The Wireless Carrier Market: A Two-Horse Race

|
Includes: S, T, TMUS, VZ
by: Alberto Wallis
Summary

T-Mobile and Sprint merger generated uncertainty around both stocks, making them unattractive for many investors.

AT&T has the most attractive valuation, but Verizon has the stronger results.

Verizon and AT&T have a good track record of increasing their dividends, but the latter has a much higher yield.

Verizon and AT&T have plans for the full deployment of a 5G network in the medium term.

There are four major carriers in the United States: Verizon (NYSE:VZ), AT&T (NYSE:T), T-Mobile (NASDAQ:TMUS) and Sprint (NYSE:S). Their combined market shares in the wireless carrier space is over 98%. This gives them a larger than usual market power, which should yield larger than usual returns. However, this is not always the case. In fact, Sprint is facing serious trouble keeping their operations afloat, and T-Mobile seems to have little upside in my view. This is really a two-horse race between Verizon and AT&T and, depending upon strategy, I believe both could be great additions to a portfolio.

Recent Performance

Last year wasn’t a very good year for the major US carriers. In 2018, Verizon’s stock saw an increase of 6.22%, while T-Mobile barely stayed positive with an increase of 0.16%. The other two, Sprint and AT&T, experienced declines of 1.19% and 26.59% respectively. Still, except for AT&T, all had better years than the S&P 500 which declined by around 6.35%.

Chart Data by YCharts

In 2019, maybe in part to a correction by the market and in part because of other factors, the roles have been partially reversed. Sprint, T-Mobile and AT&T have seen huge rises in price of 27.32%, 22.91% and 14.02% respectively. Meanwhile, Verizon has barely stayed in positive territory with a price appreciation of 1.99%.

Potential T-Mobile and Sprint Merger

On April, the WallStreet Journal revealed that Sprint told regulators “that its performance isn’t as strong as it appears and it will struggle to operate as a stand-alone company.” T-Mobile is on a much better place, although as I will explain in the financial comparison section, none of their numbers suggest they offer the best value.

On top of that, these companies are in the middle of a proposed merger. According to the Washington Post, “the Justice Department antitrust enforcement staff have told T-Mobile and Sprint that their planned merger is unlikely to be approved as currently structured”.

Given the uncertainty of the outcome, I would stay away from both. Although many expect the deal to be blocked by the Justice Department, having the increased volatility and doubt surrounding either stock does not sit well with me. I’d rather go for the stability and dividends T and VZ provide, than enter into a position facing severe uncertainty.

Market Power

The Wireless Carrier business in the United States is highly concentrated, with only a few real players: Verizon, AT&T, T-Mobile and Sprint. According to the latest numbers by Statista, Verizon leads the wireless subscription by market share. The latest numbers show they own around 34.91% of subscriptions, slightly ahead of AT&T which possesses 34.07%. T-Mobile and Sprint lag behind with market shares of 17.51% and 12.13% respectively.

One way to estimate the level of market concentration is the Herfindahl-Hirschman Index (HHI). This index is calculated by squaring the market share of each company competing in the same market, and summing up the results.

Using the previously mentioned market shares, we can calculate the HHI index for the wireless carrier market in the USA. The markets shares used for the calculation are below, and the carriers from left to right are: Verizon, AT&T, T-Mobile, Sprint, US Cellular, and Others.

HHI = (34.91)^2+(34.07)^2 +(17.51)^2 +(12.13)^2 +(1.14)^2 +(0.24)^2= 2.843,56

This index is used by the Department of Justice for the evaluation of potential mergers. According to their guidelines, a moderately concentrated market should have an HHI of around 1500-2500, while a highly concentrated market has an HHI of above 2500. Thus, this index shows what many consider a universal truth, the US Wireless Carrier market is highly concentrated and companies have larger than usual market power.

This is one of the reasons the Department of Justice might be against a potential merger between T-Mobile and Sprint. Assuming their market share is combined, the resulting HHI would be 3.259, an increase of 416 points.

While these results don’t bode well for the potential merger, they are great for the companies already operating in the market, especially the leaders: VZ and T. The high concentration results in more market power, and allows these companies to generate higher profits.

The high level of market concentration is most certainly the result of what many consider a “moat”: the high investments needed to enter the market. To make a profit in these sectors, companies must make use of economies of scale. That is, since fixed costs tend to be extremely high and marginal costs tend to be small, companies need a very large customer base to be profitable This in turn scares away potential investors and gives certain level of security to companies like VZ, T and TMUS.

Financial Comparison

Sprint has had very bad results in the last few years and, as mentioned before, could face sever trouble to stay afloat as a standalone company. They reported a loss last year, and have a large amount of debt that will probably crush them.

T-Mobile, on the other hand, has delivered good results over the last few years. Nonetheless, their PE (21.34) is near the average for the S&P500 (21.93), while both Verizon and AT&T are considerably below. Since no other financial stat screams undervalued and in general are inferior to both AT&T and Verizon, I believe T-Mobile is not worth investing in at the moment.

Given the uncertainty surrounding Sprint and T-Mobile, and the fact that Sprint has delivered bad results while T-Mobile seems to have no upside, I will focus on T and VZ moving forward.

