Verizon Worth $53 Despite Leverage, Price War

Verizon’s (NYSE:VZ) stock has declined by over 6% in the past five months on concerns that burgeoning debt levels and rising competition from rival carriers could put pressure on its bottom line in the coming quarters. The company recently bought out Vodafone’s stake in their wireless joint venture, Verizon Wireless, for $130 billion in cash and stock, which has saddled its balance sheet with over $60 billion in debt. At the same time, it is facing rising competition from rivals such as AT&T, T-Mobile and Sprint, all of whom have either introduced new plans or cut prices to poach subscribers in an increasingly saturated postpaid market. Verizon still leads the industry in LTE coverage, but the gap between itself and rivals has decreased significantly over the past year, making it tougher for the carrier to gain significant market share going forward. Moreover, any further consolidation in the wireless market, led by a Softbank-backed Sprint, could cause a prolonged price war and eat into Verizon’s healthy margins in the coming years.

While these concerns are legitimate, we believe that the company’s strong business fundamentals and cash flows mitigate most of the risks. With the buyout of Vodafone’s Verizon Wireless stake, the company will have access to a larger portion of its cash flows and profits to pay off the debt and reduce its interest burden, which it has said is its priority ahead of share buybacks. Also, despite rising competition, the carrier has refrained from cutting its own prices by much, illustrating the pricing power that it commands in the industry due to its strong and reliable network coverage. Sprint’s aggressive posturing as an industry consolidator and disruptor could have long-term bearings on Verizon’s stock, but the carrier will have to first deliver on its aggressive network plans and convince regulators about the merits of a T-Mobile merger – both of which could take a while to come to fruition. Our $53 price estimate for Verizon is about 15% ahead of the current market price.

See our complete analysis for Verizon

Verizon-Vodafone deal

Verizon’s recently completed acquisition of Vodafone’s stake in Verizon Wireless saw Verizon take on over $60 billion in debt and issue shares worth almost an equal amount to Vodafone’s shareholders. Given that the value of Vodafone’s stake was put at a high $130 billion, and Verizon had little to gain operationally from the deal since it already had full control over the JV, the sole motive behind the transaction seems to have been changing the capital structure. From a business that was funded substantially by Vodafone equity, management has now successfully transitioned it to one funded significantly by debt, thereby increasing leverage but lowering the cost of capital. The deal has increased Verizon’s debt-to-equity ratio from an earlier 37% to 55%. But since Verizon was able to raise debt at last year’s low interest rates and will benefit from tax breaks on interest payments, it has been able to lower its overall cost of capital by about 10 basis points, by our estimates. This may not move Verizon’s value by much, but the overall benefit could have been more if it hadn’t offered such a high premium over similar-maturity government bonds at the time (see Higher Cost Debt Limits Verizon’s Ability To Generate Value Out Of Vodafone Deal).

While $60 billion does seem like a lot of debt to have raised, the carrier should have no problem servicing the interest payments. At an average interest rate of 5.3% , the carrier is liable for around $3 billion in additional interest payments. This is less than 20% of our estimate for Verizon’s long-term consolidated annual free cash flow of $20-22 billion. Our analysis does not include the impact of the tax shield due to the additional interest payments, which actually adds to our unlevered free cash flow estimates and further lowers the net interest impact. As a result, we do not think that the debt raised is any kind of concern for the carrier.

Verizon’s pricing power

On the other hand, the bigger concern for Verizon’s shareholders should be the fact that the wireless market has become largely saturated, and competitors are getting aggressive with their pricing strategies in order to gain market share. The biggest threat is coming from T-Mobile at the moment, with the carrier having launched several ‘Uncarrier’ initiatives over the past year. In recent weeks, T-Mobile has come up with a revised data allocation for its postpaid plans, adding 500MB of data to its lowest two data tiers for the same price. In response, AT&T slashed the price of its 2GB Mobile Share Value plan by $15 to $65 as well as that for two lines sharing the data by the same amount to $90. These changes came on the back of price cuts announced on its more expensive family data plans in February. Sprint has also made a big move this year, launching its cheaper ‘Framily’ plans, which reduce monthly fees as subscribers add more people to their group. ^[1]

In comparison, Verizon has been more conservative in launching new pricing schemes, banking on its network advantage to pull it though the ongoing price war. In February, the carrier made its first big move but that didn’t change the equation by much when compared to competitors’ plans. It renamed its “Share Everything” data plans to “More Everything” and increased the data that subscribers get by 500MB or 1GB, depending on the tier. It also made its Edge device financing and early upgrade plans more attractive by reducing the price of the accompanying service plans, making them look more similar to competitors’. However, the carrier did not offer deep discounts like AT&T or T-Mobile have, choosing to maintain its premium pricing, especially for subscribers on lower data tiers. ^[2]

While we expect the rivals’ pricing moves to have an impact on Verizon’s service pricing in the long run, its response so far shows that the carrier is willing to offer significant discounts on only the higher data tiers. By enticing subscribers to use more data, Verizon is looking to offset the impact of the pricing discounts on offer, thereby defending its long-term data potential.

Consolidation threat from Sprint

Further consolidation in the wireless market is another threat to Verizon, with Softbank looking to gain support from regulators in favor of a potential T-Mobile bid through Sprint. However, regulators and anti-trust officials the U.S. have voiced their reservations about reducing the number of national carriers from four to three, especially in light of the disruption being caused by T-Mobile’s aggressive pricing moves in recent months. More importantly, such a merger could increase Sprint’s network headaches. Combining Sprint’s and T-mobile’s networks would require a complex merger of disparate network bands and technologies, made all the more risky by the fact that the carrier is currently undertaking an expensive network modernization drive of its own that includes the integration of Clearwire’s spectrum (see Pursuing T-Mobile Could Be Risky For Sprint Given Regulatory And Operating Risks). It is therefore uncertain how well Sprint might be able to execute on its plans of creating a faster mobile broadband network than rivals, without which it will have a tough time mounting a strong offensive against the bigger rivals.

Moreover, the fact that Verizon is adding data capacity to its initial LTE network by deploying its AWS airwaves in urban areas should limit the impact of Sprint’s aggressive plans going forward. Lastly, Sprint’s higher-speed LTE network is expected to reach around 100 million PoPs by the end of this year – only about a third of the U.S. population. It is therefore unlikely that Sprint’s LTE network would hinder Verizon’s chances at gaining additional subscribers in the near term. However, given that Sprint is a more direct competitor to Verizon, owing to their similar CDMA networks, its LTE modernization initiatives could have a longer-term impact on U.S.’ largest wireless carrier.

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1. AT&T cuts Mobile Share Value prices, T-Mobile adds data to Simple Choice plans, FierceWireless, March 10th, 2014 [↩]
2. How does Verizon’s ‘More Everything’ stack up to competitors’ offers?, CNET, February 17th, 2014 [↩]