EUR 850.00 For Business Accounts Only

Morningstar | Verizon Investor Meeting Focuses on the Network; Fair Value Estimate Remains $58

Verizon’s first quarter was a touch soft, as competitive pressure across the wireless industry continues to ebb and flow. Though the stock is trading lower following the earnings release, we view the shares as fairly valued relative to our unchanged $58 fair value estimate.

The firm lost 44,000 net postpaid phone customers during the quarter, which was only slightly worse than a year ago (24,000 net losses) but reversed the solid momentum that built in late 2018. Given Verizon’s performance, we believe the wireless market remains somewhat challenging as Sprint and T-Mobile chase growth. Until the fate of those two firms is settled, through their proposed merger or another strategic reshuffling, we don’t expect the environment to change. We still believe Verizon is the best positioned to weather competitive ups and downs while still generating solid returns for shareholders. Verizon also announced a partnership with Google to distribute YouTube TV, which we believe is a smart move, but it calls into question the future of the firm’s media segment.

Management indicated that it declined to match aggressive promotions early in the quarter, only ramping up efforts in March. Strong growth in revenue per customer lends credence to this claim. Average service revenue per postpaid account increased 3.8% versus a year ago, marking the first meaningful growth in this figure since the shift to unsubsidized rate plans began five years ago. Total wireless service revenue increased 4.4%, also the best performance in nearly five years. We suspect Verizon is willing to let price-sensitive accounts leave to protect the value of its core customer base, striking back only often enough to avoid losing material market share and keep rivals honest. As a result, customer growth will likely remain vulnerable to periods when competitors are aggressive, but we were pleasantly surprised to see an offsetting benefit in revenue per customer this quarter.

Profitability is difficult to assess given the accounting changes that have hit over the past couple years. Wireless operating expenses, excluding phone and other customer equipment costs, increased more than 10%, but a sizable portion of this increase is tied to the amortization of commissions, which Verizon only began capitalizing in 2018. The capitalization of operating leases starting at the beginning of 2019 also increased reported expenses. The wireless EBITDA margin declined to 47.4% from 47.8% a year ago, but management claims the margin would have increased to 48.3% absent the accounting changes. Given the strong growth in wireless service revenue and Verizon’s expense management track record, we believe it is highly likely that wireless profitability improved year over year. In any case, the firm likely remained far more profitable than its rivals during the quarter.

The fixed-line segment continues to struggle, at least when viewed in isolation, with revenue declining 3.9% year over year, its worst performance in recent memory. The wholesale business remains a trouble spot, with revenue down 12.5%. Management expects improvement in the rate of decline in this segment going forward, but we expect the secular challenges facing this business will persist for the foreseeable future. On the positive side, the consumer business returned to growth for the first time in six quarters, with revenue up 0.1%. This improvement reflects modest growth in the Internet access business, partially offset by the accelerating decline of the television business. FiOS now makes up most of the consumer segment revenue base, which bodes well for future growth.

Fixed-line profitability remains a sore spot, with the EBITDA margin down about 1 percentage point year over year, pushing the segment to an $88 million operating loss for the quarter. Management indicated that the voluntary employee separation program, enacted in late 2018, saved Verizon $180 million during the quarter, with 60% of the savings hitting in the fixed-line segment. The firm doesn’t expect the full benefit of the program to hit until the third quarter.

On a consolidated basis, Verizon reported 1.1% revenue growth year over year for the quarter. Wireless equipment revenue declined 2.2% as the percentage of customers upgrading phones continues to decline (4.4% of the postpaid base versus 5.0% a year ago). Free cash flow totaled $2.8 billion during the quarter, up from $2.1 billion a year ago on lower capital spending and pension contributions. Net debt inched up slightly to $111 billion from $110 billion at the end of 2018, with leverage holding steady at 2.3 times EBITDA. Management pegs unsecured debt at 2.1 times EBITDA, closing in on its target range of 1.75-2.0 times.