Verizon Stock’s Capital Allocation And Why I Am Allured (NYSE:VZ) (2024)

Thesis

Our bull thesis for Verizon (NYSE:VZ) is built on two simple arguments: the secular growth of our data needs and its heavily discounted valuation. We’ve focused more on the valuation aspects before, and this article will explore the first in more depth. Probably, the following comments from its CEO Hans Vestberg in its 2022 Q1 earnings best encapsulate such long-term growth potential (the emphases were added by me):

As you’ve heard me say many, many times, mobility, broadband and cloud are the essential pieces of the 21st century’s infrastructure. We’re already taking advantage of this infrastructure and capitalizing on an addressable market that is growing as consumers and businesses adopt 5G. We saw this growth in our wireless sales, our customer loyalty and the rapid expansion of our fixed wireless business in this quarter.

The CEO's above comments are indeed corroborated by other independent sources. Take 5G as an example. The following report from Grand View Research projects the global 5G infrastructure market to expand at a CAGR of more than 34% in the next 10 years. As a leading player, VZ is well-positioned to ride on this trend.

However, telecommunication is a capital-intensive business. Therefore, the focus of this article is to examine closely whether VZ has the resources to keep up with the infrastructure needs and capitalize on this secular trend. And you will see, my answer is a definitive yes.

Strong financial strength in a decade

Its Q1 2022 shows that the company's finances are in terrific shape. VZ’s balance sheet at the end of the quarter showed $1.66 billion of cash on hand and about $140 billion in long-term debt (down from $149.7 billion). As its CFO Matt Ellis commented (abridged and emphases added by me)

In addition, we completed a number of other transactions during the quarter the proceeds of which were used as consideration in an over $5 billion tender offer to retire some higher cost, long-term debt. We ended the quarter with a net unsecured debt to adjusted EBITDA ratio of approximately 2.8 times flat on a sequential basis as expected.

Its financial strength is currently near a peak level in a decade as you can see from the following interest coverage ratio. Its interest coverage ratio has fluctuated from about a low of 4.1x to as high as 12.3x in the past decade. It has been in steady improvement since 2019 from about 5x to the current value of 10.1x. So, currently, it is at its peak financial strength, only requiring less than 10% of its earnings to service its debt. I wouldn't be shocked if the firm continue increasing its dividend distribution and made further acquisitions in the future. Indeed, management has stated their commitment to augment the company's strategic capabilities as well as its wireless-spectrum asset, as detailed next.

Capital allocation flexibility

For capital expenditures in 2022, management’s guidance is between $16.5 billion to $17.5 billion. The majority of the money is earmarked to sustain traffic growth on its 4G LTE network and boost the reach and capacity of its 5G Ultra-Wideband network. In particular, additional costs associated with the company's C-Band 5G network deployment are projected to be in the $5 billion to $6 billion range. And as CFO Matt Ellis commented (abridged and emphases added by me):

Capital spending for the first quarter, totaled $5.8 billion, an increase of $1.3 billion compared to last year, driven by C-Band spending of $1.5 billion. The continued build out of OneFiber and our investment to support growth of traffic on our 4G LTE network while expanding the reach and capacity of our 5G Ultra Wideband network great extends our opportunity to effectively compete in all of our businesses. The net result of cash flow from operations and capital spending is free cash flow for the quarter of $1.0 billion.

Looking forward, VZ certainly generates enough organic cash from operations to cover these expenditures as shown by the next chart. The firm generated about $1B of free cash flow in Q1 after all the capital expenditures. And it just reaffirmed its full-year guidance. Adjusted EBITDA earnings are expected to grow by about 2% to 3%, and adjusted EPS is expected to be in the range of $5.4 to $5.55, representing a growth of about 0% to about 3% from last year. My estimate for the overall net profit is about $8B and free cash flow about $9B.

Valuation and projected returns

A brief look at valuations. As the following data show, VZ is undervalued both compared to the overall market and its own historical records. The discount is about 25% in terms of PE multiple from its historical averages. Its present FW PE is only about 9.4x and the historical average is around 12.5x. In terms of dividends, it currently yields about 5.04%, about 15% undervalued compared to its historical average yield of 4.4%.

With the compressed valuation, a healthy projected return can be expected even assuming conservative growth rates. Its return on capital employed (“ROCE”) is about 31%. A 10% reinvestment rate can lead to 3.1% real growth organically (and as aforementioned, it is reinvesting more than 10%). Adding an inflation factor of say 3% can easily lead to a growth rate of about 6% to 7%.

But even under a conservative growth rate of 4% as shown below, for the next 3-5 years, the total return is projected to be in a range of 34% (the low-end projection) to about 55% (the high-end projection), translating into an annual return of 7.6%to 11.7%. A highly asymmetric opportunity in my view especially when adjusted for its A+ financial strength and A earning consistency.

Final thoughts and risks

Our bull thesis for VZ is built on two simple arguments: the secular growth of data needs and its compressed valuation. Its financial strength is near a peak in a decade. Interest coverage is currently 10.1x, the second-highest level in a decade. Looking forward, VZ generates enough organic cash to cover the CAPEX requirement to keep augmenting its leading network. CAPEX is projected to be between $16.5 billion and $17.5 billion in the next year. The majority of it will strategically support its 4G LTE network and 5G Ultra-Wideband network.

Despite the strong financial position and growth potential, the stock is at a discount of ~25% in terms of PE multiple and ~15% in terms of dividends. The combination of business fundamentals and valuation compression creates a highly asymmetric opportunity with favorably odds for double-digit annual return but little downside.

A few final words about the risks. The risks I see currently are primarily macroeconomic risks. There is a reasonable chance of a recession in the near future. Many leading companies, ranging from high-techs like Tesla (TSLA) to staples like Walmart (WMT), have all reported inflationary pressure and announced hiring freezes (or even layoffs) recently. VZ relies on debt financing to a substantial degree and its interest rates could rise if borrowing rates keep climbing. With about $140B in total debt, a 1% increase in borrowing rates would translate into about $1.4B of additional interest expenses, about 4% of its operating cash.