Verizon Stock Ownership Breakdown and Why I’m Seduced (NYSE:VZ)
Our bull thesis for Verizon (NYSE: VZ) is based on two simple arguments: the secular growth of our data needs and its heavily discounted valuation. We have focused more on the evaluation aspects before, and this article will explore the former in more depth. Probably, the following comments from its CEO Hans Vestberg in its Q1 2022 results best sums up this long-term growth potential (emphasis added by me):
As you have heard me say many times, mobility, broadband and the cloud are essential elements of 21st century infrastructure. We are already taking advantage of this infrastructure and capitalizing on a addressable market that grows as consumers and businesses adopt 5G. We saw this growth in our wireless sales, customer loyalty and rapid expansion of our fixed wireless business during this quarter.
The CEO’s comments above are indeed corroborated by other independent sources. Take the example of 5G. The following report from Grand View Research predicts that the global 5G infrastructure market will grow at a CAGR of over 34% over the next 10 years. As a top player, VZ is well placed to ride this trend.
However, telecommunications is a capital-intensive business. Therefore, the aim of this article is to take a close look at whether VZ has the resources to meet infrastructure needs and capitalize on this age-old trend. And you will see, my answer is a definitive yes.
Solid financial strength in a decade
Its first quarter of 2022 shows that the company’s finances are in excellent shape. VZ’s balance sheet at the end of the quarter showed $1.66 billion in cash and about $140 billion in long-term debt (vs. $149.7 billion). As its CFO Matt Ellis commented (abbreviated and underlined by me)
In addition, we entered into a number of other transactions during the quarter, the proceeds of which served as consideration in more than $5 billion takeover bid to pay off more expensive long-term debt. We ended the quarter with adjusted unsecured net debt EBITDA ratio of around 2.8 times dish on a sequential basis as planned.
Its financial strength is currently near a decade high, as you can see in the following interest coverage ratio. Its interest coverage ratio has fluctuated from around 4.1x to 12.3x over the past decade. It has been steadily improving since 2019, rising from around 5x to the current value of 10.1x. So currently it is at its peak financially, requiring less than 10% of its profits to service its debt. I wouldn’t be shocked if the company continues to increase its dividend payout and make more acquisitions in the future. Indeed, management has stated its commitment to increasing the company’s strategic capabilities as well as its wireless spectrum asset, as detailed below.
Capital Allocation Flexibility
For capital expenditures in 2022, management’s forecast is between $16.5 billion and $17.5 billion. The majority of the money is intended to support traffic growth on its 4G LTE network and increase the range and capacity of its 5G Ultra-Wideband network. In particular, incremental costs associated with rolling out the company’s C-Band 5G network are expected to be between $5 billion and $6 billion. And as CFO Matt Ellis commented (abbreviated and underlined by me):
Capital expenditures for the first quarter totaled $5.8 billion, an increase of $1.3 billion over last year, driven by C-band expenditures of $1.5 billion. The continued construction of OneFiber and our investments to support traffic growth on our 4G LTE network while expanding the reach and capacity of our 5G ultra-wideband network great extends our chances of competing effectively in all of our businesses. Net cash flow from operations and capital expenditures was free cash flow for the quarter of $1.0 billion.
Looking forward, VZ certainly generates enough organic cash from its operations to cover these expenses, as shown in the following chart. The company generated about $1 billion of free cash flow in the first quarter after all capital expenditures. And it has just reaffirmed its forecast for the full year. Adjusted EBITDA earnings are expected to grow approximately 2% to 3%, and Adjusted EPS are expected to be between $5.4 and $5.55, representing growth of approximately 0% to approximately 3% versus to last year. My estimate of overall net income is around $8 billion and free cash flow around $9 billion.
Valuation and Projected Returns
A brief overview of valuations. As the following data shows, VZ is undervalued both relative to the broader market and its own all-time highs. The discount is around 25% in terms of PE multiple from its historical averages. Its current PE FW is only around 9.4x and the historical average is around 12.5x. In terms of dividends, it currently yields around 5.04%, undervalued by around 15% compared to its historical average yield of 4.4%.
With the compressed valuation, one can expect a healthy projected return, even assuming conservative growth rates. Its return on capital employed (“ROCE”) is approximately 31%. A reinvestment rate of 10% can lead to organic real growth of 3.1% (and as mentioned above, it reinvests more than 10%). Adding an inflation factor of 3% for example can easily lead to a growth rate of around 6% to 7%.
But even with a conservative growth rate of 4%, as shown below, for the next 3-5 years, total return should be in the range of 34% (the low projection) to about 55% (the projection high). final projection), translating into an annual return of 7.6% to 11.7%. A highly asymmetric opportunity in my opinion, especially when adjusted for its A+ financial strength and A revenue regularity.
Final thoughts and risks
Our bullish thesis for VZ rests on two simple arguments: the secular growth in data needs and its compressed valuation. Its financial strength is near a decade high. Interest coverage is currently at 10.1x, the second highest level in a decade. Going forward, VZ generates enough organic cash to cover CAPEX needs to continue to grow its top-tier network. CAPEX is expected to be between $16.5 billion and $17.5 billion next year. The majority of them will strategically support its 4G LTE network and 5G Ultra-Wideband network.
Despite the strong financial position and growth potential, the stock is trading at a discount of around 25% in terms of PE multiple and around 15% in terms of dividends. The combination of business fundamentals and valuation compression creates a highly asymmetric opportunity with favorable probabilities for a double-digit annual return but few downsides.
A few final words on risk. The risks that I currently perceive are mainly macroeconomic risks. There is a reasonable possibility of a recession in the near future. Many leading companies, ranging from high tech like Tesla (TSLA) to commodities like Walmart (WMT), have all reported inflationary pressures and recently announced hiring freezes (or even layoffs). VZ is heavily dependent on debt financing and its interest rates could rise if borrowing rates continue to rise. With total debt of about $140 billion, a 1% increase in borrowing rates would result in about $1.4 billion in additional interest expense, or about 4% of its operating cash.