Description

Many investors own Verizon Communications ("VZ") because it pays a high dividend, has a relatively low valuation and is viewed as a "safe" investment.  It is considered by many to be a company that has a steady business and is a firmly entrenched, well positioned, long-term survivor.  We view VZ differently.  We agree that it is a good investment-a good short investment that is, for the following reasons:

1.      The VZ fixed line business is in a steady and secular decline. VZ saw a 10.0% decline in switched access lines in 2009, with the majority of the decrease in the residential retail market, which experienced an 11.0% access line loss primarily due to substituting traditional landline services with wireless, VoIP, broadband and cable services. VZ also saw a 7.0% decline in small business retail access lines, due to cyclical factors, as well as competition and a secular shift to IP and high-speed circuits.

2.      Cable competition and the strength of the Docsis 3.0 platform for cable is clearly superior to VZ's Fios platform, providing cable with a sustainable competitive advantage over VZ in broadband. Cable companies have much more advanced and complete networks than Fios, which will continue to require enormous additional capex by VZ to expand its coverage.  In areas where VZ has built out Fios networks, Fios broadband subscriber additions have slowed dramatically while cable subscribers have accelerated. This is because cable networks provide higher broadband access speeds at a lower cost, a more attractive proposition for customers. This calls into question the viability of a Fios as a true competitive platform, making the return on capex for VZ uncertain.  Recently, VZ has announced that it will substantially curtail and in certain areas, terminate its Fios build-out. It appears that cable has won the critical war for broadband access.  Importantly, it is broadband that has become the key driver in the reduction of customer churn and ASP  increases.

3.      Despite the fact that Verizon Wireless ("VZW") is the largest and most successful wireless provider in the United States, wireless competition has intensified.   Recently, a number of competitors have announced new fixed price "eat-all-you-can" business models, where pricing discipline has deteriorated. We think the economics of the wireless business is facing new challenges, given deflationary topline and inflationary cost and capex items (spectrum is simply not free).

4.      As on offset short / pair trade against a Vodafone ("VOD") long, one of our largest long positions (in part, for reasons discussed below).

All the foregoing are good reasons to short the shares of VZ.  However, our short thesis on Verizon is predicated on the fact that analysts lack an appreciation for the true dynamic of the relationship between VZW, VZ and VOD, and dramatic decline of VZ free cash flow (free cash flow, defined as cash flow from operations less all capital expenditures, is hereafter referred to as "FCF") following the pay down of intra-company debt that VZW owes to VZ, which pay down is expected to occur in April 2010. It seems that the Street has not focused on the fact that VZ only owns 55% of VZW and that VOD actually owns the remaining 45% pursuant to a partnership both companies entered into when Bell Atlantic Corp was merged into Airtouch (owned by VOD) in 1999 to form VZW.  In our view, VZ's 55% stake in VZW is worth approximately $30 per VZ share, the entire value of the current market capitalization of the company.  However, as we show below, we think that the rest of VZ is worth negative $9.50 per VZ share plus a pending stake in Frontier telecom worth $1.50 per VZ share.  Adding up the pieces gives us a target price for VZ of less than $22.    

VZW is unquestionably a solid and very valuable growing asset.  In fact, we regard VZW as one of the best-run global wireless operators. VZW is a cash flow machine that generated $1bn of FCF a month after interest, capex and tax in 2009. We expect that VZW will generate more than $13.7bn of FCF in 2010, and $15.4 bn in 2011. Remember however, that VZ only owns 55% of those FCF, with VOD owning 45%. Analysts do not seem to realize this because dividends from VZW to its two parents were suspended following the acquisition of Alltel Wireless by VZW in 2008 pursuant to which all of VZW's free cash flow is required to first pay down the loan that VZ made to VZW to finance the deal. Accordingly, VZ has been receiving distributions of approximately 100% of VZW's FCF to pay down the Alltel intra company debt.  As a result, the dividends are distributed upstream to VZ by VZW to pay down the debt.  Consequently, the financial statements of VZ reflect that VZ is receiving the full amount of the VZW FCF, even though VZ has a claim on only 55% of such cash flows when the VZW debt to VZ is fully paid. However, once that intra-company debt to VZ is fully repaid (scheduled to occur by sometime in May 2010), the impact of the VOD ownership stake in VZW will be made clear to the Street. Analysts and investors who have mistakenly assumed that VZ will continue to receive and grow the entirety of these VZW cash flows indefinitely, will then be forced to make a massive adverse adjustment to VZ's FCF going forward in their models.  This should cause these analysts to significantly lower their valuation targets for VZ.

