Quick Thoughts: VZ – A Plateau Doesn’t Rise on the Other Side
VZ CEO Lowell McAdam – “While well-positioned for the future, Verizon’s full-year 2016 earnings may plateau at 2015 levels as the company manages near-term impacts.” These words at an investors’ conference yesterday morning hit the stock 2% in trading, although it remains at a healthy 11.5x forward earnings projections that do not yet reflect the company’s expected “plateau”. Going forward, we believe that the market conditions behind VZ’s current woes – a shift in wireless buying criteria from coverage to data speeds/availability/cost, an aggressive TMUS taking subs and pressuring ARPU, a squeeze in PayTV, ongoing deterioration of the traditional wireline franchise, and the specter of future competition in broadband – will get worse rather than better. As a result, investors could see falling revenues, earnings and cash flows in 2017 and beyond, yielding future multiple contraction and threatening dividend yields. We cannot recommend holding VZ or T at this time, and greatly prefer TMUS, on which we have recently published an in depth report. (http://www.ssrllc.com/wp-content/uploads//ftr/15.07.09-TMUS-Wireless-Ain%E2%80%99t-What-it-Used-to-Be.pdf).
As of yesterday, analysts were pretty bullish on Verizon. The average rating of the 33 brokers that cover it directly was solidly in Outperform territory, with only 3 assigning an Underperform or Sell rating. Expectations for 2015 forecast 3.4% sales growth, 17.6% EPS growth, and 22.4% free cash flow growth, while the consensus through 2019 projected 5 year CAGRS of 1.9% top line, 6% EPS and 5.4 for FCF. Against this outlook, VZ was trading at a near 11.5x multiple of forward earnings, buoyed by its 5% dividend yield.
However, Verizon CEO Lowell McAdam threw a bit of cold water on that optimism this morning speaking at the Goldman Sachs Communicopia Conference:
“While well-positioned for the future, Verizon’s full-year 2016 earnings may plateau at 2015 levels as the company manages near-term impacts. These impacts include the commercial model change in wireless, year-over-year wireline financial comparisons following the expected first-half 2016 sale of operations to Frontier Communications Corp., and the ramp up of new business models for wireless video and IoT.
With expectations of continued strong cash flow, Verizon reiterates its capital allocation priorities of network investment, returning value to shareholders, maintaining a strong balance sheet, and returning to the company’s pre-Vodafone-transaction credit rating profile in the 2018-2019 timeframe.”
Of course, McAdam is hoping to imply that the diminished guidance for 2016 is the result of a one-time blip, but the paradigm shifts wracking the telecommunications industry, and in particular, the duopoly of Verizon and AT&T that have ruled the wireless roost for well over a decade, seem rather more permanent than that.
Let’s consider wireless, where Verizon collects about 70% of its sales and almost all of its operating income. Within that, Verizon’s wireless services, almost 3/4ths of wireless revenues and sporting a nearly 50% operating margin, have turned down YoY in each of the past two quarters after an essentially unbroken string of growth over many years. In contrast, the sale of mobile devices, the remainder of the wireless revenues and a substantial loss maker, are up nearly 10% in the most recent quarter, due, at least in part, to higher than expected upgrade sales of the expensive iPhone 6 and 6 Plus. The change in the commercial model noted by McAdam is a shift from phone subsidies to installment sales. This may should greatly improve the economics of distributing devices, but will expose the services business to pricing pressure and higher churn as subscribers will be more free to shop for better rates. And those rates are out there. T-Mobile has led the charge in reducing rates, offering unlimited voice, text and data plans at better than 40% discounts for heavy users, combined with the numerous consumer friendly policies introduced in its “Uncarrier” initiatives.
In the past, Verizon, and its fellow duopolist AT&T, have been able to fall back on network quality to justify their ample price umbrella. By virtue of the superior spectrum granted their historical antecedents back in 1982 when the original cellular licenses were awarded, the two market leaders have been able to serve larger swaths of unbroken territory with fewer cell sites, an advantage long touted in Verizon’s “Can you hear me now?” and coverage map advertising. However, consumer perceptions of network quality are changing, with voice calling and coverage falling in importance and data availability and speed coming to the fore. As a result, T-Mobile’s strategy is working now, enabling it to harvest subscribers from below while the market leaders play defense to protect their ARPUs, a dynamic that we detailed in our recent deep dive piece (http://www.ssrllc.com/wp-content/uploads//ftr/15.07.09-TMUS-Wireless-Ain%E2%80%99t-What-it-Used-to-Be.pdf)
We do not believe that Verizon’s move to mimic T-Mobile’s device financing without corresponding rate reductions and more liberal data plans can stem the tide. We do not believe that Verizon’s mobile TV aspirations will be sufficiently differentiated to make much of a difference. We expect the market for Internet-of-things (IoT) connectivity will be very price sensitive and competitive. In short, we see Verizon’s 2016 plateau as the inflection point for a long, slow and inevitable deterioration in the company’s core wireless business and a consequent deterioration in the company’s cash flows and, thus, dividends.