Table Made With Data From: FINVIZ

In terms of P/E, both VZ (14.82) and T (12.64) seem undervalued, although T looks more attractive. Forward P/E tells a very similar story, with T (8.96) leading the charge and VZ (11.83) slightly behind.

Looking at P/B, VZ appears to be the most overvalued at 4.25, while T is only at 1.29. However, I wouldn’t give much importance to these ratios. Most of these companies’ value comes from their future cash flows and market power, not their assets.

Both of these companies have most of their debt in the form of long-term debt. Verizon has the largest Lt. Debt/Equity ratio at around 1.88, more than double that of AT&T (0.89). However, Verizon’s quick ratio is around 0.8, so they should have no trouble meeting its debt payments in the near future.

Also, worth noting is the company’s interest rate. In 2018, Verizon paid an interest rate of around 2.26%, while AT&T paid 2.36%. Both of these are considerably low, and show that lenders are extremely confident in both of these companies’ ability to repay their debt.

When looking at efficiency, Verizon sweeps the board. Their ROA (5.9%), ROE (29.7%) and ROI (12.2%) are clearly above the others. This could imply the company has been more efficient at using their resources and allocating their capital, which has led to higher returns. AT&T, on the other hand, has a ROA of 3.5%, ROE of 10.2% and ROI of 5.9%. While these numbers are not bad, they’re clearly inferior to Verizon’s.

In terms of profit margin, Verizon once again wins with a net profit margin of 12.2%. AT&T sits behind at 10.6%. While it may seem a very small difference, Verizon’s margin is 1.15 times that of AT&T.

Overall, it’s clear that AT&T’s current valuation is more attractive. However, since Verizon seems to be more efficient at allocating resources and turning a profit, they seem poised for a better future.

Dividends

One thing that makes both of these companies very attractive are their dividends. Over the last years, both companies have slowly but steadily increased their dividends. In the last ten years, Verizon grew their dividend by almost 32%, while AT&T saw a slower growth of 24%. Nonetheless, it’s great to see both companies steadily growing their dividends paid.

Chart Data by YCharts

At the moment, Verizon has a dividend yield of 4.2%, while AT%T has a yield of 6.27%. Certainly AT&T’s yield is far more attractive. However, we must look at it with a grain of salt. Verizon’s payout ratio is just 61.6%, compared to AT&T’s ratio of 75%. If Verizon where to increase their payout ratio to equal AT&T’s, their yield would be 5.11%. That 1% difference is still important for many investors, but should not be a deal breaker for Verizon.

Another thing worth considering is that, since VZ has ROI more than double that of T, it is logical for the company to keep more of its earnings to reinvest than to distribute them to its shareholders. Long-term, this should yield higher growth and returns for Verizon.

Future Plans

Both companies main focus at the moment is deploying a 5G network across all US states. According to Verizon[AW1] [AW2] , the development of 5G will allow higher throughput, lower latency and handle more traffic. The company believes 5G would provide eight capabilities: peak data rates, mobile data volumes, mobility, connected devices, energy efficiency, service deployment and reliability.

Verizon has already commercially launched 5G Home in four markets: Sacramento, Los Angeles, Houston and Indianapolis. They expect to launch mobile 5G services in 2019. On the other hand, AT&T introduced mobile 5G services in parts of 12 cities, and expect to deploy nationwide by early 2020.

5G is the next big thing in terms of communication, and both of these companies are near full deployment. Investors shouldn’t expect big results in the short term from this technology, but in the medium term this will be of vital importance for their growth of these companies business.

Verizon is also working on adding capacity and density to their 4G LTE network, by using small cell technology, in-building solutions and distributed antenna systems. This enables them to add capacity to address the increasing mobile video consumption and demand for IoT products and services. They also have an Intelligent Edge Network Initiative, whose purpose is to evolve the network architecture to a multi-use platform that provides better efficiency, increased automation and opportunities for edge computing services.

On the other hand, AT&T seems to be trying to grow other parts of their business. While in 2017 their communications segment accounted for 94% of operating revenue, in 2018 that figure was reduced to 84%. Their WarnerMedia Segment was mostly responsible for this reduction, as its revenue increased considerably. This segment includes Turner, Home Box Office and WarnerBros.

Conclusion

For investors looking for some exposure in the communications segment of the economy, both Verizon and AT&T provide good value and dividends. Sprint has been having trouble for a while now, while T-Mobile’s valuation is not attractive at the moment. On top of that, the added uncertainty generated by the potential merger between the two is unattractive for many.

On the other hand, Verizon and AT&T both seem undervalued and they come along with high yields and a strong track record of increasing their dividends. I believe both of these companies should have a space in the portfolio of the average investor. If I had to pick one, I’d rather go for Verizon, as I see a larger potential in the long-term, since they reinvest a larger percentage of their profits and they generate higher returns on these. However, for investors looking for a faster return on their capital, I’d go with AT&T, given their higher yield. Finally, when taking into consideration the fact that the wireless carrier market in the US is an oligopoly, and both of these companies have a high level of market power, I feel confident they will continue delivering solid returns for a long time.

Disclosure: I am/we are long VZ, T. 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.