Verizon Communications (NYSE:VZ) is the world’s largest telecommunications company and continues to benefit from a tangible narrow economic moat built upon their massive scale of operations and exceptional network capabilities.
The firm continues to have industry leading margins and ROIC with Verizon outpacing their competitors substantially. While the market may be mature with little room for growth, Verizon is in prime position to continue generating massive revenues into the future.
Some cyclical headwinds have led to share prices falling rapidly over the last five years. This presents value investors with a potential 38% undervaluation to take advantage of in Verizon shares.
Therefore, I rate Verizon stock a Strong Buy in fall 2023.
Verizon is an American telecommunications company that offers a wide range of network connectivity products to both consumer-grade and enterprise level customers alike. The firm has grown to become the world’s largest provider of wireless, fiber optics and global information networks services.
The firm’s primary business relies on the provision of wireless network services through cellphone and network contracts. Verizon also operates a smaller (by revenue) fixed-line business that provides telecom services and broadband to around 8 million customers.
Verizon operates within the highly competitive and increasingly consolidated telecommunications business and is by far the largest player within the industry. While key rivals AT&T (T) and T-Mobile (TMUS) are much smaller than the firm, a mostly rational pricing model has emerged between players especially post the T-Mobile merger with Sprint.
Given the massive capital requirements and mature market environment, Verizon has relatively muted market share or growth prospects in the future. Nonetheless, the firm’s dedication to ensuring their networks are of the highest quality and the most reliable within the industry should help the firm earn outsized returns on their invested capital.
Hans Vestberg took over the helm at Verizon being appointed as CEO back in 2018. Vestberg is an experienced leader within the telecommunications industry having served both as Ericsson’s CEO and as CTO at Verizon. Despite Vestberg having overseen some slightly disappointing years from a fiscal standpoint, I believe he has the knowledge and industry understanding required to lead Verizon moving forwards.
Economic Moat – In Depth Analysis
Verizon has managed to build a narrow yet relatively robust economic moat within the telecommunications industry. The firm’s prioritization of network quality and reach has developed a reputable image for the Verizon brand which along with their massive scale helps the firm earn outsized returns on invested capital.
Since the firm’s founding in the late 1990s, Verizon has grown rapidly primarily through a strategy of internal investment and a few strategic acquisitions. The acquisition of Alltel in 2009 massively increased Verizon’s overall reach and customer base within the U.S. telecommunications market and ultimately is the reason Verizon is so far ahead of its rivals in terms of scale.
I believe the overall reach and presence of Verizon wireless networks is what generates the majority of the firm’s economic moat. The capital required for AT&T or T-Mobile (let alone a new entrant into the market such as Dish) to match Verizon’s sheer scale of wireless networks coverage is essentially unviable for either of these two competing firms to achieve.
Verizon therefore tangibly benefits from being the largest wireless provider in the U.S. as their massive scale allows the firm to target both the highly populous (but also competitive) markets along with more rural ones.
Rural markets in particular allow Verizon to benefit from an almost dollar-store style monopoly whereby the firm’s wireless network services are essentially the only real option for consumers looking for telecommunication products.
Overall, the firm’s massive scale of wireless network operations generates a narrow economic moat thanks to the increased exposure to potential customers and the essentially irreplicable capital assets the firm possesses.
I also see Verizon tangibly benefitting within the market from their reputable brand image. The firm has built an incredibly reliable and high-quality wireless network offering for its clients which over the last five years has consistently ranked as the top network provider in the U.S.
Ookla’s RootMetrics network analysis tool has ranked Verizon as the top wireless telecom provider in the U.S. for nine of the past 10 years only having been beaten by AT&T in H1 2023.
It is this fundamental network superiority along with a host of strategic brand partnerships with the likes of Disney, Apple and Amazon that has allowed Verizon to build and maintain their reputable image as the both the quantitative and qualitative leaders in the telecommunications industry.
Considering Verizon’s scale, reach and brand advantages, I award the firm with a narrow economic moat rating which I believe will see the firm benefit from a tangible competitive edge for at least the next 10 years.
