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Telecom Stocks

AT&T and Verizon Communications Extend Their Reach

By Roger S. Conrad on Aug. 10, 2016

My 2002 book Power Hungry: Strategic Investing in Telecommunications, Utilities and Other Essential Services called for the rise of “a second Ma Bell” as the inevitable result of fierce competition in the scale-driven telecom sector.

I envisioned the so-called “Baby Bells” growing into this role because of their strong balance sheets and dominance of the local telephone service, a business that generated significant cash flow.

At the time, the conventional wisdom held that nimble competitors would drive adoption of emerging technologies and would eat the Baby Bells’ lunch while their phone businesses withered on the vines. But in the end, these ostensible disruptors went the way of the dodo.

Although many investors probably remember WorldCom’s spectacular crack-up, the preponderance of competitive local exchange companies also failed–after issuing more than $100 billion worth of debt and equity.

Amid this carnage, two champions emerged from the ranks of the Baby Bells to dominate the telecom sector: AT&T (NYSE: T) and Verizon Communications (NYSE: VZ).

Still Confronting Doubters

These days, analysts and pundits routinely question whether these telecom titans will maintain their dominance or lose market share to T-Mobile US (NSDQ: TMUS), which has sought to attract customers through aggressive discounts.

But the latter’s efforts have primarily succeeded in stealing business from the moribund Sprint Corp (NYSE: S), the US wireless industry’s No. 4 provider.

T-Mobile US also continues to lag behind AT&T and Verizon Communications on capital spending, leaving the No. 3 wireless provider with an inferior network relative to its larger peers.

In the first half of 2016, T-Mobile US invested $2.7 billion in its network and spent another $2.8 billion on wireless spectrum—expenditures that amount to roughly two times its operating cash flow. Over this period, the company issued about $1 billion in bonds and sold $3 billion worth of assets to cover this shortfall and take care of maturing debt.

Verizon Communications, in contrast, spent $7.7 billion on its network and additional spectrum. And the telecom giant generated $12.8 billion in operating cash flow, leaving ample funds to pay a generous dividend and reduce debt.

AT&T’s capital expenditures totaled $10.6 billion, an amount that the company’s $18.2 billion in operating cash flow easily covered.

Sprint must pay off or roll over almost $10 billion in maturing debt through the end of 2018. The US wireless market’s fourth-largest player spent almost $6 billion over the 12 months ended March 31, 2016, and generated just $3.9 billion in operating cash flow.

Questions have also emerged about whether Softbank Group Corp (Tokyo: 9984, OTC: SFTBY), which owns 83.3 percent of Sprint and has a sub-investment-grade credit rating, can afford to continue to make up the shortfall.

Spending Wisely

AT&T and Verizon Communications’ industry-leading capital expenditures on their 4G wireless networks have spurred data traffic and limited customer churn to less than 1 percent.

Both companies plan to roll out 5G wireless capabilities nationwide in 2017, leaving their rivals with no choice but to step up their capital expenditures or fall even further behind in the race for network coverage and quality.

However, AT&T and Verizon Communications’ recent acquisitions have raised some eyebrows.

AT&T’s acquisition of DirecTV created cross-selling opportunities and gave the company a foothold in the Mexican market. We analyzed this deal at length in AT&T Goes Direct.

Verizon Communications has announced two major acquisitions this summer:

  • The $4.8 billion purchase of Yahoo’s (NSDQ: YHOO) operating business; and
  • The $2.18 billion takeover of  Fleetmatics Group (NYSE: FLTX), a software-as-a-service provider that specializes in solutions that help companies improve the efficiency of their commercial fleets by collecting and analyzing data related to vehicle and driver behavior.

In addition to these deals, the company continues to seek regulatory approval for its $1.8 billion purchase of XO Communications’ fiber-optic network.

This pending acquisition has attracted scrutiny from regulators because the deal will give Verizon Communications fiber-optic networks in 40 major US markets and 20,000 fiber-route miles connecting 85 cities. Rivals also worry that these assets will aid the telecom behemoth’s push to create the dominant 5G wireless network.

Management aims to close the purchase of XO Communications’ fiber-optic network before June 30, 2017, and expects to complete the less controversial acquisition of Fleetmatics in the fourth quarter of 2016. Verizon Communications’ takeover bid for Yahoo likewise shouldn’t encounter too many regulatory hurdles.


How do these disparate businesses fit into Verizon Communications’ strategic plans?

XO Communications’ fiber-optic assets will complement Verizon Communications’ existing FiOS business and give the company an edge in rolling out its 5G network.

The purchase of Fleetmatics increases Verizon Communications’ exposure to the internet of things, an emerging opportunity for telecom’s largest players.

A growing number of cars include connections to the cloud to download the latest traffic data, send back information related to driver and vehicle performance, and download the latest updates to the automobile’s software.

