David Ramos
Admittedly, Verizon (NYSE:VZ) is not a high-growth investment as it engages in the mature telecom business, despite its foot in the burgeoning 5G market in recent years. Management has vowed to achieve a conservative GDP+ growth trajectory of more than 3% y/y over the longer-term, as it seeks to recoup returns on capital-intensive investments made into building out its 5G capacity in recent years by capitalizing on the next-generation of connectivity demand. Yet, it seems that the growth target, though conservative, is becoming further out of reach, with Verizon’s disappointing 1H22 results expected to last through the second half after CEO Hans Vestberg warned of continued churn in the current quarter as customers become increasingly price sensitive under the restrictive economy.
Because the results are such a stark contrast to rival AT&T’s (T), which benefited from resilient consumer wireless take-rates despite similar price hikes earlier this year, Verizon’s near-term fundamental weakness is indicative of isolated internal operational inefficiencies that may pose a bigger problem than just macroeconomic headwinds felt across the industry. Although Verizon is not a growth stock, maintaining sustained top- and bottom-line expansion remains crucial to safeguarding its dividend payout, which is critical to its income-focused investor base. With no positive catalysts within sight for Verizon, its GDP+ growth plans are becoming further out of reach, which risks further volatility in the stock as investors attracted to its generous dividend yield now place further scrutiny into the sustainability of its fundamentals in the near-term.
Increasing Churn Doesn’t Look Good
Verizon has already fallen behind rivals’ postpaid consumer wireless net adds by a far cry in the second quarter, citing customers’ price sensitivity after the company decided to hike monthly plan rates by as much as $12. As a result, Verizon has been forced to adjust its full-year fundamental guidance for a second time this year, with its earnings expectations being cut from an earlier range of $5.40 to $5.55 per share, to $5.10 to $5.25 per share, which left a sour taste in investors’ mouths. The fact that key rival AT&T had gained market share after taking similar steps in raising monthly plan rates indicates that Verizon’s market leadership is gradually losing its strength to heightened competition, putting its long-term growth and investment recovery goals further out of reach:
Although more of Verizon’s customers are adopting 5G today, its subscription base is contracting… Verizon is experiencing one of the highest churn rates on record, with competitors aggressively vying for market share through similar offerings. While AT&T has also raised prices on legacy plans this year as part of a push to encourage greater migration to its higher priced, higher margin unlimited plans, Verizon seems to have executed its strategy rather poorly based on the wide distance in both carriers’ postpaid phone net adds during the second quarter.
Source: “Verizon: Is the Yield Worth the Risk?“
In the latest development, Verizon CEO Vestberg warned of continued churn in consumer wireless as the retail market accustoms to rising plan rates that have been strategically adjusted to account for higher value offerings and increasing operational costs under the current economic environment. While we agree with Vestberg that the price increases put into place to encourage greater adoption of unlimited plans and compensate for increasing operational costs is a step in the right direction from a business perspective, the company’s execution appears to be the source of the problem considering the comparatively substantial churn experienced at Verizon when compared to rivals like AT&T and T-Mobile (TMUS), which continue to benefit from resilient demand amid rising recession risks. The bigger setback for Verizon is the fact that while it has been one of the biggest spenders in 5G investments in recent years, the rate of conversion to returns seems to be muted and lags behind peers’ by wide margins as well, which further raises concerns on execution risks considering the company’s top-line deceleration and bottom-line contraction observed through 1H22.
And while Apple’s (AAPL) newest iPhone 14 release has been the hottest talk of town in telco over the past few weeks, Vestberg’s recent negative commentary appears to have cut the party short for Verizon. The company currently boasts one of the most competitive and attractive iPhone 14 incentives, offering up to $800 in rebates on eligible iPhone trade-ins and subscriptions on select 5G Unlimited plans that start at $90 per month, although it concludes additional access to the Apple One service bundle that combines Apple Music, Apple TV+, Apple Arcade and iCloud+ ($14.95/month value). But with churn expected to remain elevated through 2H22, Verizon is likely experiencing weak take-rates still, with additional cost pressures stemming from the promotional incentives that have already weighed on its margins:
Adjusted EBITDA was $11.9 billion for the quarter, down 2.6% year-over-year due to the divestiture of Verizon Media, higher device subsidies and promotional spending associated with the increased wireless activations, wireline revenue declines and inflationary cost pressures.