I would usually not rate a narrow economic moat as providing more than five years of competitive advantages due to the lack of substantial switching costs traditionally associated with narrow moats.
However, I believe that due to the huge capital required to build and maintain wireless network solutions, Verizon is uniquely placed to benefit from their moat for an additional five years.
Still, the ultimate lack of switching costs for both enterprise- and consumer-grade customers along with the mostly mature nature of the industry limits my ability to assign Verizon with a wide economic moat.
From an operating performance perspective, Verizon continues to generate consistent and reliable profits.
The firm’s last (as measured from FY22) 5Y average gross, operating and net margins of 58.29%, 22.66% and 15.15% are impressive given the highly competitive nature of the telecommunications industry.
A 58% gross margin illustrates that at its core, Verizon has a successful and profitable enterprise that has not suffered any tangible degradation despite compromising macroeconomic conditions.
Verizon’s operating and net margins in particular exceed those of rivals T-Mobile and AT&T by over 5% respectively which illustrates the overall cost advantage Verizon enjoys thanks to their economic moat.
Verizon’s 5Y average ROA, ROE and ROIC are 6.40%, 31.02% and 11.00% respectively. While these returns are not particularly impressive compared to firms operating in other industries, Verizon continues to lead rivals AT&T (ROA: 1.88%, ROE: 5.75% and ROIC: 4.45%) and T-Mobile (ROA: 2.74%, ROE: 8.35% and ROIC: 5.81%) substantially.
The last 10 years have essentially seen Verizon enjoy consistent returns and margins with little change occurring year-to-year. I believe this illustrates the overall advantage Verizon enjoys from a cost perspective within the industry which further increases the challenge for competing enterprises to match Verizon’s scale and customer base.
FY23 has been a little more difficult for Verizon than previous years with revenues, adjusted EBITDA and EPS declining QoQ.
Q1 saw a slight slump in YoY revenues with total consolidated revenue dropping to $32.9B. This drop in overall revenues was accompanied by an approximately equal 1.1% drop in adjusted EBITDA to $11.9B.
This drop in revenues was primarily caused by a drop in wireless equipment revenues induced by lower demand for wireless devices resulting in fewer phone upgrades and devices sales.
Despite this fiscal weakness Verizon recorded 437,000 new broadband net additions (which includes 393,000 fixed wireless access additions) along with a 3% YoY growth in overall wireless service revenues.
Cash flows from operations increased substantially from $6.8B in Q1 FY22 to over $8.3B in Q1 FY23.
A similar mixed bag of fiscal and operational performance was observed in Q2 of FY23 with the firm once again recording a YoY decline in revenues of around 3.5%. This weakness was once again caused by the firm’s wireless equipment segment seeing a drop in total sales of 21% which offset the minor 0.4% increase in revenues observed in their service revenues segment.
The continuing inflation and resulting increase in pricing levels observed across the U.S. is placing pressure on the disposable income available to consumers which has resulted in the upgrade cycle for wireless handsets becoming longer.
These macroeconomic pressures also resulted in Verizon’s total consumer business (which represents around 75% of total revenues) seeing a 4% decline in YoY revenues while the firm’s Business client-oriented segment only saw a 2% YoY drop.
H1 of FY23 has seen Verizon’s SG&A expenses increase by around 8% YoY due to increased marketing expenses, credit losses from bad debt reserves and increased charges related to information technology contracts and third-party employee costs.
While fiscal performance has waned throughout FY23 all the while COGS have increased, Verizon has seen their total wireless retail connections remain largely consistent YoY. The 1.1% growth seen in their wireless postpaid connections has been offset by the 6.4% drop in their less popular prepaid segment.
Fios internet and video connections have largely flatlined YoY while their total broadband segment has seen strong 16% growth.
Seeking Alpha’s Quant calculates an “A+” profitability rating for Verizon which (despite the weakening FY23 performance) I believe to be an accurate representation of the profitability potential present at Verizon.
While the firm’s performance in H1 of FY23 has been less than stellar, I believe that macroeconomic conditions are largely to blame for their fiscal weakness. Ultimately, the firm’s healthy gross margins suggest that fundamental profitability has not been compromised.
