Verizon Stock: Challenges Continue (NYSE:VZ)

In July of this year, I wondered whether it would be the time to pick up the phone for Verizon Communications (NYSE:VZ), or whether it was still too early.

The company has been going on an investment spree over the last couple of years, but it is not seeing the results to justify these investments. As a result, debt kept increasing (mostly) in absolute terms, yet, for me, Verizon no longer was the growth darling which it used to be.

Capital discipline and higher 5G revenues would be welcomed to comfort investors, as a bit more investment discipline and leverage reduction would be welcomed in a rapidly rising interest rate environment, as the company had much work to do.

Some Perspective

When I looked at Verizon earlier this year, I went back to 2018 when I last had a thorough review of the business. At the time, the company operated a cash hungry wireless business, which was funded by the cash cow called the wireline business. The third pillar was the ambitious Oath business, comprised out of the acquired activities of AOL, Yahoo and Telematics, yet their combined contribution was relatively modest, although of a higher public profile.

Note: As of today, Verizon has a different method of classifying its activities. All together, these activities generated $126 billion in sales in 2017 on which operating earnings of $27 billion were reported. This worked down to earnings of $3.74 per share, as the company torched along a substantial net debt load. Net debt was posted at $115 billion, and even $137 billion if pension related liabilities are included.

Trading at $53 at the time, Verizon traded at 14-15 times earnings, as a neutral stance seemed fair at best given the circumstances.

In the five years which followed, the company and its shares have mostly seen stagnation. Revenues rose in a modest fashion to $133 billion in 2021, yet operating earnings improved to $32 billion, as earnings rose to $5.32 per share. These modest gains were however accompanied by an increase to $148 billion in net debt, following some $50 billion being invested in wireless licenses in 2021 alone. With earnings power seen around $5 per share, its shares fell to the mid-forties in July of this year, as multiples were non-demanding.

The issue is that momentum is completely cooling down. Second quarter sales for this year (as reported in July) revealed that revenues were flat at $33 billion as inflationary trends made that operating earnings fell by $600 million to $7.5 billion, with earnings per share down sixteen cents to $1.24 per share. Despite the billions spent on wireless licenses, the company actually did not have any customer gains to show for this. Large investments and lack of growth made that earnings were pressured with full year earnings cut to $5.10-$5.25 per share, yet a 50% payout ratio and large net capital expenditure requirements made investors cautious amidst the debt taken on, and the impact of a rising interest rate environment on this debt load.

After all, the company paid about $3 billion a year in interest on $150 billion in debt, as a 1% higher increase in rates could hurt earnings by $1.5 billion, equal to 7% of earnings of $22 billion. Discipline of capital allocation in terms of investments into the network and M&A appeared to be the issue. While the dividend looks enticing, some real entrepreneurial spirit and capital discipline would be welcomed to rejuvenate the investment case.

A New Setback

Between July and now, shares have fallen following a continuation of rising rates and a disappointing third quarter earnings report, with shares now down to just $35 here. Since the release of the second quarter earnings report in July, little has happened on the corporate front other than a 1.25 cent increase in the quarterly dividend to 65.25 cents, for a $2.61 per share annual dividend payout, with Verizon only adding to its dividend commitments at a time when earnings are pressured already.

Second quarter sales rose 4% to $34.2 billion, driven by growth in equipment sales, with service revenues being largely flat. Total expenses rose 9.7% to $26.3 billion, triggering an 11% fall in operating earnings to $7.9 billion. With interest expenses on the increase, net earnings were down 23% to $5.0 billion.

Amidst a 1% dilution in the share base, earnings per share were down 24% to $1.17 per share, making that the payout ratio in terms of the dividend now solidly comes in above 50%. On the bright side, the worst of the investment spree seem to be a thing of the past, as EBITDA trends around $50 billion a year. Moreover, adjusted earnings came in a bit higher at $1.32 per share as the company took a $645 million mark-to-market charge related to pensions and a $236 million amortization charge on past deals.

Part of the growth in the business is due to a relatively stronger consumer segment versus other segments, and that is related to higher prices. That however comes at a cost, as Verizon lost 189,000 wireless retail postpaid phone users as this hurt investors, despite gains in prepaid additions and fixed wireless additions. Churn was reported at 92 basis points, which looks low but is up 18 points on the year.

Hence, the company is maintaining the guidance, but investor fear that Verizon is taking the easy route, raising prices to keep numbers up, certainly as interest rates hurt the bottom line through higher interest expenses. This is offset by a reasonable balance of a long term duration bond portfolio through which Verizon obtains its capital, of which a big portion is fixed, of course.

That provides support to the numbers in the near term, but over time it really becomes a cost, certainly as the company is up against fierce competition from AT&T (T) which appears to have found some operating momentum as again, just like T-Mobile USA (TMUS), of course.

Some Perspective

The reality is that despite the concerns about debt and lack of growth, or shrinking user base, shares only traded at 7 times earnings. Of course, the concerns about higher rates and subscriber losses are real and serious, yet the situation appears manageable as the bright spot is that most of the elevated capital spending appears to be a thing of the past by now.

Stagnating business performance, higher interest expenses and higher dividends hurt free cash flow generation, only offset by slightly lower capital investment requirements. The positive is that the business is expected to cut costs by $2-$3 billion in 2025, in an attempt to offset by some of these headwinds.

Hence, I find myself performing a balancing act between a dirt cheap earnings multiple and struggles with regard to positioning, competition and leverage, in a rapidly rising interest rate environment. Management certainly has to take part of the blame, including the fact that dividends are being hiked despite the operational challenges. The biggest long term risks might be a threat to the oligopoly in the industry, driven by technology developments in the long haul.

For now expectations are lackluster, yet so is the performance as some real cost cuts and growth has to be delivered upon to ignite some appeal again.