Berkshire Hathaway, Inc. (BRK.A, Financial)(BRK.B, Financial) was criticized by many value investors recently because of its decision to sit on a massive pile of cash without investing in the market.
The investing world has long been accustomed to Warren Buffett (Trades, Portfolio)'s brave bets on seemingly troubled companies during market downturns and economic recessions, so it was natural to assume that the guru was on a mission to find lucrative bets early last year when the market crashed as a result of the Covid-induced recession.
To the surprise of many investors, though, Buffett sold out of his investments in the airline industry, and Berkshire did not announce any major new investments despite sitting on more than $140 billion.
Things seem to have finally changed in the third and fourth quarters of 2020. According to the most recent 13-F report Berkshire filed with the SEC on Feb. 16, the conglomerate has taken a massive position in Verizon Communications Inc. (VZ, Financial) and has added a couple of other new names to its portfolio as well. At the end of 2020, Berkshire's stake in Verizon was valued at $8.1 billion.
5G creates opportunities, but the outlook is mixed
The expected rollout of 5G technology paints a promising picture for the telecommunication services industry as consumers are likely to shift to higher-priced data plans to experience the blazing internet speeds promised by this latest technology. Even in 2020 when the going was tough because of a reduction in consumer discretionary spending, Verizon reported a year-over-year revenue decline of just 2.71%, which is a testament to the resilient business model of the company.
There are, however, many challenges the company is facing. First, the adoption of unlimited data plans will initially result in higher revenue for the company, but in the future, Verizon is likely to report a steady decline in wireless services revenue because of this trend. Eventually, such a decline will result in lower average revenue per user, limiting the ability of Verizon to grow earnings.
Second, telecommunication companies have no option but to invest billions of dollars to improve the infrastructure to facilitate the adoption of 5G technology. Verizon management has guided for capital expenditures between $17.5 billion to $18.5 billion for 2021, and investments are likely to remain elevated close to $20 billion in the next few years, limiting the company's ability to grow free cash flows.
Third, there's stiff competition in the industry for market share, and Verizon is expected to carry out promotions and spend millions of advertising dollars to ensure rivals such as AT&T Inc. (T, Financial) and T-Mobile US, Inc. (TMUS, Financial) will not take market share from the company. With the completion of the Sprint merger, T-Mobile is in a dominant position, and Verizon might have to spend more than its competitors to retain its market position. These promotional activities will not help Verizon's operating margins, and the fragmented nature of the telecommunications industry paints a bleak outlook for margin expansion in the foreseeable future even after the rollout of 5G.
Even though the nationwide deployment of 5G technology will create new opportunities for Verizon, the company will incur massive costs to secure its market position in the coming years. Therefore, it would be reasonable to conclude that the outlook for Verizon is not very promising despite a few favorable macroeconomic developments, and the company is likely to grow at a slow and steady pace in the foreseeable future.
The valuation is cheap
Buffett is a value investor, so the decision to invest in Verizon does not come as a surprise to me considering the cheap valuation at which the stock is trading hands today. Even after a 5% bump in the stock price on Feb. 17, Verizon stock is down more than 7% in the last 12 months. Considering the S&P 500 index's return of 18% in 2020, this underperformance comes as a surprise. Verizon shares are trading at a forward earnings multiple of 10.73 in comparison to the communication services sector average of 22.47, suggesting the stock is significantly undervalued from a relative valuation perspective.
The dividend is another reason for value investors to be excited
Verizon pays a quarterly dividend of approximately 63 cents, which translates to an annual yield of 4.64% at the closing market price of $56.99 on Feb. 17.
The yield is significantly above what is available on the bond market today, and a closer look at the dividend history reveals Verizon has consistently covered its distributions with free cash flow, which is a good sign for income-oriented investors.
Source: GuruFocus
In the fourth-quarter earnings call, Cowen analyst Colby Synesael inquired whether the proposed increase in corporate taxes to 28% from 21% will materially impair the ability of Verizon to maintain its dividend in the future. Answering this question, Chief Financial Officer Matthew Ellis said:
"We had good dividend coverage when we had a much higher tax rate not too many years ago. So, while we certainly believe that the current rate has been very helpful in job creation and in economic growth creation, we are certainly very comfortable with how our business is set up as the administration is looking at different things."
Company executives seem to be confident of Verizon's ability to maintain the dividend at the current rate even if tax reforms negatively impact the cash flow of the company, and this is a good sign. More often than not, management's confidence about dividends can be used as a reliable leading indicator of dividend cuts, and Verizon seems to be a good bet for value investors with a focus on current period income.
Takeaway
Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway recently revealed an investment worth over $8 billion in Verizon Communications. The guru has always taken a liking to exceptional companies trading at fair valuation multiples, and the telecommunications giant fits this profile nicely. Following Buffett into Verizon seems to be a good option for value investors, but growth-oriented investors might want to look for other lesser-known companies in the market as Verizon's earnings are very unlikely to grow substantially in the next five years.
Disclosure: The author does not own any shares mentioned in this article.
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