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Morningstar | Verizon Posts Solid Third Quarter, Surprises With Capital Spending Cut

Verizon posted solid third-quarter results, with particular strength around wireless customer growth, revenue per wireless customer, and free cash flow generation. The firm again reduced expectations for 2018 capital spending, a move we find curious given where the industry is in the investment cycle. On the disappointing side, Oath revenue declined 7% year over year and management backed off its 2020 revenue target for this segment. We don’t expect to significantly alter our long-term expectations, leaving our narrow moat rating and $58 fair value estimate intact. While we continue to favor Verizon strategically among U.S. telecom companies, we believe the shares are roughly fairly valued.

As the first U.S. wireless carrier to report earnings, we don’t have much context around Verizon’s relative performance, but the numbers look good. The firm added 295,000 net postpaid phone customers, its best third-quarter performance in three years. Customer defections ticked up modestly year over year, but gross additions (primarily customers leaving other carriers and choosing Verizon) picked up more. This dynamic makes sense given that Comcast and Charter are now marketing wireless services. Given Verizon provides the network supporting these offerings, customers switching to the cable giants isn’t a total loss. Also, average revenue per postpaid account increased sequentially for the second consecutive quarter, as more customers migrate to unlimited plans and choose more expensive service tiers. Wireless services revenue growth continues to improve, hitting 2.6% during the quarter.

Wireless profitability also continues to move in the right direction, benefiting from revenue growth and Verizon’s efforts to reduce costs. Importantly, in our view, cost-cutting is showing up primarily in sales and overhead expenses rather than network costs. We expect the cost to operate the wireless network will increase over time as Verizon maintains its leadership position.

Improved wireless profitability, the completed shift to on-balance sheet receivables financing, tax reform, and lower pension contributions have provided a huge lift to free cash flow. Verizon has generated $14.2 billion thus far in 2018, up from $5.9 billion at this point a year ago. Of those factors, moving receivables onto the balance sheet is the largest, as changes in working capital have only consumed $1.9 billion through the first nine months of 2018 versus $5.5 billion last year. Verizon still benefits from its ability to borrow against receivables (it has $9.2 billion of secured debt outstanding) and we appreciate the accounting clarity that comes with keeping receivables on the books.

Slightly more than half of free cash flow in 2018 has been returned to shareholders as dividends, with most of the remainder used to reduce leverage. Net debt now stands at $110 billion, or 2.4 times adjusted EBITDA, both the lowest since the end of 2016. We believe this capital allocation balance is appropriate.

In terms of capital spending, Verizon formally cut its budget to $16.6 billion-$17.0 billion from the “lower end” of $17.0 billion-$17.8 billion previously. We’re conflicted on this development. Spending less certainly benefits cash flow, and management is adamant that the reduction springs from efficiency gains, not a change in strategic priorities. However, Verizon’s network strength and its ability to stay ahead of rivals are key advantages, especially as the effort to deploy 5G technologies intensifies. We’re a little surprised the firm didn’t quietly reinvest any efficiency gains back into the network to press its advantages here further and faster.