $199. However, Verizon has been able to manage its expenses well, driving operational efficiency through initiatives such as the $36 upgrade fee and the sale of tablets such as the new iPad at unsubsidized rates (see "Verizon Introduces Smartphone Upgrade Fee; Looking For iPhone Subsidy Relief"). Wireless EBITDA margins saw a year-over-year rise of 220 basis points to a record high 50% this quarter.

Share Everything Plans

A slowdown in subscriber growth has caused Verizon to explore new growth areas in other non-smartphone connected devices such as M2M, telematics, tablets, and e-readers. The carrier recently acquired Hughes Telematics to further its connected device ambitions (see "Verizon Picks Up Hughes Telematics For Connected Devices Push"). The recent launch of multidevice data share plans called the Share Everything plans was also done to get users to add more of these connected devices to the carrier's wireless network. While this might decrease the average revenue per device seeing as these connected data-only devices consume much less data, as users connect more devices to the wireless network, Verizon will be able to draw more revenues from each individual subscriber. Moreover, since their data consumption is low, it will help shore up the service margins for Verizon.

The focus on margins is also evident from the fact that Verizon has prohibited its unlimited plan users from availing smartphone subsidies in case they want to continue using their plans (see "Verizon’s Share Everything Plans Could Kill The Last Unlimited Plans"). This, we believe, is a step in the right direction since it will help Verizon more efficiently manage network resources that are not exactly unlimited in nature and monetize every bit of data transferred through its pipes. Despite the hue and cry over the supposedly complicated nature of pricing that the shared data plans have, 13 % of Verizon's postpaid base, or almost 12 million subscribers have already switched to one of these plans.

LTE Adoption Rises Steadily

Verizon also saw LTE adoption rates increase this quarter with both LTE smartphones as well as LTE Internet devices seeing a good uptick in volumes. The company sold about 3.7 million 4G LTE smartphones this quarter, which is about 50% more than it did in the first quarter. This increased LTE adoption at the end of Q2 to 16.5% of its postpaid subscriber base, up from about 12% last quarter. LTE adoption seems to be gradually picking up, and with the iPhone 5′s recent launch, Verizon should be able to market its industry-leading LTE coverage better and drive LTE adoption rates up further.

Increased adoption of 4G will reduce dependence on Verizon's 3G networks, which are under great strain due to heavy data usage by smartphone users. Also, LTE as a network technology not only supports higher speeds but is also more efficient than the current 3G networks at handling data, thereby improving margins by reducing maintenance and handling costs. It is therefore a good sign that almost 35% of Verizon's data traffic is on its 4G LTE network already. As more people switch to 4G LTE-compatible smartphones, the higher LTE speeds will see subscribers increasingly use data-intensive applications on their smartphones. This will drive data revenues, thereby increasing ARPU levels for Verizon over the coming years.

Disclosure: No positions.