According to Berkshire Hathaway's (BRK.B & BRK.A) latest Form 13-F, the holding company had invested about $524 million in Verizon (NYSE:VZ) as of March 31, 2014. While this investment seems to be a substantial amount, it is relatively small relative to Berkshire's entire equity portfolio, which was worth around $106 billion as of March 31, 2014.
Warren Buffett normally handles Berkshire's large investments and business acquisitions that are worth billions. Hence, his two investment managers, Todd Combs and Ted Weschler, who handle smaller investments, were likely the ones who invested in Verizon. Regardless of who invested in Verizon, the million dollar questions are: 1) why did Berkshire invest in Verizon and 2) should you invest in Verizon.
Why Berkshire Hathaway Invested in Verizon
Berkshire's equity portfolio largely consists of dividend paying stocks that have 1) good long-term prospects, 2) increasing dividends, 3) wide economic moats, and 4) trustworthy management teams. For example, Berkshire's top seven holdings (see image below) meet all of the investment criteria above. Buffett handpicked Berkshire's largest equity investments, and the top seven holdings make up 74% of Berkshire's $106 billion portfolio.
Source: Berkshire's Form 13-F, March 31, 2014.
While Verizon makes up only about 0.5% of Berkshire's entire stock portfolio, I believe Berkshire invested in the stock because it met all of the investment criteria that I stated above (good long-term prospects, increasing dividends, wide economic moats and a trustworthy management team). Moreover, Verizon was likely traded at a sensible price at the time Berkshire invested in the stock. Buffett and his investment managers often invest in stocks when they are undervalued or fairly valued with a good expected return on capital.
Verizon's Long-Term Prospects, Competition and Economic Moat
Verizon is the largest mobile operator network with the largest 4G LTE network in the U.S., covering 97% of the U.S. population. The company has two main business segments: wireless and wireline.
- The company's wireless business (aka Verizon Wireless) provides voice and data services (e.g. Verizon Edge and More Everything plans) as well as equipment sales (e.g. smartphones, tablets and basic phones) to consumers, businesses and government customers across the U.S.
- The company's wireline business provides retail customers, businesses and government customers with communication services such as broadband data and video (e.g. FiOS Internet and FiOS Video services), corporate networking solutions, cloud services and long distance services.
I will focus on Verizon's wireless business because it is its biggest revenue and operating income generator (see image below).
Source: page 17, Verizon's Q1 2014 10-Q Report.
I believe that Verizon has good long-term prospects because the company's wireless business - e.g. its device connection and account growth - is benefiting from the increasing sales of smartphones and tablets, especially 4G LTE devices. According to the 2013 Annual Report, the management is expecting that connection growth will continue to grow as the company introduces new smartphones and tablets and as the company invest more in its 4G network.
Verizon also benefits from smartphone and tablet sales because a large portion of them require data plans for internet access. These data plans can generate higher average revenue per account (ARPA) for Verizon. Moreover, the amount of data used on smartphones and tablets is increasing. This means that Verizon - like other wireless carriers in the U.S. - can gradually increase the price of data plans as customers use more data on their mobile devices. As a result, I believe that the increasing popularity of mobile devices should help Verizon grow its device connections, subscriber accounts and ARPA gradually over time.
Verizon's biggest competitors are AT&T (NYSE:T), Sprint (NYSE:S) and T-Mobile (NASDAQ:TMUS). AT&T is Verizon's biggest competitor because its subscriber base is almost as large as Verizon's (see image below) and because AT&T also has fairly strong financials.
Verizon's biggest competitive advantage or economic moat is likely its 4G LTE network, which is arguably the fastest and most reliable network in the U.S. It takes billions of dollars for a company to develop a wireless network that has the largest coverage that is also fast and reliable. The company also needs to spend billions of dollars to acquire wireless spectrum (wireless frequencies) from regulators each year. Since Verizon and AT&T have the most subscribers and financial resources, I believe that they should continue to lead in the long term.
Earlier this year, Verizon acquired the remaining 45% interest of Verizon Wireless from Vodafone (NASDAQ:VOD) at a cost of $130 billion. This allows Verizon (the parent company) to retain all of Verizon Wireless' cash flows for investment purposes. But the downside is that the company had to issue $49 billion of debt to finance the $130 billion acquisition (source: 2013 Annual Report). This caused the company to have a substantial amount of long-term debt ($108 billion as of Q1 2014). Hence, I think Verizon's biggest risk is paying off its long-term debt in the upcoming years.
Should You Invest in Verizon?
At this moment, I believe that Verizon has favorable long-term prospects and is a good company for long-term investing. The main question is whether the stock is traded at a sensible price, which can potentially give you a good return on capital. A sensible price would be a price that is either fairly valued or undervalued. It is always best to invest in a stock when it is undervalued because it tends to have lower risk and a higher potential return.
I have estimated Verizon's intrinsic value (business value) based on three scenarios (see image above):
- An optimistic valuation with a free cash flow (FCF) compound annual growth rate (CAGR) of 7% over the next 10 years.
- A fair valuation with a FCF CAGR of 5% over the next 10 years.
- A pessimistic valuation with a FCF CAGR of 3% over the next 10 years.
My other assumption is that the discount rate is around 13%.
Based on my fair intrinsic valuation, I believe that the stock is worth around $214 billion in market cap or $51.6 per share, assuming that the Verizon's free cash flow will grow at a CAGR of 5% over the next 10 years. This means that the stock - as of May 30 - is either fairly valued or slightly undervalued. If Verizon's free cash flow grows at a CAGR of 3% over the next 10 years (this is a pessimistic scenario), the stock would be slightly overvalued.
The Bottom Line
Verizon should be a great investment for the long term because its wireless business is benefiting from the increasing popularity of smartphones and tablets that requires data plans for internet access. The company's free cash flow should continue to grow over the next decade as the company invests more in its wireless networks and acquires more subscriber accounts and connections. The stock is likely worth around $214 billion in market cap or $51.6 per share - at the time of writing - if its free cash flow grows at a CAGR of 5% over the next decade.
Sources: Berkshire Hathaway 13-F (March 31, 2014), Verizon 2013 Annual Report, Q1 2014 10-Q Report, Q1 2014 Conference Call, Strategy Analytics, Morningstar, Yahoo Finance, SA Transcripts and Intelligent Stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.