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TECHNOLOGY

INITIATING COVERAGE REPORT

William C. Dunkelberg Owl Fund February 5th, 2014 Jesse Worek: Lead Analyst jworek@theowlfund.com Nathan Clark: Associate Analyst nclark@theowlfund.com Ryan Rinaldi: Associate Analyst rrinaldi@theowlfund.com

Verizon Communications, Inc.


Exchange: NYSE Ticker: VZ Target Price: $53.95
COMPANY OVERVIEW Verizon Communications Inc. is one of the worlds leading providers of communications, information and entertainment products and services to consumers, businesses and governmental agencies. Verizon has two primary segments, Wireless and Wireline. Wireless communications products and services include wireless voice and data services and equipment sales, which are provided to consumer, business and government customers across the United States. This segment makes up 67.4% of 2013 revenue and 77.4% of EBITDA. Wirelines voice, data and video communications products and enhanced services include local and long distance voice, broadband Internet access (FiOS) and video, corporate networking solutions, data center and cloud services, and security and managed network services. Wireline makes up 32.6% of 2013 revenue and 22.6% of EBITDA. INVESTMENT THESIS After investors were unresponsive to Verizons strong fourth quarter earnings, the company became undervalued to its own history. Investors are cautious of Verizons market share and outlook because of wireless pricing competition, a bearish outlook for smartphones, Wireline concerns, and a significant debt increase. Looking forward, Verizon is going to benefit from restoring stability in its Wireline segment, purchasing the remaining stake in Verizon Wireless from Vodafone, and the continuing transition into data driven phones. We expect multiples to appreciate as investors take advantage of a strong dividend, impressive earnings from removing Vodafones stake, and Verizons competitive advantage in the protective Telecommunications sector.

Sector Outperform Recommendation: BUY


Key Statistics:
Price Projected Return Shares O/S (bn) Market Cap Earnings Date 1Q13 2Q13 3Q13 4Q13 Year 2012 2013 2014 2015 2016 Q1 $0.59 $0.68 $0.82 $0.98 $1.04 $48.02 16.8% 2.86 $136.32 EPS $0.68 $0.73 $0. 77 $0.66 Q2 $0.64 $0.73 $0.90 $0.98 $0.98 52 Week Low 52 Week High Yield Enterprise Value Revenue YoY 4% 4% 4% 3% Q3 $0.64 $0.77 $0.94 $1.01 $1.00 Q4 $0.38 $0.66 $0.82 $0.83 $0.89 $43.34 $54.31 4.41% $233.48 Price 2.77% -1.52% 3.49% -1.34% Total $2.24 $2.84 $3.46 $3.83 $3.97

Earnings History:

Telecommunications

Earnings Projections:

One Year Price:

All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via CapIQ, Bloomberg and other vendors. The William C. Dunkelberg Owl fund does and seeks to do business with companies covered in its research reports.

Spring 2014

CATALYSTS Verizon Wireless Deal. Purchasing the remaining interests in Verizon Wireless (VZW) from Vodafone will bring future revenue and flexibility to Verizon. VZW is the largest wireless service provider in the U.S. This segment, which grew 6.8% from 2012 to 2013, will continue to drive revenue for Verizon. In the past, Verizons net income was decreased by 76% in 2011, 92% in 2012, and 51% in 2013 due to minority interests. This minority interest payment has increased by 24% each year over the past 3 years. Purchasing Vodafones 45% stake in Verizon will greatly decrease the amount of net income that Verizon loses due to minority interests and drive its bottom line. Verizon executives have also noted that the purchase of VZW will allow future flexibility since they will no longer have to consult Vodafone when making decisions. Copper to Fiber. Following Hurricane Sandy, Verizon had decided to replace copper lines with fiber optics. Fiber has proven to deliver better service in terms of voice quality and fewer dropped calls. Upgrading to fiber will bring cost savings to Verizon in regards to maintenance as well. The change to fiber also allows Verizon to offer its FiOS products to customers. Altogether, the wireline shift into fiber optics will bring higher quality, cost savings, (predicted to be more than $100 million) and more revenue from customers who purchase FiOS products. 4G LTE Coverage. Verizon has the largest 4G LTE network in the U.S. with coverage of over 97% of Americans. As of the end of 2013, approximately 69% of the Verizons wireless traffic was on this network. Over the past couple years there has been a migration from 3G to 4G LTE. Verizons network helps capture those customers wishing to increase their coverage and has helped offset losses due to a market that is saturated by smartphones. Spectrum. Spectrum (also known as public airwaves) is essential for the telecom business. Licenses are needed in order to use the airwaves and are very limited. Verizon has the upper hand on AT&T, T-Mobile, and Sprint when it comes to the amount of licenses it holds. Due to the low supply and high demand, Verizon is positioned to take advantage of its vast amount of licenses that it currently holds.

