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Ishan Majumdar
Ishan Majumdar
Articles (131)  | Author's Website |

Verizon: The 5G Question Marks

The company generated good cash in its recent result, but its growing spending could be a concern

October 23, 2020 | About:

Verizon Communications Inc (NYSE:VZ) was recently in the news for its nation-wide 5G rollout. The company is the largest wireless carrier in the U.S. and is looking to grow rapidly through its 5G offerings in the coming months.

The company has been spending billions of dollars on increasing its capacity and speeding up its network, but there is a big question around whether the actual consumption of its services will increase as significantly as the expenses.

The company recently released earnings results and guided for a further increase in capex in the coming months over and above strong dividend payouts, but the question remains whether it will be able to generate sufficient cash to sustain all of this burn in the long run.

Financial results

Verizon had a mixed result for the 2020 third quarter, which ended Sept. 30. The company underperformed analyst predictions on the revenue front but managed to deliver an earnings beat.

The company reported a top-line of $31.5 billion, which was below the analyst consensus estimates of $31.59 billion and a drop of 4.1% as compared to the $32.90 billion reported in the corresponding quarter of 2019.

The consumer segment and business segment were both in red as they declined by 4.3% and 1.7%, respectively. However, it did witness positive growth from its Total Wireless service revenue, which grew 0.3% to $16.4 billion, backed by 553,000 retail post-paid net additions. The management did succeed in keeping the retail postpaid churn below 1% in Q3 as well (at around 0.89%). Verizon's media segment also underperformed as its revenues were down 7.4% as compared to the same period in 2019, but this segment showed a 21.2% recovery as compared to Q2, backed by a 22% rise in monthly active users for the Finance offering and a 13% rise for the News offering.

Source: Company Presentation – Q3 2020

The good news from the management was the margin expansion. Verizon managed to increase its Ebitda by 1% from 36.6% in Q3 2019 to 37.6% in the recent quarter, which contributed to a higher-than-expected net profit.

In terms of the earnings per share (EPS), the company reported $1.25, which was above the analyst consensus estimate by 3 cents. There was definitely a negative impact from the pandemic on the business, but Verizon's wireless sub-segments managed to perform well.

The 5G question

Verizon rolled out its 5G network across the U.S. recently, using a long-range spectrum to cover about 200 million Americans. In terms of technology, it is using high-frequency, short-range bands across 60 cities for this implementation.

The company is expected to start witnessing a material impact of 5G on its revenues from 2021 onwards. Verizon will be clearly able to distinguish the 5G revenues flowing in as they will fall under its 5G Home fixed wireless broadband service offering. Currently, the company requires its customers to subscribe for unlimited data to go in for the 5G option, but it continues to provide similar 4G plans too, and hence, I think there is a limited reason to switch for many consumers.

The broader concern remains whether the usage of 5G will allow the company to increase pricing. Verizon is spending close to $20 billion of its cash flows each year on upgrading its network speed and adding capacity, but whether this capacity will be used or not (and what additonal fees customers are willing to pay for it) remains to be seen.

Verizon has been aggressive in pushing its 5G offering through Apple's (NASDAQ:AAPL) latest iPhone 12 via big discounts. It looks to capture subscribers of T-Mobile (NASDAQ:TMUS) and AT&T (NYSE:T) through its efforts, though both these companies are making their fair share of efforts with respect to 5G as well.

T-Mobile has managed to build a solid 5G network after the Sprint acquisition and poses a genuine threat to Verizon. AT&T is also pushing the iPhones at huge discounts. It remains to be seen as to which of these companies emerges with the maximum subscriber growth at the end of 2021.

Cash flows, leverage and dividend

Verizon's year-to-date cash flow has been very strong at $32.5 billion, a solid increase of $5.7 billion as compared to the previous year. However, its average cash-to-debt ratio is a meager 0.6, which indicates very high leverage on its balance sheet.

The company's high capital gearing is also clearly reflected in its debt-to-Ebitda ratio of 3.09, although it does have a decent ability to bear its interest costs on the debt, as the interest coverage ratio of 6.55 reflects.

The capex in 2020 so far has been $14.2 billion, which is well below the cash generated, and this number is going up rapidly. The management has already guided on a total capex of $17.5 to $18.5 billion for the year and it might go up in 2021. Over and above this, the management also declared a dividend increase for the 14th year in a row in the previous quarter, resulting in a payout ratio of 0.56. While the yield of Verizon may appear very attractive at 4.31%, given the heavy investments in 5G with as-yet-uncertain return, it will be hard for the company to sustain such massive payouts over the coming years. In fact, I think it would be a far more prudent decision on the management's part to start reducing the dividend to help pay down the high debt levels and reduce the financial leverage.

Final thoughts

Verizon's recent earnings result came with strong cash flows. After the fall in the stock price, its 4.31% dividend yield also appears very attractive. While there are question marks associated with the impact of 5G on the company's top-line, one can certainly term it as the dawn of a new era in world telecommunications.

Verizon's debt levels are uncomfortably high, but that has not stopped the management from continuing dividend hikes. Investors will have to wait for 2021 for the answers to their questions on the profitability of 5G, as the management does not expect a material impact of 5G on the company's financials until that time.

Overall, I believe that the company's stock appears worth a "hold" rating at current levels, given that the GuruFocus Value Chart considers it to be fairly valued.

Disclosure: No positions.

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About the author:

Ishan Majumdar
I am a qualified Chartered Accountant with a Masters in Management (Grande Ecole) from HEC Paris. I run a proprietary boutique financial advisory firm called Baptista Research (www.baptistaresearch.com) specializing in M&A, corporate advisory, equity research and valuation of listed companies.

I have nearly a decade of experience spread across investment banks, financial advisory firms, investment funds and other corporates in many different geographies, such as France, Spain, India and others. I was a part of the LBO Financing team at BNP Paribas where I worked on deals with a combined enterprise value of over $1 billion. I have also worked in mergers and acquisitions with Credit Agricole CIB and corporate strategy with Groupe Danone SA. Over the years, I have developed a strong specialization in corporate valuations, strategy and financial analysis.

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