TBC - Verizon Approaches A Critical Crossroads

2024-01-11 17:58:50 ET

Summary

• Verizon Communications Inc. Q4 revenue is expected to slightly decline, but revenues are anticipated to bottom out this fiscal year.
• Projecting strong net additions in customers, particularly in retail postpaid and broadband, as a result of heavy promotion.
• Verizon's Q4 EBITDA is expected to be similar to Q3, with cost controls helping to drive higher earnings.
• What can take shares higher?

We have had a buy rating on Verizon Communications Inc. (VZ), a high-dividend-paying stock which has been battered. We stepped up our conviction as the stock breached the $30 level, and since then, shares have enjoyed a significant rally. Of course, there are many who have bought in earlier that are under water. Timing, like everything else in life, is everything. No one will get it perfect, but being able to be nimble and adapt is what separates wins and losses.

In this game, being nimble means trading around a position, taking stop losses when appropriate, employing options approaches to help define entry or generate income, as well as buying when the opportunity arises. If you are moderately successful as some of these approaches, you will almost always outperform the buy and forget investor.

With that said, using this approach has led to great success for our team and those among our group, but there is still a risk in holding Verizon or similar names. From a trading perspective only, we closed out a "trade" in Verizon recently on the strength of the 25% plus run. However, we still own shares in a house position (which is some of the trading profit) for income and future potential gains.

Still, we do not hold and forget. Like competitor AT&T ( T ), the debt is the main risk here, but the dividend is well covered. A very critical earnings season is around the corner, and Verizon will report earnings for Q4 on January 23rd, pre-market . In this column, we will discuss what we see ahead for Q4 performance and highlight what we are watching. Of course, the guidance for the year for sales and cash flows will be paramount to maintaining this rally. Let us discuss.

Verizon Q4 revenue and customer outlook

This is a key earnings season because the markets have been in rally mode and the Street is looking for companies as a whole to forecast strong earnings, helping to justify the rally, and perhaps add more steam to it. Failure to do so could lead to a range bound year. For Q4, we are anticipating a very slight revenue decline at the midpoint of our estimates, but we continue to suspect that revenues are bottoming out this fiscal year. For Q4, we are looking for $34.45-$35.05 billion for the top line. Make no mistake, there is a ton of competition and there was heavy promotion during the holiday quarter among the major telecoms to attract and retain customers.

When Q4 is reported, the revenue will set the tone for the rest of the down line items on the quarterly print. The revenue number is vital, but keep in mind promotions to drive the top line could lead to an impact on margins from heavy promotion. Revenues have come in recently lower.

In Q3 , revenue came in at $33.3 billion and was down 2.6% from last year. It was a decent quarter overall. As we move into the promotional Q4, we expect some strong net additions in customers. We are looking for retail postpaid net additions of 500,000+ and wireless postpaid phone gross additions to increase high single-digits year-over-year. We are looking for churn below 1.2% for retail postpaid customers, but expect churn to be higher than Q3 given competitor promotions. For broadband, we are looking for net additions of 420,000, to mark the fifth consecutive quarter of more than 400,000 broadband net additions. Business activity has been strong, and we are looking for low single-digit growth here. We are projecting 36,000+ Fios Internet net additions. This should take revenue to the mid-$34 billion range in our estimation.

Verizon Q4 EBITDA and earnings outlook

Assuming that customer additions and revenues come in around our estimated targets, operating expenses will be key. Verizon has executed on this front, controlling operating expenses to help drive EBITDA and earnings higher, despite flat to down revenues. We saw operating expenses come in at $26.3 billion and operating income of $7.5 billion in Q3. This helped drive adjusted EBITDA to rise 0.2% to $12.2 billion, with EPS of $1.22. For Q4, we are looking for similar cost controls. We are targeting operating expenses of $26.1-$26.4 billion, and operating income of $7.7-$7.9 billion. For adjusted EBITDA, we are targeting $11.7-$12.1 billion. On a per share basis, assuming our projections capture the results with relative precision, we see EPS of $1.07-$1.14 for Q4.

Verizon Q4 free cash flow

For the long term, it really is all about the trend in cash flow, as well as progress on debt/leverage. The cash flow metric is a key indicator we watch for most companies, but especially with high dividend paying companies. We believe a strong cash flow number will lead to increases in share prices, but a poor number could reverse the progress we have seen in the stock. When you have a high-yield dividend paying stock like this, a big cash flow number will lend evidence that the massive dividend yield is secure. While not nearly as high-yielding as shares were just a few months ago, we are still near 7%, which is juicy for income investors.

So, we will be looking closely at free cash flow. Free cash flow is the metric to pay attention to as it relates to dividend payment. In short, we are talking about the payout ratio . While it is not the end all, be all for coverage, it is a strong gauge of safety.

Back in Q3, cash flow from operations was a sizable $10.7 billion. Keep in mind that Verizon pays more each year to the dividend. Dividends paid were about $2.75 billion in Q3. Factoring in Capex and other expenditures, free cash flow was a very strong $6.6 billion. As such, the free cash flow payout ratio was 41.6% in Q3. Incredibly safe. For the year, we are still anticipating a payout ratio of less than 75%. That leaves a lot of room for free cash flow in Q4 to meet this. Free cash flow this year is $14.6 billion through Q3, up $2.2 billion from $12.4 billion in the comparable 2022 period, so year-to-date, we have a 65% payout ratio so far.

Assuming cash from operating activities of $10.1-$10.6 billion, capex and other expenditures of $4.8-5.2 billion, we are targeting free cash flow of $5.3-$5.8 billion. This will easily cover the dividend payments of $2.8 billion, which would be a 50% payout ratio at the mid-point. We view the dividend as safe, and if free cash flow comes in at the higher end of expectations or beyond, we think shares get a boost.

Leverage

First, we continue to believe the debt will never be paid off and Verizon will always operate with leverage. It has to in order to keep investing in growth and modernization as technology advances. However, we do expect leverage to come down. The company entered the fourth quarter with net debt of $122.2 billion, and was down $4.3 billion during Q3. This results in a debt to adjusted EBITDA ratio of 2.6X. For Q4, we know that in October per the Q3 conference call that the company used $3.7 billion of its cash to pay for spectrum clearance costs. Thus, we are not expecting much progress on debt reduction in Q4, but we do think it ticks marginally lower with some principal and interest payments being made. We will watch that metric closely.

Final thoughts

This is still a great income name. We believe you can and should increase your income and gains by trading around a core position and embracing an options approach. Buy and forget is not a strategy to consider. While we have closed a fruitful trade at our investing group, we continue to hold a position on house money. We think there is upside in shares and still rate them a buy for income. Watch cash flows, and of course, the guidance will set the tone. If management guides for free cash flow of $18.5 billion or higher for 2024, we think shares rally. It implies growth from 2023, and suggests an added margin of safety on the dividend.

What do you think?

Do you think the dividend is in jeopardy? Do you think Verizon hits free cash flow of about $18 billion for the year and guides for more for 2024? Will the active promotions lead to better than expected revenue or customer numbers? Let the community know below.

For further details see: