Verizon (NYSE:VZ) posted a strong set of Q3 2013 results October 17th, as wireless service revenues grew by 8.4% y-o-y and consolidated EBITDA margins expanded to its highest level in five years. The largest wireless carrier in the U.S. did feel the effects of a saturated wireless market in the absence of Sprint’s (NYSE:S) iDEN network and the presence of a resurgent T-Mobile, which caused its postpaid net adds to decline to about 930,000 from over 1.5 million in the same period last year. However, the carrier continued to see its ARPA levels grow, bolstered by increasing data consumption driven by the strong adoption of smartphones and 4G LTE. This, together with effective management of subsidies and other expenses, helped the carrier grow its operating income by 30% over the same period last year. Meanwhile, LTE adoption continued to rise as Verizon leveraged its LTE coverage lead over AT&T (NYSE:T) and Sprint to good effect.
In keeping with the record results announced, Verizon’s stock jumped over 4% in trading Thursday and is now trading close to our revised $50 price estimate.
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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. Verizon has led LTE deployment in the U.S., having already completed its initial LTE deployment and is currently looking to widen the gap by increasing network density with LTE-Advanced and supporting new features such as VoLTE (Voice over LTE) ahead of rivals.
Last year, Verizon racked up 5.1 million postpaid net adds versus AT&T’s 1.4 million for the full year. The trend has continued this year as well, with Verizon already adding 2.7 million net postpaid subscribers so far. Up until last quarter, the second largest U.S. wireless carrier, AT&T, had racked up only about 850,000 postpaid net adds despite splurging on marketing and promotions in Q2. (See Behind In LTE Coverage AT&T Spends Big To Gain New Customers)
However, with increasing competition from smaller carriers Sprint and T-Mobile, Verizon’s net adds seem to be slowing down slightly. Verizon said that supply constraints for the recently launched iPhone 5S prevented the net adds from being higher; so the picture should be a lot clearer at the end of Q4. Either way, it is a good sign that Verizon continues to convert more of its existing base to the higher ARPA-yielding smartphones. Verizon said that almost 85% of all retail postpaid activations this quarter were smartphones, with 33% of those upgrading being first time smartphone buyers. This helped increase its smartphone penetration within the postpaid subscriber base to more than 67% – up from 58% at the start of the 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 over $155 in Q3 2013, almost 7% 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 the iPhone 5S 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) The carrier has also recently increased the minimum upgrade eligibility from 20 months to 24 in a bid to increase the upgrade cycle and mitigate the margin impact. Wireless EBITDA margins in the first three quarters this year have increased almost 200 basis points over the same period last year
Share Everything Plans
The saturated wireless market has caused Verizon to come up with strategies to increase consumer loyalty and 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 off 50% of the unsubsidized cost of the phone. Last year, the carrier launched Share Everything data plans that allow subscribers to add more mobile devices to their service account. Customers who subscribe to these initiatives get further entrenched in the Verizon ecosystem, making it tougher to switch carriers. This is important because rising competition from smaller rivals such Sprint and T-Mobile seems to be increasing Verizon’s churn numbers of late. Compared to 0.97% in Q3 2013, Verizon had a churn of 0.91% 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 shared data plans will decrease the average revenue per device since the non-smartphone connected devices consume much less data. But Verizon’s revenues from each individual subscriber should also rise at the same time, as the plans incentivise users to connect more devices to its wireless network. It should also help shore up service margins due to low data consumption of these connected devices. Moreover, since the shared data plans are tiered, increasing usage of Verizon’s high-speed LTE network will cause subscribers to jump to the higher tiers, enabling the carrier to better monetize its existing subscriber base.
LTE adoption rises steadily
Verizon also saw LTE adoption rates increase this quarter with both LTE smartphones as well as LTE Internet devices seeing a good uptick in volumes. The company sold almost 6 million 4G LTE smartphones this quarter, which is more than 50% ahead of what it did in the year-ago quarter. This increased LTE adoption at the end of Q3 to 38% of its postpaid subscriber base, up from about 17% a year ago and 33% the previous quarter. LTE adoption has picked up well in the past year with the launch of the new iPhone and other LTE-capable smartphones such as the Galaxy S4, and Verizon will be looking to market its industry-leading LTE coverage and drive LTE usage further.
Increased adoption of 4G will reduce dependence on Verizon’s 3G networks, which are under great strain due to heavy data usage by smartphone users. Also, LTE as a network technology not only supports higher speeds but is also more efficient than the current 3G networks at handling data, thereby improving margins by reducing maintenance and handling costs. It is therefore a good sign that almost two-thirds of Verizon’s data traffic is on its 4G LTE network already. As more people switch to 4G LTE-compatible smartphones, the higher LTE speeds will see subscribers increasingly use data-intensive applications on their smartphones. This will drive data revenues, thereby increasing ARPA levels for Verizon over the coming years.