Verizon Communications: The Signal in the Noise
Over the last month, we’ve built a position in Verizon Communications (VZ), the largest wireless provider with over $80 billion in wireless revenues, 105 million retail customers, and coverage of more than 95% of the U.S. population. At about 34% market share each, they and AT&T have a commanding lead over their only other significant competitors, Sprint (16% share) and T-Mobile (15% share). We believe we’ve been able to acquire this business at an attractive price as result of two primary factors.
The first factor is overblown fears about intensified competition in the wireless market. Investors are concerned that, after years of generating subpar returns for shareholders and in a desperate grab for share, Sprint and T-Mobile may either merge or cut their voice and data plan pricing significantly, either of which they fear could significantly impair the profitability of Verizon and AT&T. We are skeptical. If Sprint and T-Mobile are eventually allowed to merge, it seems unlikely to us that they will destroy profitability for a cozy three-player oligopoly. If they are never allowed to merge, as seems to be the case based on the FCC’s recent commentary, we still think it’s unlikely that they destroy profitability for the two industry goliaths. Given the rapid growth in data usage and people’s increasing reliance on their cellphones as their primary mode of communication, the industry appears to have evolved from a market in which cell phones are chosen on the basis of price to a market in which cell phones are chosen on the basis of their network coverage. In this environment, AT&T and Verizon should be able to maintain premium pricing because of their vastly superior networks. Finally, even if Sprint and T-Mobile eventually achieve network parity, the fundamental limitations of spectrum availability combined with rapid data growth (Cisco Systems predicts 50% compound annual growth in the U.S. through at least 2018) have a very good shot of creating a market in which wireless data demand outstrips supply growth. If this condition persists over a long time period, it is a surefire prescription for sustained pricing power as the wireless providers can sell access to their networks at ever-higher prices to those who most value this access. This pricing power is in great contrast to the wireline business, in which far fewer technical challenges to network capacity expansion as well as the installation of multiple competing lines (from cable to fiber) eventually led to virtually unlimited wireline voice communication supply, aggressive pricing, and razor thin margins.
The second factor is an uninspiring past decade of financial performance that masks underlying changes in both Verizon’s business composition and its financial liabilities. These changes have put Verizon on much firmer footing and should drive significantly better future results.
The first change, in business composition, has been dramatic. Over the past 10 years, Verizon has had mediocre operating results as its torrid wireless growth has, to a large extent, been offset by declines in wireline as more and more people cut their home and business phone cords. Now, however, after years of this dynamic combined with the recent purchase of Vodafone’s 45% stake in Verizon Wireless, fully two-thirds of Verizon’s business is wireless. Thus, going forward, we believe the wireless business, which operates at an extremely healthy 34% operating margin with mid to high single digit revenue growth rates, should overwhelm the meager results of wireline, which will likely continue to be a 0-2% operating margin business with flattish revenue growth. This much greater impact of wireless results should lead to mid-single digit revenue growth for the overall enterprise. Even better, margins should expand as a simple consequence of the continued mix shift to more and more wireless. If margins in the wireless division continue to expand as well, so much the better. Finally, as Verizon moves closer and closer to becoming a pure-play wireless company, its valuation multiple should increase.
The second change that has muddied the results, particularly over the last five years, is the pension liability, which is fairly material at about 11% of the enterprise value of Verizon. Accounting rules have forced Verizon to run big positive and negative charges through the income statement as a result of changes in the discount rate on pension liabilities and differences between actual and expected investment results on pension assets. This earnings volatility has likely confused many investors, causing them to ascribe a lower earnings multiple to Verizon’s stock. Furthermore, the impact of these charges has more often been negative instead of positive as the discount rate on the pension liabilities (by far the biggest swing factor in Verizon’s pension charges) has relentlessly declined with interest rates over the last five years. Given that interest rates are likely artificially depressed as a result of the Fed’s massive quantitative easing, we think it’s highly probable that the discount rate doesn’t get much worse from here and reasonably probable that it actually gets significantly better, providing a boost to earnings over the medium term.
So, overall, there’s a lot to like. Verizon is the largest and most profitable player in a growing market with utility-like characteristics (i.e. no matter what the economic environment, the vast majority of people will continue to pay their wireless phone bill because of the critical role it plays in their professional and personal lives), and we believe it’s cheap because of a number of misunderstandings about the strength of its business model. If we’re correct in our diagnosis of the pressures on Verizon’s stock price, we believe our investment will generate returns well in excess of the market as the business performance positively surprises analysts. If we’re wrong and Verizon’s business performance more closely resembles that of the previous decade, we believe we’ll still generate solid returns on the back of Verizon’s copious and steady cash flow, which we expect to be returned to investors through debt pay-downs, the company’s large dividend, and maybe even some future stock repurchases.
Can you hear me now?
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Nothing said in this piece may be considered to be an offer to buy or sell any security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Data presented was obtained from sources deemed to be reliable, but no guarantee is made as to its accuracy. Past performance is no guarantee of future results.