Compared to high-flying tech stocks, dividend stocks have fared poorly since the onset of the pandemic, and some investors are left wondering if this trend is permanent. Verizon (VZ) is one such stock that investors have grown to trust (14 consecutive years of dividend increases), but just how safe is its business model? In particular, will its recurring subscription revenue stream (mainly from its wireless business) keep cash flowing? This article reviews the health of the business, valuation, risks, dividend safety, and concludes with our opinion on whether Verizon is worth considering if you are a long-term income-focused investor.
Overview:
Verizon Communications Inc. (VZ) is a communications services provider offering voice, data and video services, corporate networking solutions, security and managed network services, and network access solutions. Verizon also offers media products and solutions focused on online content delivery and advertising technology. The company generated revenues of $131.9 billion in 2019 and $30.4 billion in Q220. For reporting purposes, the company organizes its business into two customer-facing areas:
Verizon Consumer (~69% of 2019 revenue): offers products and services to retail customers and resellers that purchase wireless network access from Verizon on a wholesale basis.
Verizon Business (~24% of 2019 revenue): offers communications products and services to businesses and government establishments.
We believe Verizon’s business is best understood along the wireless and wireline dimensions.
Wireless: services are offered across the USA through an extensive wireless network and through wholesale and other arrangements. Verizon is the largest wireless carrier in the US with about 116 million postpaid and 4 million prepaid subscribers. Wireless equipment such as smartphones, tablets, laptops, smart watches, and other wireless-enabled wearables are also offered as part of the wireless business. Verizon’s wireless business accounts for over 70% of its revenues.
Wireline: services such as broadband, digital video, internet, and digital voice connections are provided in nine states in the Mid-Atlantic and Northeastern USA, as well as in Washington D.C., over the company’s wireline network, about three fourth of which is overbuilt with fiber optics (referred as Fios).
Stable Operational Performance Amid the Pandemic
The company’s recently reported Q2-20 results were largely in line with its earlier expectations. The pandemic did take a bite out of the revenues as wireless service revenues were impacted by lower roaming activity and Verizon’s commitments to waive certain fees and provide additional data to ease the impact on consumers and small businesses; wireless equipment sales declined significantly due to limited in-store engagement; and as media customers scaled back on their advertising campaigns.
However, Verizon’s business model, which is backed by the higher exposure to the more resilient wireless business, helped it drive healthy earnings and also grow its EBITDA margins, although by a modest 20 bps. Also, the company was able to grow its core postpaid subscriber base as its retail wireless connections increased by 352,000 to track 115.9 million in Q2-20. Customer defections also dropped sharply during the quarter as the company reported 0.78% monthly retail postpaid churn compared to 1.02% a year ago.
Source: Company presentation
High Free Cash Flows Means Dividend Safety
Verizon has never missed a quarterly dividend payment since the early 80s and has increased its dividends for 14 consecutive years now. The most recent quarterly dividend of $0.615 per share results in an annualized dividend of $2.46 and a yield of 4.3%. The risk of dividend non-payments by a company arises when its cash flows are stressed. Verizon’s operational model insulates its cash flows against situations of economic uncertainty to a great extent. Even during the pandemic, in the first six months of 2020, Verizon reported a 74% YoY growth in free cash flows to $13.7 billion. While a large part of the free cash flow growth was attributed to the timing of tax payments and working capital changes, the company was still able to cut down its net debt by $3.9 billion and pay $5.1 billion in cash dividends during this period. Also, Verizon remains committed to accomplish the remaining $2.8 billion of its $10 billion cost-cutting target through 2021, which should further accentuate the cash flows. Per the company’s Q2 earnings transcript:
“All in all, our cash flow will continue to be strong because we have -- obviously, we have a strong business with a recurring revenue stream. That will continue into the second half of the year.”
There is some concern about Verizon’s dividend yield which has been trapped at just over 4% for quite some time now and is lower than its nearest rival AT&T (T) (dividend yield of ~7%). We believe that because of Verizon’s relative strength in the wireless business which produces stable revenues, the company’s capability to generate stable free cash flows is greater than any of its rivals. Growing cash flows should accelerate dividend growth in the future.
A little digging into the historical dividend payment trends reveals that the company has increased its dividend per share after the 1st half of every year since 2007. This makes us believe that the next quarterly dividend payout will be higher than what was paid out in the previous four quarters and track at $2.49 for 2020.