Again, the anticipated burden of promotional incentives offered by Verizon is a stark contrast to benefits experienced by peers, bringing to light its elevated execution risks ahead. At AT&T, the company has instead praised its “tempered” approach to annual promotional activity for providing greater visibility into its forward growth trajectory and margin profile, while similar incentives provided by T-Mobile have also contributed to the company’s market share gains in recent years:
In fact, looking at many of your commentaries, you’ve been articulating that others have been much more aggressive in the market and probably leaning into promotional activity in a heavier way. And I would say, I would characterize our approach as being much more tempered and consistent with the past. And we have not really responded to that increased promotional activity that we’re seeing from others in the market right now… Industry growth in the first half of 2022 has been stronger than the expectations I shared with you late last year. In our view, this strong performance reinforces that our success is not solely promotion-led, but instead reflective of our improved value proposition in the market. Again, our customer growth performance was better than we expected, especially when you consider we became less active in promotional activities compared to others in our industry. So it’s clear to us that the strategic change we made to simplify our go-to-market strategy 2 years ago continue to yield great results and that our value proposition is resonating in the marketplace.
Source: AT&T 2Q22 Earnings Call Transcript
And it’s been about consistently the case in terms of the extent of that value leadership. Now we’re always introducing new promotions. But I want to be really clear. Our strategy as a company is about showing customers the remarkable value of Magenta MAX. That’s our strategy. And you can see how it’s unfolding in terms of customers self-selecting up our stack to buy our best products because they are the very best expression of the very best 5G network. And that is running on all cylinders, allowing us today with the best values and with incredible promotions in the market to tell you about for the first time in the 10 years I’ve been here, an outlook of ARPU rising. And that was something we just did a few minutes ago for the first time in the entire decade I’ve been here on the strength of this strategy.
And so it really shows that we can have it both ways. We can have the best value in the industry, remarkable promotions, bring competition to this market like we always have, to no greater or lesser extent than in our past, while simultaneously showcasing the incredible value of our leading 5G network in the expression of Magenta MAX and attracting customers to that best expression.
Sustainability of Dividend Hikes at Risk
Verizon has recently increased its quarterly dividend from $0.62 to $0.6525 per share, which translates to an annualized payout increase of 2% to $2.61. The latest dividend increase is consistent with market expectations, bringing the payout yield to more than 6.5%. The payout ratio also remains largely in line with historical trends at approximately 50%, indicating Verizon’s commitment to generating a stable return to its base of income-focused investors.
While Verizon’s annual free cash flow generation remains a significant figure supportive of its current dividend payout, its fundamental performance’s widening distance from GDP+ long-term growth goals draws the question of whether continued dividend hikes at historical trends is sustainable. The company has increased dividends at an average of about 2% over the past three years, while maintaining a payout ratio of about 50%.
But with no immediate catalysts to arrest continued deceleration and margin contraction in sight, income-focused investors have no choice but to now factor into consideration the near-term execution risks to Verizon’s fundamental prospects, and inadvertently, investment thesis. This is expected to bring about further volatility to the stock’s near-term performance, especially considering violent market swings amid tightening economic conditions that are heightening recession concerns.
Final Thoughts
While the Verizon stock is currently valued at a “multi-year low” (under 8x forward P/E, compared to ~10x 3-year average), with strong cash flows and a profitable business to back further upsides, the lack of near-term catalysts to restore investors’ confidence in the company’s fundamental strength required to regain its ground as the industry leader within the concentrated U.S. telco market introduces further volatility ahead. Paired with broad-based economic weakness that is expected to introduce continued uncertainty to the near-term market climate, the stock is likely to trend lower over coming months.
Although Verizon’s dividend yield remains attractive on a comparative basis to peers and safe when considering its generous positive operational free cash flows still, which plays to the favor of its income-focused investors’ base, the potential for protracted fundamental weakness is now risking an erosion of this thesis, which should not be overlooked.
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