Verizon’s balance sheet is in healthy shape especially when considered against their two key rivals: T-Mobile and AT&T.
The firm has $37.4B in total current assets while total current liabilities amount to $51.4B. This lack of short-term liquidity leaves the firm with a less than impressive quick ratio of 0.54x and a current ratio of just 0.73.
Nonetheless, I believe the firm’s massive unlevered FCF of $14.31B will allow the firm to meet their current liabilities without the requirement to raise additional debt to cover these expenses.
The upcoming FY23 Q3 earnings report is eagerly awaited by investors as it should illustrate the real impact the inflationary macroeconomic environment has had on end consumers.
I believe Verizon will most likely see continued revenue declines of between 0.5% and 1.5% with overall wireless equipment sales continuing to decline in the high single-digits YoY.
Total assets for the firm amount to $380B with total liabilities just $283.5B. This leaves the firm with an excellent debt/equity ratio of 0.74. Furthermore, Verizon has very limited goodwill one their balance sheet with the majority of their assets combing from net PP&E along with other intangibles associated with their business operations.
Fundamentally, I believe Verizon exhibits a healthy balance sheet that illustrates fiscal restraint from management and Vestberg. I also like the divesture of the firm’s media business (consisting essentially of AOL and Yahoo) in 2021 as the sale allows Verizon to better concentrate on their core telecommunications business.
As of Q2 FY23, Verizon has $141.6B in long-term debt. While the firm endeavors to have the majority of their long-term debentures on fixed-rates, a substantial portion are on variable rates.
This exposes Verizon to some interest-rate risk as rising rates could see the firm’s interest expenses increase over the coming years.
Verizon also acquired a massive chunk of debt during the 2021 C-band auction. While Verizon acquired a significant presence on the bandwidth, it did come at a cost of around $65B. Still, I do believe this investment was a necessity for Verizon to ensure they retain their market leading position within the industry.
Nonetheless, this massive cost placed pressure on cash flows in 2021 and will continue to rest on the firm’s balance sheet for years to come.
Moody’s credit ratings agency affirmed a reasonable Baa1 credit rating for Verizon’s unsecured domestic notes and affirmed a Prime-2 rating for their domestic commercial paper. The outlook remains stable.
Moody’s classifies “Baa1” credit ratings as being of “medium investment grade” and classifies “Prime-2” short-term debt ratings as being of the “medium quality”.
Considering Verizon as a whole it is clear that the firm remains a profitability powerhouse despite the difficult macroeconomic conditions and the effect these factors have had on their core consumer business segment.
Verizon’s mostly healthy balance sheet and smart capital allocation further bolsters the hypothesis that management is laser focused on ensuring the firm remains at the forefront of the telecommunications industry.
Seeking Alpha’s Quant assigns Verizon with a “B” Valuation grade. I believe this is a slightly pessimistic representation of the value present within Verizon stock and perfectly illustrates how even very accurate quant ratings can sometimes poorly represent the real value of a company.
The firm currently trades at a P/E GAAP FWD ratio of 6.78x. Verizon’s P/CF FWD of just 3.61x is exceptional and represents a historical low for the ratio. Their FWD EV/EBITDA of just 6.45x is representative in my opinion especially when considering the firm’s EV/Sales FWD of just 0.97.
To put this into perspective, Verizon is trading at just 97% of the expected FWD sales.
Considering these basic valuation metrics alone I believe Verizon should already start to emerge as a clear deep-value opportunity given their relative value to other players within the industry.
From an absolute perspective, Verizon shares are trading at a significant discount relative to previous valuations. Seeking Alpha’s charts illustrate that Verizon has produced just -35.8% returns over the past five years.
Compared to the 77% growth seen in the S&P 500 tracking SPY index, Verizon has been outperformed by the U.S. market index as a whole by over 100%.
While the relative valuation provided by simple metrics and ratios along with the absolute comparison begin to paint a very clear value picture present in Verizon shares, a quantitative approach to valuing the stock is essential.
