Verizon: Time To Load Up (NYSE:VZ)

Investment thesis

My previous bullish thesis about Verizon (NYSE:VZ) aged exceptionally well as the stock rallied more than 17% over the last quarter, significantly outpacing the broader U.S. market. Although the company operates in a highly penetrated industry where rapid revenue growth is not expected, I consider the stock to be a strong, deep value play for dividend investors. The current dividend yield is slightly below 7%, and I have high conviction that the dividend is safe and poised to demonstrate modest growth. As CAPEX is moderating and operating leverage is improving, I expect stable free cash flows which will fuel dividend growth and help the management to deleverage the balance sheet. The rapidly increasing net debt position was the main factor that weighed on the valuation in recent years. Therefore, given my positive outlook regarding the company’s ability to deleverage, I expect the stock to continue moving towards its fair value, which is around 40% higher than the current stock price. All in all, I reiterate my “Strong Buy” rating for Verizon.

Recent developments

VZ released its latest quarterly earnings on October 24, when the company topped consensus estimates. Revenue declined YoY by 2.6%, and the adjusted EPS followed the top line by narrowing from $1.32 to $1.22.

Despite challenges for the top line, VZ demonstrated a solid 250 basis point gross margin YoY expansion and a slight improvement in the operating margin. Margins resilience allowed the company to generate far more than $10 billion in operating cash flow during the quarter. As capital expenditures decreased dramatically as the 5G buildout peaked in the rearview mirror, VZ generated $8.3 billion in free cash flow [FCF] during the quarter. A strong FCF quarter allowed the company to sustain its attractive dividend yield of almost 7%. The leverage is still sky-high, but as the FCF improves, I expect VZ to focus on paying down the debt aggressively without hurting dividend payouts. Over the last two quarters, the net debt decreased by $10 billion, which is a positive trend for investors. During the latest earnings call, the management reiterated its commitment to continue deleveraging aggressively in 2024.

The upcoming quarter’s earnings release is scheduled for January 23, 2024. Quarterly revenue is estimated by consensus at $34.48 billion, which indicates a 2.2% YoY decline. The adjusted EPS is also expected to decrease from $1.19 to $1.09.

As the company operates in a highly penetrated industry, it is difficult to expect strong revenue growth every quarter. But VZ is an apparent value stock, and we should remember that revenue growth is not the only way to drive shareholder value. Verizon’s investors have faced significant challenges in recent years as the company’s leverage ratio experienced rapid expansion. However, this strategic shift was an unavoidable necessity for the company to adapt to the evolving technological landscape, where the demand for next-generation equipment is imperative for enhancing broadband speed. However, the 5G network buildout peaked in 2022, and the management expects CAPEX to continue moderating to more normal historical levels. Apart from moderating capital spending, the management also focuses on operating cost efficiency. That said, I expect the solid recent EBITDA trend, which protects dividend payouts, to be sustained.

It is also important to highlight that despite operating in a highly penetrated industry, it does not mean that the management is not focusing on the top line. Verizon’s consistent focus on the highest broadband quality made its network the most awarded in the U.S., which will likely help maintain high customer loyalty and attract new customers. Delivering the highest network quality also means VZ can attract higher-end customers, which makes the company well-positioned to upsell.

I also see long-term growth potential for VZ from non-traditional devices like electric vehicles [EV] or internet-of-things [IoT]. The demand for seamless communication and data exchange within EVs aligns with the company’s deep expertise in providing robust network solutions. Let me remind you that the U.S. EV industry is expected to compound at a massive 18% over the next multiple years. The growing ecosystem of IoT devices also presents good opportunities for VZ to expand its reach. Despite statista.com expecting the IoT industry to grow at a notably slower pace than the EV industry, the forecasted CAGR for IoT is still in double-digits.

All in all, despite having a sky-high leverage ratio, the company’s solid revenue predictability, together with financial discipline and moderating CAPEX, suggests that VZ’s future cash flows will be sufficient to both deleverage and sustain its generous dividend.

Valuation update

The stock declined by about 5% year-to-date, significantly lagging behind the broader U.S. market. Seeking Alpha Quant assigns VZ a solid “B” valuation grade because of the relatively low ratios compared to the sector median and historical averages. That said, the stock is undervalued from the perspective of valuation ratios.

I want to proceed with my analysis of the dividend discount model [DDM]. I use a 7% WACC as a required rate of return, which is recommended by valueinvesting.io. Consensus dividend estimates forecast an FY 2024 payout at $2.68, which I use for my DDM simulation. I use a 2% dividend growth rate, which is the stock’s last five years’ CAGR.

According to my DDM calculations, the stock’s fair price is almost $54. This indicates a massive 40% upside potential, meaning the stock is very attractively valued.

Risks update

The rapidly evolving technological environment forced VZ to invest substantial amounts in CAPEX in recent years, leading to a rapid increase in financial leverage. As technology evolves rapidly, there is always a possibility that telecom companies like Verizon will need to increase capital expenditure again to address the changing environment. If this is the case, the increased leverage will weigh on the sentiment toward the stock, which will lead to investors’ sell-off.

Given Verizon’s dominant position in the American telecom industry, the company’s operations are constantly under deep scrutiny from Antitrust authorities. Verizon’s significant presence in consumer and business segments means that any findings of monopolistic behavior or unfair business practices could result in regulatory actions. Such actions will highly likely undermine the company’s financial performance and its reputation.

Bottom line

To conclude, VZ is still a “Strong Buy”. I see several positive developments, which include profitability metrics, resilience and balance sheet improvement. I expect free cash flow to continue improving as the massive 5G network buildout peak is in the past. Predictable and wide free cash flow suggests that the modest dividend growth is safe. The management will also continue focusing on the balance sheet deleveraging, which will help the valuation move closer to the stock’s fair value.