Risks Verizon Wireless. With the upcoming acquisition of Verizon Wireless from Vodafone, there is the chance of Verizon over paying for the remaining stake in Verizon Wireless. This is a significant risk because of the record breaking debt ($41.7 billion) the company has issued for the deal. Smartphone Saturation. United States smartphone saturation is projected to reach around 82% by the end of 2014. We expect this to lead to declining smartphone sales in the future. Increased Wireless Competition. T-Mobile as begun a new campaign targeting mid to low-end customers and has caused other wireless providers to reduce prices and create new plans. This could be a threat for Verizons dominating market share.

Economic Moats Spectrums. Verizon enjoys a surplus of spectrum (public airwaves) licenses while demand in the industry is sharply increasing. Smaller competitors like Sprint and T- Mobile are fighting to acquire licenses that Verizon currently owns but are not used. This prevents competition from stealing market share in key wireless locations. Contracts. Verizon operates in an industry with medium to low barriers to entry because of contracts. Contracts secure customers for several years or require a fee to cancel the contract early. 4G LTE Coverage. Verizon has the largest 4G LTE coverage in the US and is able to provide to 97% of the US population. This provides a wide, stable moat because competitors are unable to enter this space without costly capital expenditures. Wireline Bundles. Verizons wireline segment offers bundles that include FiOS TV, FiOS Internet and FiOS digital voice. Having all these services in one makes customers less likely to cancel services.

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TARGET PRICE
Our target price is derived from multiplying a weighted average of Verizons competitors forward earnings multiple times the companys NTM EPS of $3.46. It should be noted that Verizon has historically traded at a premium to AT&T. In order to capture this premium, we multiplied AT&Ts forward multiple by the historic spread of 1.266 that Verizon has traded (See Appendix). After factoring the companys 4.45% dividend yield, we arrived at a projected return of 16.8%. (See Appendix for comprehensive walkthrough) Peer Analysis Target Price= $53.95 Relative Target Multiple = 15.59x NTM Forecasted EPS = $3.46

PEER GROUP IDENTIFICATION


Wireless Services AT&T, Inc. (NYSE: T) - AT&T Inc. provides telecommunications services to consumers, businesses, and other providers in the United States and internationally. The company operates in two segments: Wireless and Wireline. Wireline Services CenturyLink, Inc. (NYSE: CTL) - CenturyLink, Inc. operates as an integrated telecommunications company in the United States. Comcast Corporation (NASDAQ: CMSCA) - Comcast Corporation operates as a media and technology company worldwide. It operates through Cable Communications, Cable Networks, Broadcast Television, Filmed Entertainment, and Theme Parks segments.

