Description

VZ is a long, which we like anyway; especially so in this environment. 

Verizon Communications offers communications, technology, information, and entertainment products and services to consumers, businesses, and government entities worldwide. The company, incorporated in 1983 in New York, was formerly known as Bell Atlantic Corporation and changed its name to Verizon Communications in June 2000.

Investment Thesis

The dominant theme for the major network providers (Verizon, AT&T, and T-Mobile) is currently the rollout of 5G. This new technology promises ultra-fast wireless speeds which are already ~20x faster than average 4G speeds, but investors and consumers should understand that not all 5G are equal. 5G's capabilities and service quality are entirely dependent on which part of the electromagnetic spectrum one uses. At the low band or low-frequency spectrum, 5G overlaps with existing 4G LTE and operates essentially the same. The high band or millimeter wave (mmWave) is the incredibly fast part of the spectrum that will transform wireless networks and Internet access. Verizon holds almost double the level of mmWave spectrum that its competitors own. Because mmWave can travel only very short distances, usually a few city blocks, Verizon is deploying over 14,000 sites equipped with mmWave antennae in 2021, with the intent of bringing the total to more than 30,000 by the end of this year. The initial focus of the mmWave deployment is on areas with the most constrained capacities, currently in urban areas.

mmWave 5G comes with many opportunities for Verizon. The most obvious benefit is improved service, with more speed, reliability, and data capacity. 5G service is expected to accelerate the growth in data consumption, and customers are increasingly shifting to unlimited plans with higher prices of roughly ten dollars per month. More than 20% of Verizon’s phone customers are already using 5G devices. Verizon is employing aggressive promotions to increase the adoption rate of new 5G-capable phones but also requiring upgrades to its premium plans which should generate an additional ten to twenty dollars per month, per customer. Management forecasts that 90% of its customer base will have an unlimited data plan by 2023, with over 50% on a premium unlimited plan, up from 27% currently. These upgrades should drive the company’s revenue growth rate above 2%, as well as deliver higher operating margins. Despite the current 5G promotions, Verizon is experiencing record low levels of customer turnover, suggesting higher customer loyalties across the industry, a condition we believe that could lead to future price increases.

Verizon will also monetize 5G through its new fixed wireless Internet service, called 5G Home. This service relies on mmWave and offers subscribers average speeds of 300 Mbps, faster than the current Wi-Fi average speeds of 150-200 Mbps. Verizon offers 5G Home for $50/month for customers with an existing Verizon wireless plan and $70/month for non-Verizon customers. The service is currently available to specific locations in thirty-three cities. At yearend 2021, Verizon plans to offer 5G Home to fifteen million households, currently less than two million, growing to thirty million in 2023 and fifty million in 2025. Despite the higher price point, management believes that 50% of new 5G Home subscribers are not existing wireless customers—an opportunity for significant cross-selling to increase its wireless base. 5G-based Internet will also be offered to businesses and more rural and suburban populations through its 4G LTE and lower-band 5G networks. Compared with Verizon’s Fios broadband service, 5G Home is far cheaper to install given that fiber connections need only be installed to a nearby transmitter rather than on a house-by-house basis. If Verizon captures roughly four million 5G Home subscribers in the next few years, the company will generate an additional $3 billion in high-margin incremental annual sales.

Verizon is also applying its mmWave 5G to a new technology, called mobile edge computing (MEC), that enables ultra-low latencies or the time lag for data to travel across the network. Verizon has partnered with Amazon and Microsoft to offer MEC services and is the only communications provider with a commercial MEC product currently on the market. MEC appeals to enterprise customers because it addresses many of the technological developments at the frontier of 5G, including online gaming, machine learning, artificial intelligence, augmented and virtual reality, autonomous driving, and manufacturing automation. MEC’s potential is meaningful but remains in the early stages; however, management still expects MEC to contribute to revenue growth starting in 2022 with a total addressable market of roughly $1 billion, growing to $30 billion by 2025.

The competitive landscape has intensified as carriers have begun rolling out their 5G networks and offering aggressive promotions to migrate their customers over to 5G-capable devices. After the 2020 merger between Sprint and T-Mobile, the industry has significantly consolidated into the three main players. This consolidation has right-sized the industry and prices will inevitably increase after the current promotional environment subsides. Cable providers are also launching mobile operations, with Comcast’s Xfinity and Charter’s Spectrum offering mobile services. However, both Xfinity and Spectrum use Verizon’s network to offer their services and must pay Verizon a fee for each gigabyte of data used, representing a high-margin revenue stream for the company. With mobile data consumption having grown more than 20% annually in recent years, the onset of 5G is likely to only advance this growth, leading to more monetization of its 5G network.

