David Ramos
The nice thing of not having covered an individual name for a while is that once you do, you really get the chance to see how past opinions played out, as the same applies to me in the case of Verizon Communications (NYSE:VZ). With shares hitting fresh lows, it is time to update a dated investment case here.
Back To 2018
Early in 2018 I wrote that some operating momentum in the wireless business and tax reforms created some momentum after a difficult 2017, having the potential to reduce leverage over time. The business was huge of course comprised out of a growing, yet cash hungry wireless business, while the wireline business was very stable, essentially set to die over time, being cash flow positive, yet not posting real earnings based on GAAP accounting.
Of course there was a third pillar as well, the so-called Oath business which was comprised out of the acquired AOL, Yahoo and Telematics operations, but this was just relatively small. These activities combined generated $126 billion in sales in 2017 on which $27 billion in operating earnings were posted, both relative stable numbers compared to 2016.
The company earned $3.74 per share for 2017, yet operated with $115 billion in net debt, a number which rose to $137 billion if pension- and alike liabilities were included. Given the enormous EBITDA of the business, that actually translated into leverage ratios around 3 times, yet many of the cash flows are earmarked for dividends and investments in the networks, leaving few dollars to reduce leverage, certainly in an absolute dollar amount.
With shares trading at $53, the resulting 14-15 times earnings multiple looked reasonable given the stability of the operations, although some disruption over time to parts of its business could be seen, making that I was not becoming more optimistic than to issue a neutral stance.
Disappointing Performance
In the near 5 year which followed shares of Verizon have been trading range bound between $45 and $60 per share, now trading towards the lower end of the range. Early in 2022 the company posted its 2021 results as revenues have inched up modestly to $133 billion (comparing to 2017) as operating earnings improved meaningfully to $32 billion and earnings per share have risen to $5.32 per share, including a dollar gain in the last year.
The problem is that net financial debt has risen to $148 billion as more than $50 billion was invested in wireless licenses in 2021, an unprecedented number by all means as leverage ratios were still stuck around 3 times as both net debt and earnings have improved, and with earnings I am referring to EBITDA for the leverage calculation.
The problems really are seen in the results for the first half of 2022, and in a particular the second quarter. Revenues for the quarter were flat at $33 billion and change and amidst inflation in the costs base it were operating earnings of $7.5 billion which were down some $600 million on the year before. All this made that net earnings were down sixteen cents to $1.24 per share, as the company actually incurred 1% dilution in the share count and investors are arguably afraid of higher interest rates on the huge debt load, although that was not yet seen in the quarterly results.
On the operational front there are more areas of softness as wireless was long the growth engine of the business, but despite $50 billion spent on licenses last year the company actually lost 36 thousand wireless retail postpaid customers on a net basis in the first quarter, to win only 12 thousand in the second quarter. Prepaid customer declines picked up meaningfully higher to more than 200,000 losses during the quarter.
These softer trends triggered the company into guiding for flat to minus 1% revenue growth now for the year (which compares to a previous flattish revenue outlook) and with inflationary pressuring building, the full year earnings guidance has been cut by thirty cents to $5.10-$5.25 per share. Of these earnings, roughly half is paid out in the form of a very compelling >5% dividend yield with payout trending at $2.56 per share as net capex requirements provide no room to deleverage the dollar amount of debt taken on.
And Now?
Even after cutting the full year guidance, shares of Verizon trade at less than 9 times earnings which looks incredibly compelling, but there are real caveats to that. First, the business is struggling on the operational front and earnings are a bit different from cash flows, as Verizon has been spending billions to invest into the network and thus the business, making that leverage is not coming down in dollar terms.
The other issue is that the interest bill currently trends around $3 billion a year on a roughly $150 billion debt load. While the company would still earn about $22 billion this year, a 1% higher interest rates hurt earnings by $1.5 billion on a pre-tax basis, or about 7% of that profit number, as some higher interest costs should be expected.
Truth is that I think that shares are dirt cheap from an earnings point of view, but investing is all about the cash flows. A lot of money has historically gone to dividends, investments into licenses which allow the 5G transition and some ¨funny¨ deals left and right, resulting in a huge net debt load of which made me feel somewhat uncomfortable here.
Hence, discipline and allocation of capital seems the problem here and while the current operating performance is lackluster and debt concerns are somewhat there (at least with me) the issue is that if the 5G capital investment cycle is largely becoming a thing of the past (question mark) we might be able to see some improved cash flow conversion.
Amidst all these moving targets, I am allocating a small position in a dividend account. The underperformance of these names (not just Verizon) has been noteworthy over long term time frames while their function will remain critical in the future, yet some more entrepreneurial spirit and improved capital discipline would be really welcomed here.
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