The telecommunications industry is composed of four main competitors: Verizon (NYSE:VZ), AT&T (NYSE:T), Sprint (NYSE:S), and T-Mobile (NASDAQ:TMUS). As these carriers provide similar smartphone, service plan, and data offerings; these companies have been forced to compete on price. Carriers are forced to subsidize expensive smartphones and lower prices on monthly services, eating into margins. The average subsidy provided to customers is around $400 per smartphone.
Verizon is a wireless connections company serving over 25% of the US, providing over 105 million connections to US customers through wireless phones, tablets, and smartphones. Verizon's business is broken down into two segments: Wireless (67.4% of sales) and Wireline (32.6% of sales).
AT&T is the second largest carrier serving 99 million customers and an additional 14 million connected devices, such as e-readers and tablets. AT&T also operates a local phone company serving 27 million customers, 17 million internet users, and 6 million television users. In May of 2014 AT&T agreed to acquire DirecTV for about $65 billion.
Sprint is the third largest carrier in the US serving 45 million customers directly and another 10 million through its affiliates. Approximately 9% of sales come from its long-distance segment, which provides fixed-line phone and data services.
T-Mobile (after the acquisition of MetroPCS) now serves 37 million customers and is the fourth largest wireless carrier in the US. T-Mobile is currently in the process of converting MetroPCS customers to the T-Mobile network, working on the rapid implementation of a LTE network, and utilizing a highly aggressive customer acquisition strategy. T-Mobile is the fastest growing of the US carriers.
As I said earlier, wireless carriers have similar infrastructure and device offers; thus making companies compete on price. T-Mobile was first to launch an aggressive strategy to gain customers by switching away from the carrier stigma by operating as a "un-carrier." T-Mobile allows customers to upgrade their phones often, choose from simpler plan offerings, and reduce rates, and reimburse termination fees when customers switch carriers. Although this strategy has worked for T-Mobile, its razor thin margins will not be sustainable in the long run. T-Mobile is also steeply valued with a P/E of 188.9, EV/EBIT of 72.0x, and EV/EBITDA of 8.4x.
Sprint has followed T-Mobile's strategy by reducing prices, increasing subsidies, and paying termination fees for new customers. Sprint has fallen into the same trap as T-Mobile, cutting margins to unsustainable levels to maintain its reputation as a player in the market. Sprint is also expensive as EV/EBIT is 246.7x and EV/EBITDA is 10.1x.
If an investor is interested in investing in the telecom sector, there are only two major US players: AT&T and Verizon. How are Verizon and AT&T able to compete in the market if their prices are as not competitive as Sprint or T-Mobile? Verizon and AT&T are first to offer superior services to customers. Both AT&T and Verizon are in a race to be the first to launch the next fastest mobile data service. Customers are willing to pay for the superior and faster service and the reliability that comes with it.
AT&T' has been playing catch-up within the market (it was the last to implement a financing plan for upgrades). However AT&T has been able to attract customers with their lower rates encouraging customers to use more data. AT&T's reputable brand and loyal customers continue to fuel its growth and position as an industry leader.
Verizon estimates that 9.5%, or approximately 25 million of its postpaid customers, will be upgrading their phones this quarter, up 7.4% from last year. Part of this increase in upgrades has been driven by the new financing option for phone upgrades. Verizon indicates that about 24% of customers utilize the edge financing, up 12% from last quarter. Edge financing is believed to be able to offset up to half of the reported incremental subsidy expense this quarter. Verizon's initiatives to retain and renew customer contracts coupled with higher margins, and a relatively cheap share price, make the company the best play in telecommunications. Below is my analysis of Verizon's valuation.
Analysis of Comparables
As shown below, you can see that Verizon trades at a discount to industry peers in terms of EV/EBITDA and EV/EBIT. These discounts are unjustified as Verizon has higher margins, dividend yield, and free cash flow than peers. I applied the lowest of the mean and median multiples to Verizon and divided by number of shares outstanding. In my calculation of implied share price I used the average of the price calculated by theses multiples. Using comparable analysis to value Verizon, I conclude that Verizon's implied price target is $57.60 representing a 22.49% upside.
Using only Bloomberg consensus estimates for 2015 EBITDA, EBIT, and Sales, I applied the current EV/EBITDA, EV/EBIT, or Price/Sales multiples to the respective estimate to calculate implied enterprise value. After subtracting total debt, minority interest, preferred interest, adding cash, and dividing by shares outstanding, implied share price was calculated. Taking the average of the implied share price provided by the various multiples generates an average price target of $54.81 representing upside of 16.53%.
Dividend Discount Model
Using Bloomberg consensus estimates for sales, gross margin, EBITDA, D&A, EBIT, interest expense, tax expense, net income, and EPS through 2018. I applied 2013's payout ratio, the lowest in 5 years, to forecast out dividends through 2018. Cost of equity was Bloomberg estimate, confirmed using the Build-Up Method. Terminal growth was set to 2.3%, slightly above inflation, below Bloomberg estimates for long-term dividend growth, and well below historical dividend growth rates. Implied price target using the dividend discount model is $59.13, good for upside of 25.76%.
After my analysis using 3 different valuation methodologies, I conclude that Verizon's price target is $57.18, offering upside of 21.68% (each methodology was weighted equally). Verizon is trading at an unjustified discount to industry peers, confirmed with the analysis of forward multiples and discounted dividends. Verizon's undervaluation coupled with its has a high dividend yield and payout ratio (4.68% and 73.6% respectively) makes this a great holding for the long and short-term investor, as capital appreciation will be realized and dividends will generate income.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.