Fresh speculation regarding Verizon (NYSE:VZ) buying out Vodafone’s stake in their wireless joint venture have emerged once again sending shares in Vodafone up by more than 8% in trading Thursday. Verizon is however rumored to be paying as much as $130 billion for Verizon’s non-controlling stake – almost 30% more than what was previously assumed in what could likely be a desperate move to seal the deal before interest rates rise any further. Average A-rated corporate bond yields have increased by almost 80 basis points in the past few months on heightened speculation about the Fed’s tapering program.
While Verizon has long harbored ambitions of owning Verizon Wireless completely, the increased payout coupled with the high interest rate of debt financing means that the value addition to Verizon is likely to be lower than previously anticipated. Still, there seems to be enough value to be captured from the capital structure change that would result from financing the move with cheap debt.
No operational logic behind rumors
We estimate that Verizon’s stake in the wireless JV is worth about $165 billion, or almost 75% of its enterprise value. This brings the enterprise value of Vodafone’s stake in Verizon Wireless to about $135 billion. According to the company’s debt schedule, Verizon has a total outstanding debt of almost $50 billion, about 20% of which is attributable to Verizon Wireless.  If we allocate cash in the ratio of revenues, Verizon Wireless would have a net debt of about $6.2 billion. By our estimates, Vodafone’s stake should therefore be worth a little over $132 billion (135 – 45% of 6.2) – which is very close to the rumored valuation.
With rivals such as Sprint and T-Mobile getting increasingly competitive as they catch up with their respective LTE buildouts and aggressively market their unlimited plans, there is a downside risk to this valuation. Moreover, seeing as there are hardly any synergies to be gained or value to be unlocked out of this deal since Verizon already has full control over the JV, there seems to be little operational incentive for the management to go ahead with the deal.
Change in capital structure
The driving force for Verizon is therefore a change in capital structure that will increase leverage and decrease the cost of capital. From a business that was funded a big deal by Vodafone equity, the management seems to want to transition to one that will be funded majorly by debt. Considering a beta of 0.18, a risk-free rate of 3% and a risk premium of 6.5, Verizon’s cost of equity comes out to be around 4.2%. Any valuation benefit to Verizon from paying $130 billion for Vodafone’s stake would accrue only if Verizon is able to raise debt at less than the current cost of equity. However, with interest rates rising as a result of the Fed tapering concerns, the window of opportunity to raise cheap capital is narrowing with each passing day. Average A-rated corporate bond yields have jumped from a low of 2.3% in May to over 3% currently. 
Still, if Verizon manages to fund this deal by raising $130 billion of debt at 3%, we estimate that the carrier’s cost of capital will decrease by almost 50 basis points. This could unlock as much as $35 billion in value, or about 25% of our fair price estimate of the company.
However, it is unlikely that Verizon would raise this much debt, and the actual impact would therefore depend on how much of the final offer is cash versus stock. Even if Verizon does raise $130 billion of debt, we don’t think Verizon will have much of a problem servicing the interest payments. Depending on the interest rate at which Verizon raises debt (3-4%), the carrier will be liable for a maximum of 5.2 billion in annual interest payments. This is less than 30% of our estimate for Verizon’s long-term consolidated annual free cash flow of $17.5-20 billion.Notes:
- Schedule of Outstanding Debt, Verizon [↩]
- Verizon Seen Seeking $60 Billion After Record Low Debt Cost, Bloomberg, August 29th, 2013 [↩]