The More You Sell, The More I Buy: Verizon (NYSE:VZ)

Co-authored with “Hidden Opportunities”

Lifelines of the Digital Economy

Artificial Intelligence (‘AI’) is the talk of the town in 2023. The advent of ChatGPT has created uneasiness in almost every industry. Big Tech companies rushed to form partnerships or compete in the market with their AI product offering. These AI chatbots are creating jitters in the job market, with several manually intense jobs being replaced with this technological advancement.

It isn’t just AI; several domains are being challenged by technological transformations, such as Virtual Reality, the Internet of Things, Edge Computing, Robotic Process Automation, etc., and adoption is the key to survival. We saw this from K-Mart’s failure to embrace e-commerce, and we will see this in several businesses in the future. Source

There is a common denominator in all modern technologies – they all depend on the internet. Given that the internet serves as the lifeblood of the digital ecosystem, internet service providers control the essential lifelines. Only a handful of players exist in this industry, boasting a vast network of asset-based competitive advantage and formidable capital-intensive barriers to entry.

We’ll now focus on Verizon Communications Inc. (NYSE:VZ), the second-largest U.S. telecom company by 2022 revenues. This Fortune 26 company provides a wide range of services, including wireless communications, broadband, and fixed-line voice and data services to individuals and corporations alike. 99% of Fortune 500 companies are its customers, and VZ operates over 200 million 5G -enabled Points of Presence (POPS) and over 1 million miles of global fiber. VZ is the only major telecom carrier with edge computing partnerships with the three major cloud providers – Microsoft Azure, Amazon AWS, and Google Cloud Platform.

Industry-leading profitability

Through its consistent focus on high-value customers, VZ has always been a leader in profit margins among U.S. telecom companies. VZ works with business clients and customers willing to pay for premium services, and this approach allows the company to earn higher average revenue per user (ARPU).

“We’re focused on attracting and retaining high-quality consumers, those willing to pay for its higher-priced unlimited data plans. About 81% of Verizon’s consumer customers were on unlimited plans as of the end of Q3 2022.” – Hans Vestberg, CEO of Verizon

This is because Verizon is known to offer a high-quality wireless service with quality and reliability. RootMetrics rated VZ as the nation’s most reliable 5G network. For the 30th time in a row, J.D. Power ranked VZ the highest in the country for network quality.

Network quality, low latency, and overall reliability are crucial for the digital economy, and these qualities are the reason VZ has a stronghold among large businesses in the U.S.

Verizon is Past the Peak 5G and Fiber Capex

Looking at the stock price movement, Big telecom operators – AT&T (T) and VZ – haven’t had a great year. These companies are deploying billions of dollars into upgrading their infrastructure to offer the latest available technology to customers – 5G and fiber.

For FY 2022, VZ spent $23.1 billion on these upgrades (up by $2.8 billion from 2021), and management affirms that 2022 was the company’s peak year for 5G expenses. The company continues its 5G C-band deployment in 2023 but projects $18.25-$19.25 billion in Capex for the year. During 1H 2023, VZ spent $10.1 billion towards capital expenses, a $400 million reduction YoY.

From a bird’s eye view, high Capex, enormous debt, and rising interest rates are a recipe for disaster, and all Mr. Market did this year was determine the valuations of AT&T and VZ by those three words. Their common stocks were down ~20% over the past year despite both performing exactly per their guidance.

Debt Levels and Financial Position

We just discussed VZ’s capex plans for the year; let’s examine the company’s debt position and associated expenses.

Verizon maintains a strong balance sheet with excellent credit ratings from leading credit agencies.

At the end of Q2 2023, VZ had an unsecured debt of $131.4 billion with a net debt-to-adjusted EBITDA ratio of ~2.6x. 73% of the debt carried fixed interest rates.

VZ has very low near-term unsecured debt maturities, with ~$600 million due in Q2. For the first quarter, VZ had an effective interest rate on debt of 4.6% (as of the end of FY 2022). The company spent $1.2 billion on interest expenses during the quarter compared to $8.2 billion in net cash from operating activities.

To sum up, despite its higher debt load and rising interest rates, the company’s earnings can easily satisfy debt obligations. Moreover, there are no significant near-term maturities, allowing the company to proceed with growth Capex while returning excess profits to shareholders through dividends.