Source: Company data
5G Opportunity
It is widely believed that 5G, with its ultra-high data speeds, ultra-low latency, and massive network capacity, will play an important role in the future in manufacturing automation, cloud gaming, autonomous vehicles, drones, and remote health care services, to name just a few.
Verizon has been investing heavily to support traffic growth across its networks while it continues to deploy more fiber and additional cell sites to expand its 5G rollout nationwide. The company has already launched 5G mobility service in some of the targeted 60 markets as well as 5G home internet in some additional markets. Verizon has also successfully completed Dynamic Spectrum Sharing Technology (DSS - allows 5G to run in multiple bands simultaneously with LTE) tests, which should advance its 5G wireless services rollout nationwide in the second half of 2020.
Verizon’s fiber deployment, which promises to remodel Fios to serve wireless and business customers while also adding capacity in other major markets, now encompasses more than 60 cities outside of its ILEC footprint. The company laid about 1,400 route miles of fiber per month on average in Q220, an uptick from the 1,000 route miles per month averaged in Q120. This should provide strategic benefits to the company and further support its efforts to lead the industry in 5G technology deployment and serve new customers. Per Verizon’s Q2 transcript:
“Into the second half of 2020, we are, of course, excited for scaling the 5G to nationwide, scaling the Ultrawideband to over 60 cities, scaling the 5G Home to more than 10 cities and of course, start monetizing that. That's going to be a key focus for our executive team as well as capturing all the opportunities especially on the 5G mobile edge compute with our business-to-business applications.”
Valuation:
Verizon’s stock often attracts investors because of its operational stability backed by a strong wireless business which accounts for over 70% of its revenues, strong free cash flow generation, and regular dividend payments. Among all the players in the highly concentrated US wireless market, AT&T and T-Mobile are the primary rivals to Verizon. To get a broader perspective, we have compared the price performance of Verizon with these two companies, and the broader S&P500 index. Verizon’s stock has underperformed the broader index year to date but has outperformed its dividend-paying rival AT&T.
Source: Yahoo Finance
Over the past 10 years, Verizon’s stock has traded in the range of 4.7x-9.6x EV/EBITDA. The current trading multiple of 8.4x offers further upside potential if the company is able to accelerate its nationwide 5G infrastructure deployment to capitalize on the growth opportunity from 5G and create an industry-leading position. We believe the stock should appeal to income-focused risk-averse long-term investors given its recurring cash flow stream, regularity in dividend payouts, and the potential of capital appreciation from the 5G opportunity.
Source: Yahoo Finance and Company Filings
Risks:
Wireless competition: The acquisition of Sprint by T-Mobile has further consolidated the highly concentrated wireless market in the USA. Recently T-Mobile overtook AT&T to become the second-largest wireless provider in the USA. With just three large players and a few much smaller players in the US wireless market, we can see intensified competition as companies try to maximize their market share, leading to pricing pressures and a resulting adverse impact on Verizon’s topline and profitability. Nonetheless, the business remains healthy and steady.
Delay in 5G deployment: The near-term upside to Verizon’s stock price hinges on its ability to successfully deploy the 5G wireless infrastructure, given its greater reliance on wireless revenues. Any delay in 5G deployment due to economic and regulatory challenges could negatively impact the stock’s performance.
Realization of cost-cutting target: While the company remains on track to accomplish its $10 billion cost-cutting target through 2021, its free cash flows can be modestly impacted if Verizon fails to realize the remainder of the cost savings.
Debt position: So far Verizon has been able to efficiently manage its debts to maintain a net unsecured debt to adjusted EBITDA ratio of 2x. However, this ratio is at the high end of its targeted range of 1.75x to 2.0x. We believe that the company’s ability to generate robust free cash flows in the future should help it further reduce the leverage on its balance sheet.
Conclusion:
Verizon’s relative strength comes from the scale of its wireless business, which has positioned it on strong footing as compared to its rivals. We believe that because of a largely resilient business model with a recurring revenue stream, the company should be able to generate robust free cash flows in the future, thereby strengthening regular dividend payouts. Also, there is plenty of room for dividend growth given that Verizon currently pays just over half of its free cash flows in dividends. Accordingly, we believe the stock is worth considering if you are a long-term, income-focused investor. We own shares, and view them as a cash flow oasis in an otherwise volatile market.