Cars produced by Audi (Frankfurt: NSU) and Geely Automobile Holdings (Hong Kong: 175), which owns the Volvo brand, operate primarily on AT&T’s network in the US, while Hyundai Motor Co (Seoul: 005380), Toyota Motor Corp (Tokyo: 7203, NYSE: TM) and Daimler (Frankfurt: DAI, OTC: DDAIF) produce vehicles connected to Verizon Communications’ system.

Verizon Communications’ rapidly growing telematics business offers network solutions to auto manufacturers looking to roll out connected vehicles and insurance companies interested in introducing usage-based plans.

If the company had owned Fleetmatics in the first half of 2016, this business would have boosted the Verizon Telematics’ revenue by about 40.5 percent and added 737,000 subscribers in the machine-to-machine market.

Management expects the acquisition to contribute as much as $0.14 per share in earnings next year, assuming that the deal closes in the expected time frame. Even more promising, this business could reach 3.1 billion total connections by 2020.

Bottom Line: The rapidly growing telematics market could help to offset the increasing saturation in the consumer and enterprise wireless markets.

Meanwhile, the acquisition of Yahoo’s operations will beef up Verizon Communications’ content offerings; to date, results from its go90 video platform have been decidedly mixed, with its target audience of millennials preferring other content sources.

Management also hopes to increase revenue from Yahoo and AOL’s popular online content—which includes the Yahoo Finance, Sports and News portals as well as Tech Crunch and The Huffington Post—by leveraging each internet property’s advertising capabilities. These properties also create platforms for delivering high-bandwidth content that will drive data traffic on its 5G network.

Given the low multiple that Verizon Communications paid for Yahoo, management expects the deal to be immediately accretive to earnings. The company could also sell Yahoo’s search business to defray a portion of the acquisition cost and help to fund future capital spending.

The success of these efforts—particularly Verizon Communications’ foray into content—depend on navigating fiercely competitive markets. However, skeptics overlook two key points.

A Drop in The Bucket

Verizon Communications can complete all three of these deals without stretching its balance sheet or jeopardizing future earnings.

Leaving aside the earnings accretion and integration costs associated with these transactions, the $8 billion price tag represents a fraction of the telecom titan’s $232 billion in total assets and $63 billion in first-half revenue.

The company generated $1 billion in excess cash flow—operating cash flow less capital spending and dividends—over the first six months of 2016.

Meanwhile, Verizon Communications raised about $10 billion from the sale of wireline assets to Frontier Communications Corp (NSDQ: FTR) and boasts the lowest cost of capital in its sector. For example, 30-year bonds that the company issued in late July 2016 yield barely 4 percent to maturity.

Even in the unlikely event that Verizon Communications’ recent acquisitions come to naught, the effect on the company’s underlying profitability would be negligible. And management will still have plenty of funds to deploy elsewhere.

Staying on Top

Dominant companies stay on top by innovating. The acquisitions of Yahoo and Fleetmatics give Verizon Communications expertise in promising adjacent markets where the firm is still a bit player.

Some pundits will rush to judgment if the uptake of go90 continues to disappoint or the addition of Fleetmatics fails to deliver the promised bump to Verizon Telematics’ earnings and revenue. However, the success or failure of these acquisitions will be measured in years and how they help Verizon Communications to stay on top of its native industry.

Past as Prologue

Two decades ago, many pundits counted out Bell Atlantic (Verizon Communications’ predecessor) as a dinosaur doomed to extinction after the Telecommunications Act of 1986 broke up its monopoly on local phone markets.

However, the company had already started to position itself to dominate the wireless industry and hasn’t looked back.

Investors lost a great deal of money by betting against Bell Atlantic’s ability to adapt with wagers on WorldCom and competitive local-exchange companies. Vonage Holdings Corp (NYSE: VG) was another would-be challenger that failed to live up to the hype, while commentators continue to wait in vain for the likes of Google, Comcast Corp (NSDQ: CMCSA) and other well-heeled players to step up and compete in the wireless business.

Maybe this time will be different. Maybe Verizon Communications’ recent spate of acquisitions won’t pan out. Maybe intensifying competition will take a bite out of the company’s wireless business. And maybe the telecom firm’s free cash flow will dry up, forcing the firm to scale back its capital expenditures.

But the past has demonstrated that it’s easier for companies at the top to stay on top. And Verizon Communications is definitely at the top of its game.

In the second quarter, the company added 615,000 customer contracts, posted an industry-leading churn rate of 0.94 percent and lifted its cash flow margin to 47.5 percent from 43.9 percent a year ago.

Even Verizon Communications’ wireline business has started to grow again, with FiOS revenue ticking up 3.7 percent despite a strike that cost the company an estimated 13,000 new internet connections and 41,000 video connections.

However, valuation is a cause for concern. AT&T and Verizon Communications’ stocks trade at demanding multiples, thanks to investors’ appetite for yield and recession-resistant cash flow. Investors should stand aside for now and bide their time until the inevitable pullback.

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Roger S. Conrad needs no introduction to individual and professional investors, many of whom have profited from his decades of experience uncovering the best dividend-paying stocks for accumulating sustainable wealth. Roger b