Verizon financed these spectrum license acquisitions and capital expenditures with debt. The weighted average maturity of this debt is a very favorable nineteen years with a 2.5% interest rate. We expect Verizon to end 2021 with a leverage ratio of 3.1 (net debt/ EBITDA), up from 2.3 in 2020. We believe that this level of debt is manageable and expect that the company will prioritize debt paydown for the foreseeable future to achieve its target level of 1.75x leverage. We estimate intrinsic value of $76 per share for Verizon, based on the company’s ability to produce returns on invested capital that exceed 10% and our 2025 free cash flow estimate of $25 billion, offering shareholders 39% upside to its current price, but not including the current annual dividend rate of 4.9%.

History

Verizon was formed in June 2000 with the merger of Bell Atlantic and General Telephone Company (GTE). GTE was formed in 1918 when three accountants partnered to buy a business servicing 1,466 telephone lines in southern Wisconsin. For decades,  GTE grew through numerous acquisitions of phone lines. In 1950, GTE began pursuing a vertical integration strategy, purchasing telephone equipment manufacturers and electronics companies. In 1959, the company merged with Sylvania Electric Products, a leader in lighting, television, radio, and chemistry that had extensive R&D assets. GTE’s New York City headquarters was bombed in March 1970 by antiwar radicals to protest the company’s defense industry work, prompting GTE to move its headquarters to Stamford, Connecticut.

The strategy of aggressive acquisitions continued, and by the late 1970s, GTE was organized by product segments, including communications, lighting, consumer electronics, precision metals, and electrical equipment. In 1982, GTE acquired Southern Pacific Communications Company, making the combined company the third-largest long-distance telephone company. However, antitrust regulators forced the newly formed company to separate the communications assets, forming Sprint Communications. GTE began a series of spin-offs in 1986 and formed several joint ventures. In 1990, GTE acquired Contel Corporation, making it the second-largest cellular telephone company in the U.S., with over 2 million customers.

Bell Atlantic was one of twenty-two “Baby Bells” divested from American Telephone and Telegraph Company (AT&T). In 1982, the U.S. Department of Justice ended a thirteen-year antitrust lawsuit against AT&T, which was the largest corporation in the world at the time. The divestiture of the Baby Bells was the result of the settlement with the Department of Justice. Bell Atlantic had a unique strategy among its new competitors: it acquired many specialized businesses to form a full-service business that targeted mid-size customers, a market that was less competitive than the market for larger customers and one whose members were less likely to build their own information technology systems. Bell Atlantic also built up a significant telecom operation abroad, particularly in Europe

The Telecommunications Act of 1996 enabled telecommunication companies to compete in industries that had previously been separated, such as telephone, cable, Internet, computing, and broadcast. This deregulation sparked a wave of consolidation, paving the way for Bell Atlantic to purchase NYNEX in 1997, becoming the second-largest telephone company in the United States, with a particularly strong presence in East Coast markets. Shortly thereafter, the $65 billion merger between Bell Atlantic and GTE was announced. With GTE’s dominance in the western United States, the merger combined consumer and business services nationwide. The new business was rebranded as Verizon Communications, a combination of the Latin word “veritas” (“truth”) and “horizon.”

Before the merger was complete, the company formed Verizon Wireless in a joint venture with Vodafone, a British telecom company. Verizon Wireless was structured as a separate entity that Bell Atlantic would operate, which had a 55% interest in the joint venture. Verizon Wireless’ coast-to-coast scale gave it a competitive advantage over the typical regional providers around at that time, allowing the company to offer nationwide coverage at competitive rates. The timing of the merger (summer 2000) coincided with the bursting of the technology bubble, forcing the company to repeatedly postpone the IPO of Verizon Wireless. The IPO was eventually canceled, because the company’s strong profitability in the following years reduced the company’s need for outside capital. In 2003, the FCC permitted consumers to keep their phone numbers even when they changed network carriers, making Verizon much more competitive with rival AT&T. In April 2004, Verizon Communications was added to the Dow Jones Industrial Average index, replacing AT&T, which had been in the index since the Great Depression.

Business

In 2018, Verizon replaced longtime CEO Lowell McAdam with Hans Vestberg, the company’s chief technology officer, a move that surprised many on Wall Street. Vestberg only joined Verizon a year earlier and had previously worked for over twenty years at Ericsson, a key supplier of Verizon’s 5G equipment and technologies. Vestberg’s appointment clearly signaled Verizon’s strategic goals to bring 5G technologies to the company’s massive network. Vestberg has quickly moved ahead with several structural changes. He rebranded the company’s strategy to “Verizon 2.0” to emphasize the company’s “network-as-a-service” business model. He also restructured the company’s business lines to the types of customers served rather than the type of service provided. The company reconfigured the Wireless and Wireline business units to the current and more customer-centric Consumer and Business segments and a separate and smaller Media segment is current being sold to Apollo, a large private equity firm.

