Verizon: Blood In The Streets (NYSE:VZ)
The stock market has been horrific, but it really shows you how bad it has been when you see the likes of stable telecommunications company stocks dropping like a boulder down a cliff. We saw it most notably for AT&T Inc. (T), a very slow and progressive selloff for what felt like 5 years.
But today we are talking about its main competitor, Verizon Communications Inc. (NYSE:VZ). Folks, we are going to come right out and say it. At a 12-year low, this income name is at a blood-in-the-streets moment. Sentiment is horrific. The company is facing many challenges with its customers, and with competition, but we are going to stick our necks out there and say that its so hated, beaten down so much, that its probably time to consider starting to scale into this one for income, with the yield now well above 7%.
Following the just-reported earnings, there are certainly a lot of fundamental issues that justify the stock at a 12-year low, but we think other investor’s losses can be our gains. The dividend looks secure, and that is why we are considering adding this to our long-term dividend growth portfolio along with the chance to simply trade it for some gains when the market finally stabilizes in 2023, if not sooner. Astute traders can also consider selling option premium to lower entry cost, or to generate further yield via covered calls. But overall, we think the company survives, with the stock finding some footing in the coming weeks. Let us discuss.
Verizon Q3 results in context
The market has certainly been nervous about this earnings season. There was a lot of anxiety over how companies would perform as the actions by the Federal Reserve to combat inflation would weigh. Concerns over guidance. Concerns over the consumer.
Despite the rather poor report from Verizon, this is the first real week of Q3 earnings reports, and for the most part corporate earnings have been strong, along with the outlook. Verizon was a let down, however, with its Q3 earnings, despite managing to beat expectations on both the top and bottom line. Make no mistake, after this report management is taking serious measures to address the high inflationary pressures that are out there, slow customer churn, and return to growth. But the pressure is certainly on, and the company needs to save money. This was noted in the conference call:
“[W]e are making efforts to take cost out of our business. We are constantly thinking about how we run our enterprise everyday to enhance our performance while delivering on our strategy. In this period, we have designed a company-wide cost savings program that we expect will save between $2 billion to $3 billion annually by 2025.”
So, this cost savings plan can help maintain earnings in the event that revenues slip to some degree.
To remain competitive, we thought the company would be very promotional given the changes in the economy, or the perceived changes that a recession brings. Instead, the company focused on pricing power, and to a degree, this backfired and hurt customer growth. We also learned on the call:
“The pricing actions we took around administrative fees and metered plans led to an increase in disconnects. With certain price-ups being phased in throughout the third quarter, we would anticipate some disconnect pressure to carryover into Q4. Taken together, we currently expect the gross add and disconnect performance to result in positive consumer phone net adds in the fourth quarter.”
Basically, management has not acted like the consumer or businesses are facing all that much pressure by toying with pricing, and that weighed on customer counts, even though revenue came in at $34.2 billion and was up 4% from last year. They still beat by $410 million.
Verizon’s Q3 revenue drivers
So revenues beat, but there was weakness in customer adds. This weakness is spilling over into Q4. So, how were the numbers? Wireless postpaid growth saw just 8,000 new net adds. There was retail postpaid churn of 1.17%, rather high. Despite only have 8,000 net adds to postpaid, total wireless revenues were up 10%. A lot of this is boosted by 5G availability and the specific promotional marketing strategies employed, as well as pricing increases. Over in broadband, the company saw net adds of 377,000, which was positive. This was up from 109,000 net adds in Q2. Business also reported 360,000 wireless retail postpaid net adds. So this is not all bad here, folks. The company also saw 61,000 Fios net adds in the quarter. This was positive and an increase from the 36,000 net adds in Q2. This was impressive in this environment.
Verizon Q3 earnings outperformance
So, the company saw decent adds outside of postpaid. That is good. Revenues were much better than expected and grew from last year. As far as earnings go, with a nice top line beat we were expecting a decent EPS result. Analysts were looking for $1.29, and this was surpassed by $0.03. That is a nice beat. Keep in mind, however, that this was down from a year ago, which saw $1.42 in EPS. What? Yes, net income was $5.0 billion, a decrease of 23.3% from last year, although adjusted EBITDA was about flat at $12.2 billion.
Now, one could argue that the beat should have been better with the nice revenue beat, but management acknowledged it wants to reduce costs in the future. We applaud the cost reduction efforts that will be put into place and have already started to be put into place. Operating expenses remain high, and let us not forget that interest expense is up now due to higher rates. Further, CAPEX is up to $15.8 from $13.9 billion.
The thing is, after the stock has been slaughtered we are looking at this as a dividend play. One concern has been declining free cash flow.
Verizon Q3 free cash flow covers dividend, but watch leverage
Folks, we are looking at a blood-in-the-streets moment for the share price despite this is being attractive for income. The dividend has been raised for 16 consecutive years. If something happens to the dividend and this streak is broken or there is a cut, then the bottom will be much lower than here. But we do not see that happening. However, cash flow is a concern, though the dividend is being more than covered.
The dividend is covered, but we have to acknowledge the decline in free cash flow. Taking that into account, free cash flow is key to covering the dividend payment. We mentioned higher expense, and notably capex was higher year-to-date. Well, folks, free cash flow is now much lower year-to-date-than in 2021. This highlights the need to do something to save money. The net result of cash flow from operations which were $28.2 billion (down about $3 billion from last year) and the aforementioned and capital spending is free cash flow of $12.4 billion for the first three quarters of the year. Folks, this is down from $17.3 billion last year. That is painful.
Let us not forget the company is shelling out more in dividends than last year, having paid $8.1 billion versus $7.8 billion year-to-date last year. Doing the math, we see the payout ratio has ballooned from a safe 45% in 2021 up to a still safe, but eye-popping, 65%. A huge increase in the payout ratio, but still not cause for alarm. It is something to keep a close watch on, however.
We also need to remind you that, much like competitor AT&T, Verizon has a massive debt burden. It is incredibly high, and that is a risk in a rising-rate environment. The company is trying to chip away, but the net debt is still massive at $129.3 billion, despite decreasing sequentially by $1.3 billion. This leaves a debt to adjusted EBITDA ratio of 2.7X, which we will point out is less than AT&T’s 3.2X
As we look ahead, we are viewing this as an income name. Verizon will do all it can to protect the dividend. Shares will start to stabilize with both: a) the market, and b) when the company shows it is effectively cutting costs and free cash flow improves. That is the metric to watch, free cash flow. Guidance for earnings is $5.10-$5.25, and that means the stock is now less than 7X FWD EPS. That is cheap. It can get cheaper if earnings fall more, but a lot of risk is baked in here. We think you buy with the blood in the streets.