Verizon Communications (VZ) is getting risky to some investors out there. In essence investors are worried for three reasons: the prospects of higher interest rates, M&A activity into unrelated businesses (read: Yahoo (YHOO) & AOL) and fierce competition from the likes of T-Mobile (NASDAQ:TMUS) in particular.
As a result shares have now declined 10% over the past year, and are down nearly 20% from a high of $55. They are currently trading in the mid-forties. Does this mean shares look like a decent opportunity given the 5% yield, or should investors be worried at these levels?
Let´s start with a quick review of the events.
A Lot Of M&A, What is The Outcome?
Verizon has existed in its current form since 2014, after it completed the purchase of the remaining 45% stake in Verizon Wireless from Vodafone (NASDAQ:VOD) in a huge $130 billion deal. The strong position of the wireless business had long been the backbone of the company, but management decided to diversify into internet related businesses with the purchase of AOL for $3.8 billion and more recently Yahoo, as well, for $4.5 billion.
Other deals included last year´s purchase of Fleetmatics in a $2.5 billion effort to provide fleet and mobile workforce management solutions, as well as the $0.9 billion acquisition of Telogis. The company spent even more money when it bought wireline business XO Holdings for $1.8 billion as well. Total spending of $13-$14 billion on these deals in 2016 and 2017 was partially offset by some divestitures. The company sold its data centers for $3.6 billion to Equinix.
These initiatives were designed to create some diversification and growth, as 2016 was a difficult year for Verizon. Sales fell more than 4% to $126 billion last year, and operating earnings were down $6 billion to $33 billion - still representing enormous numbers, of course. The big decline in earnings resulted from a more competitive environment, as well as a pre-tax $2.9 billion charge related to its pension plans. With those charges excluded, adjusted EBITDA came in at $44 billion.
The vast majority of Verizon today consists of the wireless business, which makes up $89 billion of the total $126 billion in revenues. Wireline revenues amount to $31 billion and corporate revenues amount to $7 billion; that is the division in which AOL and Yahoo will be placed. The wireless business remains by far the most important segment of the business, but it is cooling down amidst fierce competition from T-Mobile USA. Total net additions slowed down from 5.5 million in 2014 to 4.5 million in 2015 and just 2.3 million in 2016. Worse, ARPA was down more than 5% last year to still a respectable $144, which is still a substantial amount and is the reason why competition is undercutting Verizon on price.
The Debt Load And Earnings Capacity
Verizon ended 2016 with $2.9 billion in cash and equivalents. Total debt stood at $108 billion, and the net debt load of $105 billion translates into a leverage ratio of 2.4 times based on adjusted EBITDA of $44 billion. This excludes employee related obligations, mostly pension and healthcare plans, of another $26 billion. If these are included in the calculation, the net debt load rises to 3 times. This does not even include the purchase of Yahoo, which only closed this year.
The quarterly dividend of nearly $0.58 per share has to be paid out on nearly 4.1 billion shares for an annual dividend payout of $9.5 billion. Verizon posted operating earnings of $27 billion, or $30 billion if pension plan related charges are excluded in 2016. The interest bill amounted to $4.4 billion, but this could easily rise to $5 billion going forward amidst rising rates. That yields pre-tax earnings of $25 billion, or $16 billion after applying a 35% tax rate. Taking the $9.5 billion divided payment into account, the capacity to deleverage runs at just $6.5 billion. A 60% payout ratio remains reasonably high as well given the rapid changes in the industry and the competitive nature of the business.
This calculation above does not even take into account the investments that Verizon needs to make in order to make the business competitive. Depreciation and amortization charges run at $16 billion a year, lagging capital expenditures by a billion, creating an other modest drag on free cash flow generation. Free cash flow generation is further impaired by deals which still have to prove themselves as Verizon, on a net basis, has recently been buying more companies vs. assets sold.
Verizon´s first quarter results gave little reason to be upbeat. T-Mobile US has rapidly risen to a +$50 billion market capitalization and has an investor base focused on growth and investments instead of dividends. This creates a serious disadvantage for Verizon.
First quarter results reported by Verizon were weak, with sales down 7% to a little less than $30 billion, driven by the wireless business; the wireline business has traditionally been the weak link. If we account for all the acquisitions and divestitures, sales were down by 4.5%. This deleverage in terms of sales resulted in operating earnings dropping 10% to $7.2 billion, at a rate of $29 billion per annum, although that is shrinking as the company is now losing wireless customers at a rate of 1.5 million per year while rates remain under pressure. That rate of customer losses was the case halfway through Q1, when the company announced Verizon Unlimited, which effectively halted the decline and resulted in very modest growth in the user base.
Total debt - including pension related liabilities - stood at $134 billion, and the small sequential increase in net debt and pressure on EBITDA has pushed up the leverage ratio to little over 3 times. As adjusted earnings were down 11 cents to $0.95 per share, the payout ratio has risen to percentages in the low sixties.
T-Mobile is not the only company stepping up its game, with its addition of roughly 3 million customers this year for growth of 10%; Sprint (NYSE:S) is stepping up with its free-year family plan as well. While Sprint itself is not the most formidable competitor, recent deal talks between numbers 3 and 4 could create a more formidable competitor, and that would present a big negative to Verizon.
Verizon is facing quite a bit of pressure. The company is dealing with revenue pressure in both the wireless and wireline businesses, as diversification efforts are too small and not growing enough to make a dent. It is also losing operating momentum as T-Mobile, notably, steps up its competitive efforts. This increased competition is hurting Verizon over time, and it will accelerate if a deal between T-Mobile and Sprint is approved under the current administration.
Verizon is now operating with a 3 times leverage ratio, but the ability to deleverage is limited given the +60% dividend payout, as network investments typically outpace depreciation charges as well. As a result, both payout ratios and leverage ratios would increase if T-Mobile continued to gain share. If a T-Mobile-Sprint deal took place, I think a dividend cut might be necessary.
Let me point out that dividends are crucial for investors - which typically means that management is reluctant and late to employ a dividend cut. As a result, we might only see real pressure on the dividend in 2018/2019 if current trends prevail, as the cash flow trends simply do not look very sustainable.
That being said, shares have priced in some bad news already, and this has de-risked the stock to some extent. Even if the payout is cut by a third, which would free up much needed $2-$2.5 billion in annual cash flow, the yield still comes in at 3.3%. This would create a more sustainable picture, but it probably would go hand in hand with a sell-off in the shares. Given the lack of growth, legacy obligations (debt, pension and implicit dividend commitment), and very fierce competitive field, I am not that interested even if the multiple is modest at 12 times, as I see no earnings growth and no real prospects for multiple expansion.
Disclosure: I/we 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.