Verizon: Are Big Gains Ahead For The Big Red V?

| About: Verizon Communications (VZ)
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Anyone even remotely familiar with downloading videos through their mobile device knows about Verizon (NYSE:VZ). They may not actually use Verizon's LTE service, but they want the incredible speeds that make watching videos and downloading media-rich content a breeze.

It isn't surprising, therefore, that Verizon's stock continues to motor ahead. In the year thus far, it has gained 19.3%, compared with an 11.7% return for the S&P 500 and 13.4% for the Dow Jones Industrial Average.

This is actually a little surprising given that Verizon missed analysts' fourth quarter 2012 consensus earnings estimate by 10%. Those looking for the full Q4 earnings release can find it here. Digging a little deeper into the numbers is much more encouraging. On April 17, Verizon is expected to post earnings of 66-cents a share - about 12% higher than its level a year ago and, for the whole year, Verizon is expected to have earned $2.77 per share. That's 20% higher than it earned in 2012%.

In that sense, the nearly 20% gain in Verizon's stock is driven by optimism regarding its future prospects; its run-up is justifiable only in the context of its expected earnings. That said, if the company is already fairly valuable in the context of its current year's earnings, is there still a case for buying the stock?

Let's consider the following:

1. Future Prospects. Verizon is actually expected to earn close to 14% more in 2014 than it will this year. That's on the back of 3.6% revenue growth after registering an expected 4.2% revenue growth rate this year.

Forward earnings tend to be noisy as analysts prefer to hedge their forecasts given the uncertainty, but the fact that Verizon is expected to see double-digit EPS in the next 20 months should be encouraging for potential investors.

What's more impressive is the fact that Verizon is expected to grow by this much considering that the wireless industry, as a whole, has seen an average annual revenue growth of just 3.7% over the past 5 years.

Also, Verizon's EPS growth has consistently outpaced its revenue growth despite the fact that it has continued to deploy considerable capital (an average of $16 billion each year over the past three) to expand its LTE network.

This is largely a result of two things. First, broad smartphone adoption in the U.S. There are estimated to be 137.5 million smartphones in 2013 - roughly 5 of every 9 Americans will have one by year-end. Second is Verizon's prescient tiered consumer pricing plans which allows it to take advantage of these data-hungry devices. It should also be noted that the larger screens of mobile devices these days means that data usage will increase even if nothing else changes other than screen-size - larger screens require more bandwidth to stream high-definition content.

As a consequence, Verizon's Average Revenue Per Account (or ARPA; Verizon's version of ARPU) grew by 9.5% in 2012 and 6.6% in the fourth quarter, versus negative 2% ARPU growth for the industry.

Verizon's ARPA (or ARPU) growth will probably remain stable for the next few years. To wit, the company has revealed that video makes up half of its network traffic at present. That number should grow to two-thirds by 2017.

What this means for investors is that Verizon's industry-beating gross margins of 60% (versus 58%) is likely to persist for some time.

2. Financial Sustainability. Verizon's ability to lead the industry depends in large part on its ability to keep rolling-out its LTE network. Absent this, challengers such as Sprint (NYSE:S) and T-Mobile could take market share away from it.

In this regard, investors should take note that Verizon is not particularly over-leveraged. Specifically, its current long-term debt-to-equity ratio is at 1.4x versus around 1.1x for its industry. While that seems higher, it ought to be noted that Verizon has continued to expand so it should surprise no one that it has taken on more debt financing.

Moreover, other financial strength indicators are favorable. To wit, its quick ratio of 0.6 is right in line with that of the wireless industry (though lower than the average S&P 500 company's 1.1 - but that is skewed by large companies such as Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), which have tremendous cash reserves). Meanwhile, Verizon actually has a far better interest coverage ratio (4.8x) versus the wireless industry (3.3x). Implicitly, given Verizon's higher-than-average leverage and industry-average liquidity, this means that Verizon's debt is cheaper - and it would only be cheaper if the buyers of its credit judged its credit to be robust.

The question, however, is whether Verizon can continue to finance itself at such cheap levels. Certainly, the economic environment supports much lower financing rates than they did just five years ago, but the main concern is whether Verizon's need to expand its network will eventually lead it to take in more debt than is prudent.

3. Valuation. Clearly, Verizon's forward prospects are good - but is the stock too expensive at this time?

It's a little complicated: Verizon's trailing EPS makes its current P/E of 164x look absolutely irrational but on a forward P/E basis, it is only trading at 16x earnings - that's not considerably higher than the S&P 500's forward P/E of 14x and would actually be less than half that of the wireless industry's 39x P/E.

At the same time, the S&P 500 earnings growth rate for 2013 is estimated to be at roughly 13% -- that trails Verizon's 20% EPS growth estimate for 2013 so a bit of a forward earnings premium is to be expected. What's more, Verizon's dividend yield of 4.2% is double that of the S&P 500 so it is relatively more valuable from that perspective as well.

In short, given Verizon's forward earnings prospects and its current dividend yield, it's hard to argue that its stock is especially overvalued relative to the benchmark or its peers.


Overall, it appears that Verizon's future prospects are solid: its earnings growth is assured by still growing demand for very fast data connections and it is only limited by its ability to deploy its LTE networks fast enough.

That being said, Verizon is still coming off a relatively weak year and we've yet to actually see what Verizon's 2013 results will look like, coming as it did from an earnings miss. In our view, Verizon can't afford to miss estimates - it's essentially priced as though it will meet them.

As such, while we like Verizon, we would not be buyers of the stock at current levels but would instead prefer to wait until the company reports earnings. Outside of very strong numbers, we believe it would be wise for investors to avoid the stock until after earnings, as there could be bit of a selloff in the event that it only met expectations.

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

Business relationship disclosure: Black Coral Research is a team of writers who provide unique perspective to help inspire investors. This article was written Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Black Coral Research is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.