Verizon’s Earnings: Margin Recovery And LTE Focus Drive $42 Value

Verizon (NYSE:VZ) is expected to announce its Q1 2012 earnings on April 19th, and we will be keenly looking for a revival in the company’s margins after the last quarter’s surprise. Record smartphone sales led by the launch of the iPhone 4S last quarter hurt the company’s bottom line as wireless gross margins fell by almost 500 basis points over the previous quarter. Increasing smartphone penetration should however enable the company to post a sequential increase in postpaid ARPU levels, bolstered by data ARPUs. In addition to the company’s financials, we will also take special interest in the uptake in LTE subscriber numbers as Verizon looks to promote LTE widely this year, challenging AT&T (NYSE:T) and Sprint (NYSE:S) in the wireless market.

Our $41.89 price estimate for Verizon stock is about 12% higher than the market price.

See our complete analysis for Verizon

Margins may rebound

Smartphone sales increase postpaid subscriber additions and bring in juicy data revenues but they are also very expensive due to the huge subsidies that carriers provide in return for long-term contract plans. For example, a basic model of iPhone 4S costs around $650 for carriers who then subsidize it heavily to sell the handset for $199. The enormous subsidies that the carrier had paid in the quarter when the iPhone 4S sold like hotcakes had a bearing on its margins. Consequently, Verizon ended last quarter with a $212 million loss, down from a $4.6B profit returned in the same period last year, in part also because of the pre-tax noncash pension charge that it had to incur.

We expect margins to rebound this quarter, as smartphone buyers take a breather following the frenetic holiday buying seen last quarter. However, this may not last as Verizon tries to promote LTE aggressively this year by bringing out cheaper LTE smartphones. The fact that LTE’s adoption rates so far have been sluggish may coax Verizon into offering higher subsidies in order to spur demand in the yet nascent technology.

ARPU rises

Having borne the brunt of the smartphone subsidies last quarter, Verizon will look forward to a positive impact on its ARPU levels this quarter. Verizon had sold about 4.3 million iPhones last quarter, almost double the previous best it had for the year.

The holiday quarter saw huge sales for other smartphones as well as smartphone penetration reached 44% of Verizon’s postpaid base, up from 39% a quarter ago. The increased adoption of smartphones bodes well for this and subsequent quarters as well as Verizon reaps the fruits of its smartphone subsidies over the term of its contractual period. As a result of the increasing smartphone penetration, we see the churn rate reducing as well.

LTE update

Verizon has made very clear its aggressive LTE intentions for the year by announcing that it plans to introduce only those phones that support the high-speed network this year. Moreover, it has also decided to increase its target year-end LTE coverage to 260 million Americans from the earlier 250 million target.

The company is currently well ahead of AT&T and Sprint in terms of LTE deployment with coverage in almost 200 markets across the U.S and plans to add another 200 by the year’s end. As a result, its capital expenditures have been mounting and Verizon will be seeking to earn a return on that investment as soon as as it can. Also the fact that higher LTE speeds will see subscribers increasingly use data-intensive applications on their smartphones, thereby positively impacting data ARPU levels, makes it important for Verizon from a long-term perspective.

It will therefore be interesting to know the sales figures of its LTE smartphones and the outlook for the year given by the management in this respect.

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