Verizon Is a Port in the Coming Storm

 | Nov 01, 2013 | 12:00 PM EDT
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After a great market run, we have been flashing the yellow light of caution and prudence. While we are not saying the sky is about to fall, we do expect the pace of market gains to slow. At this point, we therefore suggest that investors avoid chasing the current big gainers and focus their new buys on stocks that should provide modest but steadier and more reliable returns in a potentially choppier environment.

One industry that typically fills this bill is telecom. While we are not great fans of this industry, we do believe that both AT&T (T) and Verizon (VZ) should provide good income and realistic appreciation going forward, while also offering some stability once volatility returns. Having previously discussed AT&T, we'll now focus on Verizon.

Verizon reported solid third-quarter results with revenue and earnings coming in slightly ahead of consensus expectations. Overall company operating revenue grew 4.4%, marking the fourth consecutive quarter of 4%-plus revenue growth. Wireless service revenue, which represents two-thirds of consolidated revenue, grew more than 8% to $20.4 billion, with 7.6 million smartphone activations, up sequentially and 12.5% higher than a year ago. Revenue growth was driven by increased connections, data usage and smartphone penetration gains. Retail postpaid revenue per account grew 7.1% to $156 per month.

About a third of Verizon customers who upgraded to smartphones during the quarter were purchasing one for the first time. Of the 7.6 million smartphone activations this quarter, 77% were for 4G LTE. At the end of the third quarter, 38% of retail postpaid connections are 4G LTE, up from 17% a year ago; this represents 64% of data consumption. Total smartphone penetration among customers is now 67%.

While theoretically that leaves another third of customers to be upgraded, not all of them will buy smartphones and a data package. But some will, and that leaves more opportunity for additional data usage and revenue growth.

One astute analyst noted that Verizon had extended its upgrade window to 24 months from 20 months, and that the first customers affected by the extended cycle were those who qualified for an upgrade in September 2013. This implies a more normal upgrade pattern in the fourth quarter, as well as holiday sales of new iPhone products.

In Wireline, consumer revenue increased 4.3%, driven by FiOS penetration. Year-to-date free cash flow increased 23% to $16.6 billion. FiOS average revenue postpaid per user was up 8.7% to $113. Two-thirds of FiOS customers are triple play. More than half the FiOS Internet sales in the quarter were for speed in excess of 50 megabits per second, and just over 40% of FiOS customers subscribe to Quantum with speeds ranging from 50 to 500 megabits per second.

The company estimates that it still has a large number of customers on copper lines. It converted 80,000 in the quarter and 250,000 year to date through the third quarter, and Verizon said it will have fewer than 1 million copper-line customers by year end. The converted customers come over to fiber initially at the same price, but there is an opportunity to sell faster Internet speed and also TV service. Verizon management said it sees about a 30% conversion to TV about nine months after the switch from copper. Additionally, the cost of servicing fiber is much less than the cost of servicing copper.

The big news in the quarter was the agreement to buy Vodafone's (VOD) 45% stake in Verizon Wireless. The terms of the deal are for Verizon to pay Vodafone's shareholders $130 billion -- $58.9 billion in cash, $60.2 billion in stock and about $11 billion in smaller transactions. (The shares will have a floor price of $47 and a cap of $51.). To finance the deal, the company raised $49 billion in a bond offering, and it has an agreement for a $12 billion term loan. Verizon anticipates that the deal will close in the first quarter of 2014 and will be 10% accretive to earnings per share.

Verizon is running its business very well, and the purchase of the 45% interest in Verizon Wireless from Vodafone is a decided plus. There are competitive pressures from T-Mobile (TMUS), AT&T and Sprint (S), and even Verizon says its 8% wireless revenue growth will slow over time. But looking at where Verizon is today, and the moves the company is making to retain market leadership, we believe the shares are a good buy for income-oriented portfolios.

In the current market environment, appreciation has been dwarfing dividends, both as the key component to returns and as the driving motivation for investors. However, looking down the road, Verizon's biggest attraction might be the steady rise of its already attractive dividend. The company recently increased its quarterly dividend for the seventh consecutive year, to $0.53 per share, or $2.12 annually, equating to a current yield of 4.2%.

Given Verizon's attractions, both opportunistically and defensively, we would suggest a modest initial buy at current prices, with the intention of building a position in the $47 to $48 range.

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