Verizon Rides Out Sequestration Weakness In Wireline With Sustained Wireless Growth

Verizon (NYSE:VZ) reported a yet another set of strong wireless results Thursday, but overall growth was tempered by weakness in enterprise spending on wireline services. The largest wireless carrier in the U.S. reported a healthy 4.3% y-o-y growth in revenues, bolstered by a strong adoption of its 4G LTE network and the recently launched Share Everything data plans. Despite a saturated wireless market, Verizon was able to leverage its superior LTE coverage to add 941,000 of the more profitable postpaid connections during the quarter – growth of about 6% over the same period last year. More importantly, however, the carrier was able to grow its operating income by about 16% as wireless EBITDA margins improved by 80 basis points year-over-year on effective management of subsidies and other expenses.

The traditional wireline business however continued to be a drag on overall results, as revenues declined 2% and operating income more than 60% over the same period last year. Most of the decline – almost 60% – was a result of the ongoing sequestration activity affecting government spending, and the rest due to corporate cost cuts. While we don’t expect this to reverse in the near-term, its impact on the company seems limited considering that the well-performing wireless division accounts for a vast majority of Verizon’s value by our estimates. Verizon’s 55% stake in the wireless division accounts for about 75% of our $48 price estimate for the carrier. It is due to this reason that there have been rumors about Verizon looking to buy out the rest 45% of stake from Vodafone, but no comments were made in this regard during the earnings call.

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ARPU rises on growing smartphone penetration

The U.S. wireless market has become increasingly saturated with wireless connections having exceeded the population in mid-2011. This has made acquiring new subscribers, especially those that pay for the higher-margin data plans, very tough for the wireless carriers. Despite this, Verizon has banked on its better 4G LTE coverage to do well on the postpaid front in the recent quarters. Last year, Verizon racked up as many as 5.1 million postpaid net adds in 2012 versus AT&T’s 1.4 million for the full year. The same seems to have continued this quarter as well, with the carrier adding close to 950,000 postpaid subscribers despite AT&T’s aggressive marketing and promotional spending during the quarter. (See Behind In LTE Coverage AT&T Spends Big To Gain New Customers)

In addition to acquiring new postpaid subscribers, Verizon also managed to convert more of its existing base to the higher ARPU-yielding smartphones. Verizon said that more than 84% of all retail postpaid phone sales this quarter were smartphones with 38% of those upgrading being first time smartphone buyers. This helped increase its smartphone penetration within the postpaid subscriber base to more than 64%, up from less than 50% at the same time last year. Increasing smartphone penetration helped drive postpaid ARPA, as smartphone users are usually heavy data users as well. Verizon’s postpaid ARPA (average revenue per account) grew to about $152.50 in Q2 2013, more than 6% over the same period last year .

Smartphone sales may 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 5 costs around $650 for carriers who then subsidize it heavily to sell the handset for $199. However, Verizon has been able to manage its expenses well, driving operational efficiency through initiatives such as the $36 upgrade fee and the sale of tablets such as the new iPad at unsubsidized rates. (See Verizon Introduces Smartphone Upgrade Fee; Looking For iPhone Subsidy Relief) Wireless EBITDA margins saw a y-o-y rise of over 80 basis points to just under 50% in Q2.

Competition heating up

Increasing competition from the smaller carriers such as Sprint and T-Mobile could however pressure margins going forward. Sprint, which recently received a cash infusion from Softbank and used it in acquiring Clearwire for its spectrum hoard, is putting its weight behind unlimited plans with its recently launched lifetime guarantee program. Meanwhile, T-Mobile is looking to shake things up by promoting contract-less service plans as well as unlimited data plans of its own. With Verizon having done away with unlimited plans completely, competition from these value carriers could lead to subscriber loss as well as bring down prices.

In order to counter this, Verizon is coming up with strategies to increase consumer loyalty and be able to better hold on to its existing customer base. It recently launched a new program called Verizon EDGE which allows subscribers to upgrade their smartphones every six months so long as they have paid 50% of the unsubsidized cost of the phone. Last year, the carrier launched Mobile Share data plans that allow subscribers to add more mobile devices to their service account. Subscribers who subscribe to these initiatives get further entrenched in the Verizon ecosystem, making it tougher to switch carriers. This is important because rising competition seems to be increasing Verizon’s churn numbers off late. Compared to 0.93% in Q2, Verizon had a churn of 0.84% in the same period last year. A higher churn implies that a carrier is losing more of its existing subscribers, leading to higher costs as it looks to acquire new ones.

However, the increasing adoption of the shared data plans will decrease the average revenue per device since the non-smartphone connected devices consume much less data. But AT&T’s revenues from each individual subscriber should also rise at the same time, as users connect more devices to its wireless network. Moreover, since the data consumption of these connected devices is low, it will help shore up the service margins for AT&T. Also since the shared data plans are tiered, an increasing usage of AT&T’s high-speed LTE network will cause subscribers to jump into the higher tiers, enabling the carrier to better monetize its existing subscriber base.

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