INDUSTRY OVERVIEW The telecom industry is facing several headwinds and tailwinds. Wireless (three year CAGR of 6.3%) has been driving industry growth for the past several years due to affordability for customers and wider margins for service providers. Smartphones and improvements in data have driven wireless growth the past several years. Approximately 56% of wireless customers had smartphones in May 2013 and is expected to reach 82% by the end of 2014. The industry is worried that this will lead to smartphone saturation. In order to fight this, telecom companies are bringing a stronger focus to tablets and other data driven devices in order to drive revenue. The wireless industry has faced increasing pricing competition due to T-Mobile lowering rates. This has caused other providers to reduce prices and create new service packages. This is expected to shift market share in the wireless segment. Wireline (three year CAGR of 0.04%) has been flat in recent years. There has been a shift from voice revenue into video and internet services. The number of wireless households has grown to 39.4%. In order to hedge against this, service providers have started bundling voice, video, and internet services in order to retain customers.

FINANCIALS Verizon Wireless Deal: Vodafone holds a 45% stake in Verizon Wireless and receives a significant portion of Verizons income. On January 28th, Vodafone approved to sell the stake for $130 billion. Verizon will pay for this stake in $58.9 billion in cash, $60.2 billion in Verizon stock, and $11 billion in smaller transactions. The deal has to be reviewed by regulators but is expected to go through with no problems. The financial details of the deal will be released on February 21 st.

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Verizon Wireless Deal (cont.): Fully controlling Verizon Wireless is a strong move for Verizon. Although the company took on $41.7 billion to finance the deal, Verizon will no long have to give earnings to Vodafone and will significantly improve VZs bottom line. In a qualitative sense, Verizon will be able to have increased flexibility for decision making in its Wireless segment. Revenue: Wireless accounted for 67.4% of FY 2013 revenue and grew 6.8% YoY. As of 2008, Wireless has been the Verizons dominant segment with sales growing at a five year CAGR of 10.4%. Superior coverage and the transition from basic to smartphones has allowed Verizon to experience Wireless growth. Looking forward, we expect the wireless pricing war to attract more customers to Verizon as it lowers rates for data plans. This will drive revenue and lock more customers into contracts, securing future revenues. We expect Wireless revenue to increase 6% in 2014. In 2013, Wireline made up 32.6% of revenue and declined 6.3% YoY. Revenue from Wireline services has been declining since 2006 at a CAGR of -3.6%. This decline can be attributed to the increasing number of wireless households (12.8% in 2008 and 39.4% in 2013) and decline in business demand. Recently Verizons Strategic Services segment has been able to capitalize on businesses entering emerging markets, creating revenue growth to stabilize the declining business segment. In addition, Verizon has begun to bundle its home services (phone, internet, and cable) to attract more customers. We expect Wireline revenue to decline 0.9% in 2014, improving from 6.3% decline experienced in 2013. Margins: Verizons margins improved dramatically in 2013 with its EBITDA margin growing from 25.6% to 40.3% and profit margin improving from 0.76% to 9.54% (2011 profit margin was 2.17%). This improvement can be attributed to managements anticipation of demand which helped dramatically lower operating expenses. The EBITDA margin for 2014 is expected to be around 36%. Due to Verizons planned acquisition of Vodafones stake in Verizon Wireless, we believe that profit margin will improve substantially. In 2012, Verizon lost 91.7% of its income to minority interests and depleted its earnings. Profit margin for 2014 is estimated at 10.7%. We believe that 2014 profit margin will much higher considering because Vodafone historically received around 90% of Verizons minority interest ($12 billion in 2013), which has been growing at 24% the past three years. Within segments, we expect the Wireless EBITDA margin to remain flat around 49%. The Wireline segment plans to go through cost cutting procedures to improve its EBITDA margin from 22% to around 25%. Dividend: Verizon holds a 4.45% dividend yield. Verizons dividend has declined in the past three years. In 2011, the dividend yield was 5% and as high as 5.3%. The dividend reached its lowest in 2013 (at almost 4%), but has been increasing ever since. Verizon is expected to recover its dividend and bring it back to historic levels. By 2017, Verizons dividend yield is expected to reach 4.8%. The companys dividend payout ratio is at a three year low of 30%. This shows that Verizon has the opportunity to give more back to shareholders and we view it as reassurance that it will increase its dividend in the future.