By utilizing The Value Corner’s specially formulated Intrinsic Valuation Calculation, we can better understand what value exists in the company from a more objective perspective.
Using Verizon’s current share price of $31.25, an estimated 2023 EPS of $4.68, a realistic “r” value of 0.02 (2%) and the current Moody’s Seasoned AAA Corporate Bond Yield ratio of 5.13x, I derive a base-case IV of $50.20. This represents a substantial 38% undervaluation in the firm.
When using a more pessimistic CAGR value for r of 0.01 (1%) to reflect a scenario where Verizon fails to expand revenues and achieve even marginal EBITDA growth in FY24, shares are still valued at around $42.10 representing a 26% undervaluation.
Considering the valuation metrics, absolute valuation and intrinsic value calculation, I believe Verizon is firmly trading in deep-value territory with current share prices presenting an intrinsic undervaluation of around 25-38%.
In the short term (3-12 months), I find it difficult to say exactly what may happen to valuations. While market sentiment has improved over the last quarter for the firm, weaker than anticipated Q3 results could lead to further drops in shares.
Tax harvesting may also lead to an increased selloff in shares as many investors seek to maximize the tax efficiency of their portfolios as the year winds to a close.
In the long-term (2-10 years), I see Verizon continuing to lead the U.S. telecommunications market as a whole thanks to their narrow yet robust economic moat assisting the firm in generating excess ROIC.
Risks Facing Verizon
Verizon faces some tangible risk from the potential for one-off costs associated with the removal of 1960s lead-sheathed cables along with some material risk arising from political agendas pressuring telecommunications companies.
The widespread use of lead-sheathed copper cables in telecommunications infrastructure during the 1960s has led to a large number of companies facing real threats of their network infrastructure being exposed to lead contamination.
This could present the public with a real health risk which has led many politicians both from republican and democratic parties to criticize telecom companies such as Verizon, AT&T and T-Mobile.
Interestingly, Verizon only has around 540,000 miles of copper cable with only around 15% of that mileage consisting of lead-sheathed cables. This means Verizon could potentially only have to recover 81,000 miles of lead contaminated cabling.
While this number is still huge, it pales in comparison to the 200,000 miles of network cable AT&T has that is at risk of lead contamination.
Verizon certainly could face some fiscal risk due to the cleanup costs associated with replacing the 81,000 miles of lead sheathed cabling. Still, considering their massive FCF and overall smaller exposure to the threat compared to its competitors, I believe Verizon will not see massive pressures on their business from this risk.
Verizon also faces some political pressure with increasingly loud demands for affordable high-speed internet to be made available to the masses. With Biden declaring that such a broadband service is no longer a luxury but a necessity, Verizon could be faced with price ceilings that may erode margins significantly.
Should such policies spread to wireless network coverage, Verizon could see their largest business segment suffering from contracting margins and falling revenues.
While I do not believe that any wide-spread price ceilings will be imposed as such policy would not necessarily be in-line with the capitalist-centric policies traditionally adopted by the U.S. and states as a whole, it is interesting to see even the U.S. moving towards such pro-social policies.
From an ESG perspective, Verizon faces very little tangible threats bar the aforementioned environmental risk of lead-sheathed cables and the social calls for more affordable network connections.
Therefore, I believe the lack of substantial environmental, societal or governance concerns make Verizon a great pick for a more ESG conscious investor.
Of course, opinions may vary and I implore you to conduct your own ESG and sustainability research before investing in Verizon if these matters are of concern to you.
Verizon is still the market leader within the telecommunications industry as a whole. Their unrivalled wireless network coverage, brand identity and cost advantage should help the firm earn outsized returns for investors over the coming years.
While recent 5G investments have been expensive, I believe Verizon has a solid balance sheet and that Vestberg has led the company in a positive direction. The focus on their core network business should help bolster future profitability and ensure the firm remains at the forefront of this industry.
Considering the potentially massive 38% undervaluation present in shares; I believe Verizon presents long-term value-oriented investors with a great opportunity.
Therefore, I rate the stock a Strong Buy.