Although Vestberg did not start Verizon’s Intelligent Edge Network (IEN), he was a key player in overseeing its development and accelerated its implementation. Before IEN, Verizon and its competitors struggled with a complex infrastructure that employed outdated and legacy technologies in certain places, which were not only inefficient but at times even prohibitive to launching new technologies. IEN addresses this problem by using an internal cloud network built by Verizon. The internal cloud uses open networking capabilities to fully automate various infrastructures that consolidate operations into a single management platform. The IEN uses significantly less power and space than the legacy infrastructure while streamlining operational efficiencies. Perhaps most important, the IEN serves as a foundation for the deployment of 5G and its related technologies. The IEN initiatives included the accelerated deployment of fiber cables. In addition to providing more broadband services to customers, the fiber buildout is essential to 5G’s services. The IEN offers much lower latency by having its infrastructure on the “edge” of the network, meaning physically closer to Verizon’s customers. The low latency and focus on the network edge are key strategic advantages for the company’s two business segments.

The Consumer segment provides consumer-focused wireless and wireline communications services and products. The wireless services are provided across an extensive wireless network under the Verizon brand and through wholesale and other arrangements. The wireline services serve nine states in the Mid-Atlantic and Northeastern U.S., as well as Washington D.C., over a fiber-optic network through the company’s Verizon Fios product portfolio and over a traditional copper-based network to customers who are not served by Fios. In 2020, the Consumer segment’s revenues were $88.5 billion, representing approximately 69% of Verizon’s consolidated revenues. As of September 30, 2021, Consumer had approximately 95 million wireless retail connections, approximately 7 million broadband connections, which includes Fios and Digital Subscriber Line (DSL) internet connections, and almost four million Fios video connections.

Verizon’s Business segment provides wireless and wireline communications services and products, including data, video and conferencing services, corporate networking solutions, security and managed network services, local and long distance voice services, and network access to deliver various Internet of Things (IoT) services and products. The company provides these products and services to businesses, government customers and wireless and wireline carriers across the United States and select products and services to customers around the world. In 2020, the Business segment's revenues were $31.0 billion, representing approximately 24% of Verizon’s consolidated revenues. As of December 31, 2020, Business had approximately 27 million wireless retail postpaid connections and approximately 482 thousand broadband connections, which includes Fios and DSL internet connections.

Valuation

Verizon is a “defensive stock” given its essential services, strong free cash flow generation and high dividend. Despite these favorable characteristics, Verizon’s business is extremely capital-intensive. The Company not only requires massive, fixed assets to run its network, but it also must routinely purchase spectrum. Spectrum licenses are issued for fixed time periods, typically ten years, and are subject to renewal by the FCC. Licenses are renewed at a nominal cost, and spectrum spending can be extremely inconsistent each year—consider that Verizon spent more than $50 billion in 2021 alone. Going forward, we model a normalized spending level of $10 billion per year.

The capital-intensive nature and maturity of the business are reflected in the traditional valuation metrics. Asset-light businesses typically deliver higher, compounding returns, returns that capital-intensive industrial companies cannot match. However, capital-intensive companies like Verizon can still deliver solid returns, which we believe is critical in the current market environment. The key is the company’s competitive advantage. For example, Warren Buffett understood that one cannot compete with a railroad; therefore, allocating capital to a durable business is sometimes more important than compounding the capital. Buffett described the railroad as "a business that is going to be around for 100 or 200 years." True, he acknowledged that one must spend money every day to keep a railroad going, but one still earns a "reasonable return" without the excessive risk found in many of today's asset-light businesses. For a competitor to emerge and rival the railway infrastructure of Berkshire Hathaway’s wholly-owned subsidiary, Burlington Northern, one would likely have to spend $100 billion to even have a fighting chance. Berkshire bought Burlington for $44 billion in 2010. Since then, Burlington has paid $41.8 billion in dividends to Berkshire Hathaway… And, Burlington Northern is worth somewhere around $100 billion today.

Verizon offers a similar investment dynamic, now that it owns a large piece of the 5G spectrum. No other competitor can operate within Verizon's 5G spectrum space. The company has already paid up for the rights, and Verizon is further investing billions of dollars to upgrade and build cell sites to utilize the spectrum. Ideally, investors seek asset-light business with extraordinary returns on invested capital, companies that offer software as a service come immediately to mind. But valuations for companies that fit that description trade at extraordinarily expensive valuations. Entry prices at such rich valuations will likely generate subpar investment returns. We believe that an investment in Verizon can earn one over 4% in annual dividends plus attractive capital appreciation potential far more predictability is a very attractive proposition in today’s market.

