Verizon Laps Up Leverage To Unlock Value
Ending months of speculation, Verizon (NYSE:VZ) and Vodafone have finally agreed on terms that will give Verizon full control over their wireless joint venture, Verizon Wireless. In return for their 45% stake in the venture, Vodafone’s shareholders will receive about $59 billion in cash, $60.2 billion in stock and $11 billion in other smaller transactions.
Both of the companies have long been in discussions to offload Vodafone’s stake in Verizon Wireless, but never seemed to have reached a consensus on the asset’s price. Verizon was earlier rumored to have offered $100 billion for Vodafone’s stake, but the recent spike in interest rates seems to have forced its hand into sweetening the deal by a further 30%. 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 increasing leverage with relatively cheaper debt.
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See our complete analysis for Verizon here
Verizon Wireless Will Operationally Remain The Same
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. [1] 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 what Verizon has agreed to pay Vodafone.
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 motive behind this deal.
Change In Capital Structure Unlocks Value
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 wants to transition to one that will be funded majorly by debt. Considering a beta of 0.4, a risk-free rate of 3% and a risk premium of 6.5, Verizon’s cost of equity comes out to be around 5.6%. Any valuation benefit to Verizon from reducing Vodafone’s stake in the joint venture would therefore accrue if Verizon is able to raise debt at less than the current cost of equity. Interest rates may have risen from historically low levels due the Fed tapering concerns, but the current rates still offer enough of an opportunity to add value by raising cheap debt. Average A-rated corporate bond yields have jumped from a low of 2.3% in May to over 3% currently. [2]
We estimate Verizon’s current cost of debt to be around 3.5%. If Verizon manages to raise $60 billion of debt at 3%, the company’s cost of debt would reduce by more than 25 basis points (0.25%). Since the company is financing the deal by a 50:50 split of cash and stock, its debt levels will rise by $60 billion and equity by an equivalent amount increasing the new Verizon’s leverage or debt-to-equity ratio from an earlier 37% to 56%. With the cost of equity hardly changing, the low cost of debt and increased leverage could decrease Verizon’s cost of capital by as much as 30 basis points by our estimates. This could unlock as much as $20 billion in value or about 10% of our fair price estimate of the new company.
While $60 billion does seem like a lot of debt to raise, we don’t think the carrier 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 $2.4 billion in additional annual interest payments. This is less than 15% of our estimate for Verizon’s long-term consolidated annual free cash flow of $17.5-20 billion. Our analysis does not include the impact of the tax shield due to the additional interest payments, which adds to our unlevered free cash flow estimates and further lowers the net interest impact.
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- Schedule of Outstanding Debt, Verizon [↩]
- Verizon Seen Seeking $60 Billion After Record Low Debt Cost, Bloomberg, August 29th, 2013 [↩]