Verizon's Margins Stood The Test, AT&T's Didn't

Includes: AAPL, S, T, VZ
by: Bidness Etc

Verizon (NYSE:VZ) reported its third quarter earnings a few days back, reporting earnings per share of 56 cents, an improvement of almost 15% over the third quarter of the previous year. Despite the 10% drop in wireline revenues, the company's wireless segment showed good growth and compensated for the decline, largely through its share everything plan and higher bills on smartphone usage. The major concern regarding Verizon's earnings release was the fact that Apple Inc. (NASDAQ:AAPL) launched its flagship iPhone5 sooner than expected, perhaps due to the fear of losing market share to Samsung. Selling smartphones comes with costs to telecom carriers as they have to subsidize the phones to lure customers to their networks, and those costs have a direct impact on their margins. Even though telecom carriers that carried the iphone5 were faced with a shorter selling period in the third quarter, there remained concerns of margin erosion with regards to companies such as AT&T and Verizon, as they have historically sold the highest number of iPhones in the US market. AT&T sold a total of 3.7 million iPhones in Q2 2012, around a million more than what Verizon managed to sell in the same quarter.

As mentioned previously, Verizon and AT&T (NYSE:T) sell the most iPhones compared to other telecom carriers. Verizon sold 6.8 million smartphones in Q3 2012, which includes 3.1 million iPhones and 650,000 iPhone 5s. The company was initially expecting to sell more, but it was not able to do so because of supply constraints. What is interesting is that despite selling around a million more smartphones in the current quarter compared to the previous one, the company's wireless EBITDA service margin expanded only slightly, to 50%. Perhaps, one of the reasons for this expansion, instead of erosion in margins, is the fact that people held off on their iPhone purchases because of the anticipated iPhone 5 launch. Another reason was the company's recent policies on high upgrade fees as well as increasing the length of upgrade period. Then of course, the share everything plan, in which the company enables its customers to connect more than one device under the one data plan, proved to be very fruitful for the company in the third quarter as it brought in more revenues than any other plan.

After AT&T reported its quarterly results last week, the focus, once again, was on the company's wireless margins and whether or not the iPhone 5 will affect its earnings in the third quarter by increasing its subsidy costs. As expected, the company sold the highest number of iPhones once again, as it has historically done so. It sold 6.1 million smartphones in the quarter, which is a million more than what it managed to sell in Q2 2012. Out of the 6.1 million smartphones, 4.7 million were iPhones. However, unlike Verizon, AT&T suffered from margin erosion because it sold more iPhones in the quarter. It was widely expected, especially after Verizon reported a slight increase in its wireless service EBTIDA margins, that AT&T would follow suit because of a shorter selling period for iPhone 5. However, AT&T surprised everyone by reporting a drop in EBITDA service margin of 40.8%, compared to 43.7% in Q3 2012.

Both AT&T and Verizon are favorite stocks of those investors who are looking for dividend yield. T offers a dividend yield of 5% which is higher than VZ's 4.6%. Both the stocks are attractive from a dividend perspective as their dividends are backed by strong cash flows and the business models are strong enough to keep generating enough cash to meet the shareholder distributions. However, both the stocks are trading at expensive valuations when compared to historical levels. The slow growth environment along with expensive valuations don't make them buys for investors looking for capital appreciation.

Sprint Nextel Corp. (NYSE:S) is another telecom operator that recently announced its results. For sprint, margin erosion was not so much a concern as for its bigger rivals; rather, the emphasis was on its overall customer base. Another important element of its earnings release was its Nextel network recapture rate. In the past few quarters, the recapture rate has increased significantly, which signals that the company has been successful in attracting those customers that were leaving its Nextel network in favor of its upgraded network. In the second quarter, Sprint reported a recapture rate of 60%, which was significantly higher (25%) than the one reported for Q2 2011. The company has scored well on both counts i.e customer base as well as recapture rate. The company added 410,000 postpaid subscribers, which is significantly higher than last year's same quarter additions of 265,000. The major reason behind this impressive increase was the fact that the company had just recently started selling the iPhone, which wasn't part of its product portfolio last year. Sprint reported a recapture rate of 59% in the quarter, which is impressive considering that it was only 27% in the third quarter of the previous year.

Sprint's shares have more than doubled in the current year. A number of factors have helped achieve that boost. The market is putting faith in its network vision program, which is well on track to give the company operational and financial synergies. Moreover, we are of the opinion that the recent deal between Japan based Softbank and Sprint will prove extremely beneficial for the latter because it would open doors for the company to compete more aggressively with its bigger rivals. The stock is trading at cheap valuations when compared to its rivals and we think its turnaround is on track. Therefore, we recommend investors to take a long position in the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Telecom Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.