The S&P 500 has surged nearly 18% over the past three months, approaching a new all-time high. This has caused the price-earnings ratio for the S&P 500 to cross north of 29 as I write this, which is more than twice the median average of the index since its inception. At the same time, the dividend yield has shrunk below 1.8%.
Finding value and income remains elusive in the current market, but there are stocks that offer the best of both worlds. One name that remains my favorite is Verizon Communications Inc. (VZ, Financial).
Verizon, which remains the number one phone carrier in the country, trades with a price-earnings ratio that is below its 10-year average and with a yield of more than 4%. Let's look closer at the company to see why it is a solid buy for investors looking for value and income.
Quarterly highlights
Verizon reported second-quarter earnings results on July 24. Revenue declined slightly more than 5% to $30.5 billion, but came in $455 million ahead of what Wall Street analysts had been expecting. Adjusted earnings per share were lower by 5 cents, or 4.1%, to $1.18. Earnings per share results were 3 cents above estimates.
Much of the decline was attributed to Covid-19, which Verizon estimates reduced earnings per share results by 14 cents. Part of this was due to costs associated with Covid-19, but traffic at physical store locations diminished significantly as well. Service revenue was also impacted by less roaming among customers, particularly in areas outside of the U.S.
Total retail postpaid net additions were 352,000 for the quarter. Of these, 173,000 were phone additions. Total postpaid churn was 0.78%, compared to 1.02% in the prior year. Looking at just wireless phones, postpaid churn declined 18 basis points to 0.58% year over year, an industry best mark. Certainty, some portion of this low churn rate is due to customers not being able to visit competitors and change service, but Verizon has a long history of maintaining its customer base. The average retail postpaid phone churn rate over the past four quarters is 0.82%.
The consumer segment produced revenue of $21.1 billion, which was a 4% decrease from the previous year. Equipment revenue fell nearly 18%, while wireless service was down almost 3%.
Verizon did see solid improvements on several key metrics. This segment had more than 5 million postpaid device activations during the quarter. Postpaid wireless phone subscribers were a net 76,000, easily beating consensus estimates of a loss of 100,000. Included in this is 199,000 postpaid smart phone additions. This helped Verizon see a slightly uptick in its wireless retail connections to 94 million. Retail postpaid phone churn was 0.51% compared to 0.72%. Service revenue was down 1.7%, mostly due to the previously mentioned lower roaming revenue.
The phone upgrade rate was 3.7%. As 5G service begins to turn on in cities in the U.S and as well as the rest of the world (Verizon tested 5G service to customers traveling to South Korea in early August), phone upgrades should pick up at a brisk pace.
Fios video net adds were down 81,000, which is an issue that the company has faced for several quarters now. Consumers continue to forgo large bundles from providers in favor of lower-priced streaming services. This is an area I expect Verizon to continue to struggle with as consumers reduce expenditures. On the other hand, Fios internet added 10,000 subscribers.
Verizon's business segment had a 3.7% decline in revenue to $7.5 billion. Phone gross adds were down almost 17% and gross additions overall decreased 3.7%, again on limited customer interaction. Phone upgrades increased 2.7%. Business had 280,000 net additions, 14% below the second quarter of 2019. Postpaid phone churn fell to 0.90% from 0.97% in the previous year.
Media sales fell 24.5% to $1.4 billion due to limited customer interaction. Verizon did see an increase in traffic to owned and operated properties, showing that content remains in high demand.
Verizon also reaffirmed its guidance for the remainder of the year and expects adjusted earnings per share in a range of down 2% to up 2% compared to 2019. At the midpoint, this would be earnings of $4.81 per share for 2020.
Overall, Verizon had a decent second quarter. Results on the top and bottom lines were lower than the previous year, but ahead of analysts' estimates. The company's phone churn rate remained very low. Results were impacted due to store closures, but a low single-digit decline in Verizon's two largest businesses isn't terrible considering the environment during the quarter.
Balance sheet, dividend and valuation analysis
Verizon's balance sheet ended the quarter in a much better position compared to the previous year. The company also repaid net debt of $4 billon during the quarter. Current assets stood at $37.3 billion, with $7.9 billion in cash and equivalents. Total debt was $112.8 billion, but the company has current debt of just $6.7 billion.
Cash flow from operations increased $7.8 billion to $23.6 billion in the quarter. Even though capital expenditures were higher by almost $2 billion, the company's free cash flow still improved from $7.9 billion to $13.7 billion. Granted, some of this was due to the timing of tax payments. Excluding these two items, free cash flow was $8.6 billion, still 73% higher year over year.
The company distributed $2.5 billion in dividends during the quarter, which equates to a free cash payout ratio of 29%. The year-to-date free cash flow remains low at 43%, which is much improved compared to previous years.
In 2019, Verizon distributed $10 billion in dividends while generating $16.9 billion in free cash flow for a payout ratio of 59%. The average payout ratio for the period from 2016 to 2018 was nearly 100%.
Verizon, even with a hefty dividend, is demonstrating an improved free cash flow. This should help ensure that the dividend remains safe.
The earnings per share payout ratio also shows that the dividend is safe. The company is expected to distribute at least $2.46 this year (Verizon should provide a raise for the early November payment). Using expected earnings per share, this would be a 51% payout ratio, which compares favorably to the 10-year average payout ratio of 66%.
Shares of Verizon offer a 4.2% yield. The 10-year average yield is 4.8%, but drops to 4.5% when looking at just the last five years. Based on dividend yield, the stock looks slightly overvalued.
Using the more traditional method of valuing stocks, Verizon looks undervalued. Shares trade at $58.33 at the moment. Using the midpoint for 2020 guidance, the stock has a forward price-earnings ratio of 12.1.
Shares have averaged a price-earnings ratio of 13.7 since 2010 and 12.2 since 2015. Using the five- and 10-year average valuations as a guide, I have a target price-earnings range of 12 to 14. Therefore, my price target range for the stock is $58 to $67 using company earnings per share guidance. At the low end, this is a very slight decrease from current levels. At the high end, the stock would return 14.9%. Add the dividend yield if the stock were to reach $67, and the total return would be 18.5%.
Final thoughts
Verizon's second quarter was better than expected in terms of revenue and earnings, but still showed a decline from the previous year. The low churn rate shows customer loyalty and net phone additions were better than expected.
Shares of Verizon trade below the historical average yields, but the stock offers a yield more than twice that of the S&P 500. The stock also trades at the low end of my valuation range. The downside doesn't appear to be too great, but the potential total return is almost 19% from the current price. For this reason, I continue to rate shares of Verizon as a buy.
Disclosure: The author has a long position in Verizon Communications.
Read more here:
- Realty Income Shows Its Resiliency
- United Parcel Service: Entering Overvalued Territory
- The Market Continues to Misprice CVS Health
Not a Premium Member of GuruFocus? Sign up for afree 7-day trial here.