The Lead Cable Allegation

The use of lead-clad cables was phased out in the United States in the 1950s in favor of plastic sheathing. However, allegations are that the telecom companies still left behind ~2000 lead-encased cables, causing significant environmental damage over the years.

The already depressed stocks of AT&T and VZ sold off excessively, exhibiting what Wall Street always does well – panic and sell!

The financial impact can be considered in four categories:

• Cost of removing all legacy lead-sheathed lines.

• Being sued by the U.S. Federal or State government agencies for ecological damage.

• Being sued by workers who developed health problems that can be tied to lead exposure.

• Being sued by people who reside in areas with exposure to lead-sheathed telephone lines.

The only one that is readily quantifiable is #1. New Street Research provided an updated estimate of ~$6.5 billion cost to remove its aboveground, buried, and underwater lead-sheathed cables. Notably, Morningstar estimates no significant liability for VZ and AT&T in connection with the lead sheathing. How accurate are these estimates – no one knows.

Investigations and litigations like this run for years, if not decades.

• It took 19 years of litigation to bring Sherwin-Williams (SHW), Conagra Brands (CAG), and NL Industries (NL) to agree to pay $305 million to settle a lead-paint lawsuit.

• It took four years of investigation and litigation to order Home Depot (HD) to pay $20.7 million for violating lead-safety work practices during home renovations.

If you owned tobacco stocks in the 1990s, should you have sold them out of fear of lawsuits? From 1990-2002, the tobacco industry outperformed the S&P 500. It has been a great cash cow for dividend investors as a mature industry with a lot of excess cash flow. This performance was despite the headwind of the customer base shrinking as smoking has become much less popular over the past 30 years. This is despite the fact that tobacco companies were forced to provide adverse health disclaimers and advertise against their product; something we don’t expect to happen for telecom firms.

Telecom companies won’t be expected to cut a check the same day even if found liable. No matter how large, settlements are first appealed, negotiated, and eventually agreed to be paid over many years. Moreover, since every telecom company will owe it, there will be no competitive disadvantage in adding a “lead fee” to customers’ bills to match whatever liability is incurred. After all, customers are still going to want to use their services.

We will not speculate on the potential liability or impact for the companies involved but will note that the above-discussed companies thrived through investigations, litigations, and unfavorable judgments.

Valuation and Dividend Payability

Verizon maintains an excellent track record for shareholder returns, with 16 consecutive years of annual dividend increases. The company’s $0.6525 quarterly dividend calculates to a 7.6% annualized yield. This dividend represents a $2.7 billion quarterly spend, which remains adequately covered by the company’s consolidated adjusted EBITDA of $12 billion for the quarter (up 0.8% YoY).

Thanks to Mr. Market’s panic-driven reaction, big telecom companies trade at valuations well below those seen during recessions over the past decades. Today, VZ is trading at a PE ratio below 7x, and AT&T is trading at a PE ratio below 6x. These valuations are significantly below the levels that were seen during the Great Financial Crisis.

These dirt-cheap valuations provide investors with a substantial margin of safety as they are currently priced for the worst possible outcome.

Note: VZ’s dividend payout ratios have been calculated based on FY 2022 dividend levels. We expect the telecom company to make its 17th annual dividend raise in Fall 2023, bringing some changes to these ratios.

VZ produced $8 billion in Free Cash Flow in 1H 2023, an $800 million improvement YoY, and provided 148% coverage to the dividend during the period. The lead issue has no impact on VZ’s FY 2023 guidance, which projects $17 billion in Free Cash Flow and Adj. EPS of $4.55-$4.85. This places its projected annual dividend at a ~60% payout ratio by both financial metrics, indicating healthy coverage and room for growth later this year.

Conclusion

No active internet or telecom connection today is installing lead-sheathed cables. Technology is the future of the global economy, and no series of lawsuits will make everyone abandon their smartphones and go back to the pre-1875 era. Individuals and companies will growingly adopt technology in the coming years to enhance productivity, reduce costs, and make life easier, and internet service providers will empower these transformations.

The best opportunities are born when the investor community panics in its decision-making. The tradition has always been to sell first and ask questions later. As income investors, we ask questions first, lock high yields, and sit back and collect our dividends as Wall Street finds its answers and realizes its mistake. VZ presents a healthy 7.6% qualified yield at a historically low valuation. The company’s high-quality network, industry-leading profit margins, and investment-grade balance sheet make it a compelling buy at these dirt-cheap prices.