Verizon (NYSE:VZ) shattered all records with a successful $49 billion debt sale, amply utilizing the low-interest rates on offer to fund its acquisition of Vodafone’s stake in their wireless joint venture. Earlier this month, Verizon had agreed to pay Vodafone’s shareholders about $59 billion in cash, $60 billion in stock and $11 billion in other smaller transactions in return for their 45% in Verizon Wireless.
While there were initial doubts about Verizon being able to fund the deal entirely through dollar-denominated bonds, the generous yields on offer saw as much as $100 billion of orders being placed in a day. However, with speculation about the Fed’s tapering program threatening to increase interest rates further, Verizon decided to price its bonds at a significant premium to raise debt in the shortest time possible. Depending on maturity, the yield on Verizon’s new debt was anywhere between 86 and 220 basis points higher than similar BBB-rated telecom debt.
While the higher yields helped Verizon secure most of the financing it requires for the deal, we see limited value being unlocked considering the carrier is already paying a steep $130 billion for Vodafone’s stake. The yield on the new debt issue is higher than Verizon’s existing debt, implying that the carrier’s cost of debt is going to rise. While the effect of the tax shield will still help Verizon derive some value out of the change in capital structure, we fear that the same will not be very substantial.
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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.  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 differentiate themselves from the rest, there is a downside risk to this valuation. Moreover, seeing as there are hardly any synergies to be gained out of this deal since Verizon already has full control over the JV, there seems to be little operational motive behind this deal.
Not much value in the capital structure change
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 therefore accrues if the carrier raises additional debt at less than the current cost of equity, adjusted for tax shield. However, the higher interest rate at which Verizon has issued its debt restricts its ability to generate a lot of value out of the leverage increase in its capital structure.
We estimate Verizon’s current cost of debt to be around 4.5%. With the yield on Verizon’s new debt in the range of 5.2% to 6.5% depending on maturity, the overall cost of debt is likely to increase by around 50 basis points (assuming that Verizon manages to fund the remaining $12 billion at similar rates). 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 55%.
With the cost of equity hardly changing, the increased leverage would still cause the overall cost of capital to decline despite the higher cost of debt, but not by much. By our estimates, Verizon’s cost of capital would decrease by about 10 basis points, increasing its value by about $4 billion or about 3% of our fair price estimate for the company. On the other hand, if Verizon had managed to raise debt at equivalent to its historical cost at 4.5%, it would have been able to unlock a more substantial $10 billion in value.
While $60 billion does seem like a lot of debt to have raised, we don’t think the carrier will have much of a 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 $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.Notes: