Telecommunications giant Verizon Communications Inc. (NYSE:NYSE:VZ) yields 4.2% as of this writing and is generally viewed as an income growth investment. From the middle of 2013 to the end of 2018, Verizon Communications Inc.’s quarterly payout has risen by 17%. This space is tricky to navigate as the telecommunications business is capital-intensive, most of these firms already have large debt loads, and a large portion of the operating cash flow telecommunications firms generate is paid out to shareholders. The idea is that due to the relatively stable nature of Verizon Communications Inc.’s cash flow, debt can be used to finance a large portion of its capital expenditures and/or dividends as it effectively is a utility company. Last year, for the first time in a while, Verizon Communications Inc. was able to fully cover both its total dividend payments and capital expenditures with net operating cash flow. Let’s dig in.
Source: Verizon Communications Inc.
Revenue and earnings overview
Verizon grew its revenue by 4% last year on a year-over-year basis to $130.9 billion, largely due to its Wireless equipment revenues jumping by 18% to $22.3 billion. Unfortunately, Verizon’s operating margin dipped from 21.76% in 2017 to 17.02% in 2018, but that needs to be taken with a grain of salt. Last year, Verizon recorded a $4.6 billion goodwill impairment charge relating to its Oath division (which is now Verizon Media). That played a key role in boosting Verizon’s operating expenses by $10.0 billion, or 10%, y-o-y in 2018. Remove the goodwill impairment charge and Verizon’s 2018 operating margin improves to 20.53%, but that is still 123 basis points below its 2017 operating margin.
The Oath impairment charges stems from the Yahoo-AOL merger, under the Verizon umbrella, not yielding promising results. Management seeks to shave billions in annual expenses from Verizon’s cost structure, and this impairment was the first step in recognizing things have to change. Verizon noted 10,400 employees have accepted buyout offers and will be leaving the company by the middle of this year. That should materially improve Verizon’s cost structure by 2020, keeping in mind this process involves Verizon recording large restructuring, impairment, and severance charges along the way.
A common theme in my past articles has been turnarounds, but to be clear, not all turnarounds involve companies standing at the brink of despair (with Chapter 11 filings in hand). Some turnarounds simply involve revamping the core business, shedding unnecessary costs, and turning around a stagnant company so it can unlock capital appreciation upside.
Verizon generated $21.0 billion in income before corporate income taxes in 2016, which fell to $20.6 billion in 2017 and fell further still last year to $19.6 billion. While the company’s net income rose by 18% from 2016 to 2018, hitting $16.0 billion last year, that was entirely due to the lower corporate income tax rate in America. Over this two-year period, Verizon’s outstanding diluted share count rose by 1%.
Balance sheet and cash flow overview
Telecommunications companies, because of the utility-esque nature of their business model, tend to sport significantly higher debt loads than companies in other industries. Verizon exited 2018 with a long-term debt load of $105.9 billion and a short-term debt load of $7.2 billion, versus a cash balance of just $2.7 billion. Its combined debt burden was down $4.0 billion from levels seen at the end of 2017, which is a good sign. Management notes that Verizon’s adjusted EBITDA to net debt ratio improved from 2.6x in 2017 to 2.3x in 2018. The goal is to bring that down further to 1.75x-2.0x over the coming years.
While Verizon exited 2018 with a poor current ratio of 0.91x, that is largely due to its near-term maturities. Removing short-term debt from current liabilities under the assumption that Verizon will refinance that burden and its current ratio firms up to 1.13x.
Cash flow generation is an area where Verizon has done very well over the past few years. From 2017 to 2018, Verizon’s net operating cash flow jumped by 41% to $34.3 billion. True, there is some noise here as its working capital build was smaller than normal in 2018.
Last year, the company spent $16.7 billion on capital expenditures and an additional $1.4 billion acquiring wireless licenses, which combined is good for $18.1 billion in cash flow outlays. $16.2 billion in free cash flow (defining FCF as net operating cash flow minus the two line-items mentioned above) easily covered $9.8 billion in dividend payments. That’s a particular area of strength as Verizon’s free cash flow generation makes debt reduction efforts quite feasible, even as the company gets ready to roll out 5G to 30 cities in America this year.
For comparison purposes, note that Verizon generated $4.1 billion in free cash flow back in 2016, which rose to $6.5 billion in 2017 before hitting $16.2 billion last year (using the FCF definition above). Over that period, Verizon’s annual dividend payments climbed from $9.3 billion to $9.8 billion. It wasn’t until last year that free cash flow fully covered Verizon’s payout. Even if one were to factor out the smaller than normal working capital build in 2018, which was roughly $5.1 billion below its 2016-2017 average, Verizon still would have generated enough free cash flow to fully cover its dividend payments.
The coming 5G investment spree will require enormous amounts of capital expenditures, and Verizon Communications Inc. has the financial firepower to make those investments. Management made the right call by targeting a lower debt coverage ratio, as having a better handle on that burden makes planning for the future significantly easier. Structural changes at Verizon Communications Inc., namely significant workforce reductions and a reorganization of its media properties, will help save a significant amount of cash on an ongoing basis while 5G presents new growth opportunities on the revenue side of things. Thanks for reading.