Verizon Communications Inc. (NYSE:VZ) is just off of a low not seen in over a decade. Folks, this income name has had some horrible sentiment, but it is tough to turn away from a yield that is above 7%. Look there are many fundamental issues here. The are debt issues in a rising rate environment. There are inflation issues pinching consumers and businesses. There is a ton of competition in the space as well. All of that is weighing. But at this price, we think the risk-reward is in the bulls favor here. We rate shares a buy under $40. The dividend looks secure, and that is why we added this to our long-term dividend growth portfolio, but we still think for our many traders that there is upside still. You can 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. Let us discuss.
Here is how we are recommending new money consider playing the stock
Target entry 1: $38.50-$38.75 (30% of position)
Target entry 2: $37.65-$37.80 (30% of position)
Target entry 3: $36.00-$36.25 (40% of position)
Target trading exit: $43
No stop is recommended
Verizon performance suggests concerns are real, but being addressed
Overall, the recent performance of the company was pretty weak, but despite the rather poor report from Verizon, its Q3 earnings managed to beat expectations on both the top and bottom line. Yet the internal key metrics largely were a concern, especially around costs.
In the report there were concerns raised over high inflationary pressures that are hitting the consumer, as well as a need to slow customer churn, and return to growth. On the conference call we learned management is working to reduce costs. They “designed a company-wide cost savings program that we expect will save between $2 billion to $3 billion annually by 2025.” So that is strong and hopefully can boost operating margins and preserve earnings and cash flow.
To protect the top line and try to attract the right customer the company focused on balancing its pricing power with growing customers. However the lack of being real promotional led to churn. The company focused on upping prices and this led to increased disconnects. Some of this pressure may carry over into Q4, but the holiday promotions that we have seen so far suggest anecdotally the company may be rethinking this approach, that is, they may be refocused on reducing customer churn at the expense of higher revenues per user. It remains to been.
What is clear is that the action in Q3 to act like all was well in the world weighed on customer counts. However, despite churn revenue came in at $34.2 billion and was up 4% from last year. This was well above expectations by over $400 million.
Churn versus net adds
Make no mistake the top line growth was strong but there was weakness in customer adds and this can have lasting impacts, especially as it seems some of the disconnect pressure from increased pricing is carrying over into Q4. Wireless postpaid growth was anemic. Wireless postpaid growth saw just 8,000 new net adds. In terms of churn, there was retail postpaid churn of 1.17%, which is quite high. But the pricing power was a big benefit, despite the anemic growth. With low customer growth and higher churn, total wireless revenues were still up 10%.
Broadband and business customer growth was still positive. Verizon saw net adds of 377,000 in broadband, quite strong. In fact this broadband growth was up from 109,000 net adds in the sequential Q2. The Business segment also reported 360,000 wireless retail postpaid net adds. On top of that Verizon had 61,000 Fios net adds in the quarter.
Given the weakening macro situation, supposedly, we think these metrics were strong.
Flat EBITDA and EPS down
While revenue grew EBITDA and EPS were flat, and down, respectively, Analysts were looking for $1.29 in EPS, and this was surpassed by $0.03 with the company hitting $1.32. That is a nice beat but we actually were down $0.10 from last year’s $1.42 in EPS. Net income was $5.0 billion, a decrease of 23.3% from last year. Pain. Adjusted EBITDA was about flat at $12.2 billion. This is why cost cutting is key. Top line growth is nice, but you cannot see eroding earnings and cash flow. The fact is that operating expenses are too high, and interest expense will be rising in the future on new debt due to higher rates. Further, CAPEX spending, while necessary to grow, is up to $15.8 from $13.9 billion. Folks, while we have outlined a trade, as an investment this is an income name. And as you can imagine, we care about the dividend.
Dividend is covered
The stock is attractive for income, especially if the company delivers on slowing churn and reducing the massive operational expenses. Ultimately, we care about the dividend being safe, i.e., covered. The dividend has been raised for 16 consecutive years. Folks, let us be clear here. 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. So, is the dividend covered by cash flow? Yes.
Cash flow declines
Readers, do be assured that the dividend is covered, but we have to acknowledge the decline in free cash flow, which is why cost cutting is paramount. 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. Free cash flow was $12.4 billion for the first three quarters of the year here. Is that bad? On its own, no, but, when you look and see that it dropped from $17.3 billion last year, you can understand some of the stock price movement.
Pro tip: we have found there is a strong correlation in our research between high-yield dividend stock share price and their trends in free cash flow. This is likely due to a gauge of safety on the dividend and the payout ratio.
More dividend payments impact payout ratio
With dividend hikes and a lack of share repurchase volume to reduce the float, more cash is going toward total dividends. Verizon year-to-date has doled out $8.1 billion versus $7.8 billion in dividends year-to-date last year. If you factor in the cash flow here, doing the math, we see the payout ratio has surged from 45% in 2021, to 65%. Now, to be clear, a 65% payout ratio is still very safe, but the magnitude of the increase in the ratio is certainly unsettling and should be the primary factor you look at in a name like this.
Lot of leverage
We know competition in this space is huge. That is a risk. International exposure in these global names is a risk. There is political risk. There are taxation issues. All of that is true, but the largest risk in this space is that many of these names carry a large debt burden. This is a problem in a rising rate environment as future debt will come with a higher price tag on the interest expense line. Net debt is still a huge $129.3 billion. While this is down by $1.3 billion from Q2 2022, the leverage is moderately high. This leaves a debt to adjusted EBITDA ratio of 2.7X. This is not as egregious as other competitors but it is a risk to be aware of especially if other key metrics falter.
This is an income stock that is setup for a trade too, but we think it’s great to have in a dividend growth portfolio. Verizon will do all it can to protect the dividend. That is the metric to watch, free cash flow going forward. All things considered, this thing has been beaten down badly, and we want to profit (further) from the reversal.
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