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Debt: In order to finance the purchase of the remaining Vodafone stake, Verizon raised $41.7 billion in debt in 2013 and recently issued $500 million in January to take advantage of lower interest rates. Including interest payments, Verizons total debt reaches $167.5 billion dollars. In the next five years, Verizon will be facing $55.4 billion in debt, and $94.2 billion in the next ten years. $6.2 billion, or 3.7% of total debt, is floating debt which will reach maturity in 2017. Verizons debt to equity is 98.1%, after having a five year average of 65.1%. Verizon is actually one of the least levered companies in the telecommunications industry. The debt to equity of the S&P 500 Telecom Index is 101.2%. With an interest coverage ratio of 12x and cash flow from operations that can handle some of the largest debt payments, we believe that Verizon will be able to effective manage this debt.

VALUATION VZ is currently trading at a P/E discount to its own history on a one- and three-year basis. The company has been expanding margins and is more efficient than the companies in its comp group. Verizon is also well above its comp group when it comes to return on assets and return on equity. With the countrys strongest 4G LTE coverage map, Verizon is now very attractive due to the increase in demand for 4G LTE as 3G becomes obsolete. We believe that this discount is unjust due to the ability of Verizon to keep customers within its growing network. It has a much lower churn (turnover) than its wireless competitors. With improvements in the wireline segment, the purchase of Vodafones stake, and Verizons vast 4G LTE network, we believe that Verizon will reach its target multiple. It should be noted that this is a conservative estimate since the target multiple is below Verizons three year average

Ticker CMCSA CTL T Mean VZ

Market Cap 140814 17236 174287 110779 136317

LTM P/E 17.89x 22.60x 24.40x 21.63x 16.91x

LTM EV/EBITDA 8.80x 5.00x 8.40x 7.40x 4.80x

Forward P/E 18.79x 10.89x 12.60x 14.09x 15.58x

Forward EV/EBITDA 8.10x 5.30x 5.70x 6.37x 5.20x Gross 69.6% 61.3% 60.0% 63.6% 62.8%

LTM Margins EBITDA 33.2% 41.2% 38.0% 37.5% 40.3% Profit 10.5% -1.4% 14.2% 7.8% 9.5%

Debt/Equity MRQ 92.0% 123.1% 81.8% 99.0% 98.1%

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Verizon Three Year P/E with Average Line:

Verizon One Year P/E with Average Line:

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Verizon and Comp Group Three Year P/E:

Verizon Three Year EV/EBITDA with Average Line:

APPENDIX:

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Verizon and AT&T Historic Three Year P/E Spread:

Target Price Walkthrough

AT&T Forward P/E: 12.60x AT&T RelVal Multiple: 15.95x CMSCA and CTL Average Forward P/E: 14.84x Wireless Target Multiple: 10.74x

Mean Spread: 1.2656

RelVal Forward P/E: 15.95x Wireless Target Multiple: 10.74x Wireline Target Multiple: 4.84x

Wireless % of Sales: 67.4% Wireline % of Sales: 32.6% Wireline Target Multiple: 4.84x

Target Multiple: 15.58x

Target Multiple: 15.58x

NTM EPS: $3.46

Target Price: $53.92

Verizon Three Year Price and Quarterly EPS:

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DISCLAIMER This report is prepared strictly for educational purposes and should not be used as an actual investment guide. The forward looking statements contained within are simply the authors opinions. The writer does not own any Verizon Communications, Inc. stock. TUIA STATEMENT Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his tireless dedication to educating students in real -world principles of economics and business, the William C. Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging, practical learning experience. Managed by Fox School of Business graduate and undergraduate students with oversight from its Board of Directors, the WCD Owl Funds goals are threefold: Provide students with hands-on investment management experience Enable students to work in a team-based setting in consultation with investment professionals. Connect student participants with nationally recognized money managers and financial institutions

Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs and partial scholarships for student participants.

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