Verizon’s shares currently trade at c. 10x next year’s earnings, representing a bit less than half the valuation for the S&P 500 index. It’s difficult to make an apples-to-apples comparison with AT&T due to its large media holdings and pending divestitures and restructurings, but measuring Verizon against T-Mobile, its top competitor in the 5G race, reveals an interesting comparison. Verizon shares trade at 10x cash flow from operations, reflecting a level that is one-half below T-Mobile, at 20.4x. This valuation discrepancy likely reflects the market’s perception that T-Mobile’s strong mid-band spectrum holdings will enable T-Mobile to grow its subscriber base to rival the size of Verizon’s subscriber base. We disagree with this view and note that Verizon’s recent C-band purchases make the company very competitive in mid-band 5G while also offering data speeds that will be far superior to T-Mobile’s mid-band 5G services. The C band is a portion of the electromagnetic spectrum in the microwave range of frequencies ranging from 4.0 to 8.0 gigahertz and is used for many satellite communications transmissions, some Wi-Fi devices, as well as some surveillance and weather radar systems.

Wall Street is likely dismissing the mmWave potential, perhaps thinking that consumers simply do not need its ultra-fast speeds on their devices. And while that may be true today, we think that mmWave’s capabilities will unlock new technologies and applications that will eventually be commonplace tomorrow. If such a scenario occurs, Verizon is currently best positioned to offer 5G services for businesses, potentially leading to significant growth in sales from enterprise customers.

Verizon announced a goal of cumulative cost savings of $10 billion annually by year end 2021. The company applied zero-based budgeting to achieve this goal. Cost cuts were achieved by removing 11,000 employees through voluntary packages and by outsourcing some IT services in India to a partner company. The benefit of the Intelligent Edge Network is driving most of these savings. Specifically, the efficiencies from streamlining and consolidating the networks are a major contributor the cost savings. Verizon remains on track to achieve these savings despite the disruptions caused by the pandemic.

In valuing Verizon shares, we use a 2025 timeframe to reflect the final launches of C-band spectrum, which should bring coverage to 250 million users. We also believe that the potential in fixed wireless Internet (5G Home and 5G Business) and MEC will be firmly established. Businesses and application developers will also have had more time working with mmWave technologies, so this potential should also be better understood at that time. We see Verizon’s competitiveness and growth in mmWave eventually driving multiple expansion so that the company’s free cash flow multiple eventually expands from its current 12x to 15x by 2025. Modeling ahead, with expected debt net of cash equal to $120 billion with 4.1 billion shares outstanding, we estimate fair value of $76 per share for Verizon.

Risk to Investment

Unfavorable economic conditions, such as a recession or economic slowdown in the U.S. or elsewhere, could negatively affect the affordability of and demand for some of Verizon’s products and services. In difficult economic conditions, consumers may seek to reduce discretionary spending by forgoing purchases of their products, electing to use fewer higher margin services, dropping down in price plans or obtaining lower-cost products and services offered by other companies. Similarly, under these conditions, the business customers that they serve may delay purchasing decisions, delay full implementation of service offerings or reduce their use of services. In addition, adverse economic conditions may lead to an increased number of consumer and business customers that are unable to pay for services. If these events were to occur, it could have a material adverse effect on Verizon’s results of operations.

Cyber-attacks, including using malware, computer viruses, dedicated denial of services attacks, credential harvesting, social engineering, and other means for obtaining unauthorized access or disrupting the operation of our networks and systems and those of its suppliers, vendors, and other service providers, could have an adverse effect on Verizon’s business.

The company depends on various key suppliers and vendors to provide them, directly or through other suppliers, with equipment and services, such as fiber, switch and network equipment, smartphones, and other wireless devices that they need to operate its business and provide products to its customers. For example, their smartphone and other device suppliers often rely on one vendor for the manufacture and supply of critical components, such as chipsets, used in their devices, and there are a limited number of companies capable of supplying the network infrastructure equipment on which Verizon depends. These suppliers or vendors could fail to provide equipment or service on a timely basis, or fail to meet the company’s performance expectations, for several reasons, including, for example, disruption to the global supply chain because of the COVID-19 pandemic.

As of December 31, 2020, approximately 22.5% of Verizon’s workforce is represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. While the company has labor contracts in place with these unions, with subsequent negotiations they could incur additional costs or experience work stoppages, which could adversely affect their business operations. In addition, while a small percentage of the workforce of their wireless and other businesses outside of wireline is represented by unions for bargaining, they cannot predict what level of success unions may have in further organizing this workforce or the potentially negative impact it could have on company operations. 

Catalyst

5G