My Thesis
After a very strong correction in telecom stocks over the last 2 years, today is the time to consider one of the industry's highest quality and highest-yielding stocks - Verizon Communications Inc. (NYSE:VZ).
My Reasoning
Pressure on the telecom sector in 2022-2023 came from all sides: rising interest rates (which theoretically reduce the attractiveness of dividend companies), Amazon's (AMZN) plans to offer a low-cost mobile service for its Prime customers, and the Wall Street Journal's investigation that phone companies have left behind a network of cables coated in toxic lead, contaminating water, and soil in some places.
The abundance of negativity surrounding this sector has caused dividend yields on genuine quality companies to rise to extreme levels over the last 10-15 years, excluding COVID panic selling. And I see Verizon as one of the highest-quality companies - let me explain why.
Verizon is a leader in the U.S. telecommunications industry, though its revenue is constantly stagnating because of market saturation. In the third quarter of fiscal year 2023, Verizon reported a 2.6% decline in revenue compared to the prior year, totaling $33.3 billion. This dip was primarily attributed to a 12% decrease in wireless equipment revenue, influenced by a 26% drop in postpaid subscriber upgrades. However, the company's wireless service revenue witnessed a 2.9% increase, driven by higher prices, a growing number of customers selecting premium unlimited plans, and enhanced contributions from the fixed wireless access rollout.
Verizon's consolidated adjusted EBITDA increased by 0.2% to $12.2 billion, with a margin expansion of 100 basis points to 36.7%. Adjusted diluted EPS fell by 7.6% to $1.22, reflecting certain costs added back in comparison to the prior year.
All of this contributed to the company exceeding forecasts for both sales and earnings in the third quarter:
VZ increased its quarterly dividend by 2% to $0.665, aligning with its dividend forecast. In my opinion, the company's latest results give reason to hope that the consensus dividend will be achieved in the next few years. If this is indeed the case, investors will receive almost 7% per annum on their investments today (with no change in the share price). But in my opinion, the stock price should adjust higher because of the background of a monetary policy turnaround by the Fed. Therefore, current yields should be somewhat lower in the foreseeable future than they are estimated at today.
Returning to the company's financial statements, it's worth noting Verizon's strong free cash flow - the key metric that value investors often look at first. VZ's free cash flow has fully recovered after the dramatic slump in 2021 and continues to grow, increasing the chances that the dividend forecasts for 2024 and 2025-26 will be met (or even slightly beat).
Looking ahead, Verizon raised its 2023 EPS forecast to $4.74 and maintained its FY2024 estimate at $4.82. The company aims to measure success through growth in service revenue, EBITDA, and cash flow. While Verizon continues to expand its 5G network and 'Intelligent Edge' services, it also focuses on operational efficiency, cost savings, and subscriber acquisition. I mentioned above that VZ's margin started to expand, and judging by management's guidance, we should expect this trend to continue (or at least stabilize, which is also good for a cash cow stock). The acquisition of Tracfone in 2021 is also expected to strengthen Verizon's position in the prepaid market, offering potential synergies and back-office efficiencies. Several years have already passed since the acquisition, and as the process of integrating companies takes some time, the fruits of the synergy should become visible shortly.
Verizon's partnership with Disney (DIS) to provide free Disney+ streaming service to select subscribers reflects the competitive landscape in the U.S. wireless market. The company is actively pursuing strategic partnerships, including those with Peloton (PTON) and Netflix (NFLX). Additionally, Verizon's substantial investment in the C-band spectrum aims to support the development of true 5G services, with a focus on fixed wireless access and business wireless opportunities. The company anticipates covering 250 million people with 5G service by the end of 2024.
From all of this, I make an intermediate conclusion that Verizon's revenue will most likely be supported by new lines of business and partnerships, which should theoretically protect the dividend against a backdrop of cost optimization.
Now for the most interesting part - the VZ stock valuation. While preparing this article, I studied the articles of some other analysts and repeatedly came across the opinion that VZ is overvalued, as the P/E ratio of VZ is significantly higher than that of AT&T (T). In fact, the input data to this statement is correct - VZ's next-year P/E ratio is 22% higher than T's:
But is it worth limiting yourself to the P/E ratio alone? What about calculating the price/sales ratio and correlating this figure with sales growth? In this respect, VZ's valuation no longer looks so inflated:
It is also worth noting that over the last 3 years VZ experienced the strongest multiple contraction in the group of companies I selected, which completely disrupted the usual sequence:
Continuing the comparison with T, the superior dividend of VZ for the next 3 years is also worth mentioning: for a $1 invested today, investors will receive, albeit not much, but still more dividend if they choose VZ instead of T:
At the same time, a kind of option is built into the VZ shares that its valuation multiple will grow in step with its competitors, which in my opinion additionally increases the potential total return. This means that if the current sales growth rates of VZ and T are maintained, the former's multiples should logically begin to reduce the existing discrepancy again and revert to the mean:
Risks To Consider
The telecommunications sector, marked by rapid technological shifts, places companies like Verizon at the forefront of innovation. While Verizon has maintained a leadership position in 4G and made strides in 5G, the industry's susceptibility to disruptive technological changes poses challenges.
Verizon faces an emerging risk related to legacy infrastructure, as highlighted by a Wall Street Journal investigation into the environmental and health hazards associated with lead-sheathed copper cables used in the past. Although Verizon transitioned away from such cables in the 1950s, uncertainty remains about the extent to which its network might still include them. This poses potential liabilities, especially considering past acquisitions like MCI and XO, which may have used similar cables. The investigation introduces a new dimension of risk, requiring thorough research and mitigation strategies to address any potential environmental and health impacts, adding a layer of complexity to Verizon's risk landscape.
In addition to the risk factors that apply to the industry as a whole, I am puzzled by VZ's debt load, which is not decreasing as much as the company's debt-to-equity ratio is increasing. If you then add to this the falling liquidity indicators, you have another fully-fledged risk factor that cannot be ignored:
Your Takeaway
Despite the existing risk factors, I believe that the overall negative sentiment towards the telecom sector is already fully reflected in the share prices of companies like Verizon. At the same time, VZ looks interesting against the backdrop of, say, AT&T, due to its plans for future development and relatively higher yield, the superiority of which, all other things being equal, should persist in the next 2-3 years. Also, the stock has a kind of reserve for rising valuation multiples in my opinion, which may give an additional boost to VZ's overall return level as the Fed funds rate falls.
Therefore, I believe it is not too late for income investors to buy VZ.
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