For some reason, there seems to be confusion regarding the amount of intra-company debt currently left for VZM to pay down. Let's go through some numbers as of December 31, 2009: VZW had total external debt of $21.7bn, intra-company debt of $5.0bn, and $0.6bn of cash, for net debt of $26.1bn. Sounds like a lot (one could actually argue too little given VZW's massive FCF generation), but remember that VZW generated $24.5bn of EBITDA in 2009 - obviously VZW comfortably covers its debt obligations.

Looking at the disclosure more carefully, the Cellco Partnership (the JV between VZ and VOD) that does business as VZW, states as of September 2009 that:

 "Through October 29, 2009, we used cash generated from operations to repay $1,445 million of our $9,363 million Auction 73 floating rate promissory note. As of October 29, 2009, $6,303 million of borrowings remained outstanding under this not"

Despite the readily available disclosure, a recent Barclays' research note from February 2010 on VOD suggested a $12bn intra-company debt number at year end 2009. However, based on the VZ and Cellco Partnership disclosures, which are pretty clear; Barclay's number is completely inaccurate. Barclay is typical of the analyst coverage of VZ.

Based on the demonstrated FCF generation of VZW, as set forth in the company's earnings release for the year end 2009 (VZW did very well, the rest of VZ deteriorated), we estimate that the outstanding intra-company debt (that stood at $5.0bn by year end 2009) will decline to $1.7bn by the end of March 2010. Thus, the debt will likely be fully paid off sometime in May 2010, two months from now.

This is the crux of our short-thesis - following the repayment of this intra-company debt, VZ does not have the ability to access the FCF generation by VZW without paying 45% of the FCF to VOD. To make matters worse, VZ has substantial cash commitments - including a $5.5bn a year dividend, significant on-going cash restructuring costs, and the further de-consolidation of $1.5bn of annual FCF from the spin-off of a number of rural lines to Frontier. We estimate that VZ will need to borrow $6.2bn in the 12 months from Jun-10 to Jun-11 just to fund its ongoing cash requirements (for interest, tax, capex and dividend at VZ).

Street models of VZ fail to consider the impact of this levering up - VZ ex VZW levering up to pay its dividend will result in worsening credit ratios, even though the consolidated VZ credit ratios look progressively better.  For example, VZ, VZW and VZ excluding VZW had net debt/EBITDA ratios of 1.7x, 1.0x, and 3.1x as at 31-Dec-09. As our thesis plays out, we estimate ratios of 1.4x, 0.0x and 4.7x by 31-Dec-11 for VZ, VZW and VZ excluding VZW respectively.

VZ will have to shoulder additional interest burden from adding leverage. We estimate that this "negative carry" is worth at least a 5 cent impact to VZ EPS estimate for FY10 (for half year's worth of impact, and 10 cents on a full-year basis). Putting CenturyLink (NYSE ticker: CTL) EV/ EBITDA and EV / (EBITDA-Capex) multiples on VZ excluding VZW suggest that the EV at VZ ex VZW is significantly less than the value of VZ's debt (excluding VZW). The reason for this is that CTL is less levered than VZ and it is the largest independent wireline company but operates in rural areas which are subject to less competition than VZ's wireline business.  Therefore, we think that by applying the multiples of CTL, we believe we are being more than fair because as a standalone business (VZ ex VZW would likely trade at a perhaps a significantly lower multiple than CTL).  Applying CTL's multiples, we arrive at a value of negative $9.18 for VZ ex VZW. By using a multiple of 10x on the 55% of VZW FCF that VZ actually owns, we arrive at a value of $29.89 a share. We also penalize VZ for $6.4bn of pension deficit at the end of 2009, or another negative $2.25 a share. The combined entity is worth around $20 a share (including the implicit value of $1.70 a share in FTR that VZ holders will obtain when the spin is completed sometime in Q3 FY10).

It is possible that we are being too conservative on the FCF multiples to VZW and too generous on the multiples to VZ ex VZW. Assuming a range of 10x to 12x to VZW FCF, and between 5.2x and 6.2x for VZ ex VZW, we get a range of targets of approximately between $19  (5.2x VZ ex VZW EBITDA and 10.0x VZW FCF), and $25 (6.2x VZ ex VZW EBITDA and 12.0x FCF).

Based on the above, one can see why VZ is not such a safe investment to me.  This past weekend, there have been several articles regarding preliminary negotiations between VOD and VZ.  These articles all cite how VOD is in the driver's seat with respect to such.  Let the games begin!!

Catalyst