RECOMMENDATION: BUY KRAUSE FUND TELECOMMUNICATIONS FALL 2015 VERIZON COMMUNICATIONS INC. (NYSE: VZ) NOV. 17, Current Share Price: $45.

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1 KRAUSE FUND TELECOMMUNICATIONS FALL 2015 VERIZON COMMUNICATIONS INC. (NYSE: VZ) NOV. 17, 2015 RECOMMENDATION: BUY Analysts Aaron Bolerjack Alex Hardie Overview Verizon Communications (VZ) is a diversified telecommunications company offering both wireless and wireline services to an incessantly growing retail consumer market. This firm sets itself apart from competitors by offering state-of-the-art information streaming technology as well as unmatched customer service, creating a strong customer base that will only continue to expand with time. In doing so, Verizon has managed to obtain a 33% market share by number of wireless subscriptions as of the second quarter of Performance Highlights 52 Week High $ wk Low $38.06 EPS (ttm) $2.49 Dividend Yield 5.11% Current Share Price: $45.22 Target Price Range: $ $65.68 Company Growth Potential Innovative Data Streaming Technology With Verizon s pioneering FiOS fiber optics, wireline data streaming has never been faster. Designed primarily for corporate customers to accommodate a growing demand for unified databases requiring tremendous amounts of information, Verizon is the first to offer such a service that does it all. Improved Customer Base Over the past five years, Verizon has steadily shifted its focus toward upgrading customer relations through a stronger consumer service network, increasing customer retention. As a result, the company has achieved a 33% market share by wireless subscribers and will only continue to grow this number over time. Share Data Beta Volume 6,106,879 Market Cap B P/E Ratio (ttm) Payout Ratio 88.82% Company Highlights Profit Margin 7.86% Operating Margin 16.22% Current Ratio 0.63 Revenue (ttm) $130.56B Operating Cash Flow (ttm) $35.90B Verizon 5yr Historical Stock Prices $55 $50 $45 $40 $35 $30 $25 $

2 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY Economic Analysis There are three economic indicators that will influence Verizon s performance in the coming years. These indicators include gross domestic product (GDP), interest rates, and inflation. Gross Domestic Product Personal consumption in the telecom sector can be tied to GDP growth and decline. If an economy is expanding, the increase in production will require more critical resources such as telecom services/products. Thus, a forecasted growth in the United States economy indicates an increase in sales for telecom companies. U.S. GDP has seen consistent growth in recent years. As seen in the graph below, GDP has shown positive increase in nearly every quarter since 2011 except for Q Growth averages around 2.2% every quarter and peaked at approximately 4.6% in Q Source: Bureau of Economic Analysis 1 We believe U.S. GDP growth rates will be consistent with the World Bank s GDP forecasts. GDP will increase by 2.8%, 3.3%, and 3.2% in 2015, 2016, and 2017 respectively. 2 Beyond 2017, we expect rates to be similar to that of the aforementioned rates; approximately 3.1%. Consistent growth in GDP will drive performance in the telecom industry through the foreseeable future. Since companies are expanding, they will need more resources such as telecom services and products. As a result, telecom companies revenues can expect to increase. Interest Rates Interest rates heavily impact the telecom sector. Companies in this sector are highly capital intensive because large portions of funding are needed to invest in fiber-optic infrastructure and to offer faster data services. When interest rates are high, companies will pay more interest expense on their high levels of debt. As a result, earnings will decrease. 3 U.S. interest rates are currently experiencing a near historic low. Following the 2008 financial crisis, rates dropped to a range less than 0.25% and have remained stagnate. 4 We anticipate the Federal Reserve increasing interest rates by the end of The Fed has been stating their desire to increase rates since the beginning of the year but would like to see higher inflation rates before the raise. 5 Discussed below, we also anticipate inflation rates increasing. As a result, we expect interest rates to see a moderate increase to 1.5% during An interest rate increase will affect telecom companies negatively because of their capital intensive nature. However, we remain optimistic about the sector s future performance because the new interest rate is forecasted to be low. Inflation The telecom sector is adversely affected by higher inflation rates. A high inflation rate is usually associated with increased interest rates which are detrimental to a telecom corporation s earnings. When inflation is forecasted to increase, creditors increase their nominal interest rate to maintain their rate of return. 3 1 P a g e

3 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY The U.S. inflation rate is currently at a record low of 0.0%. The rate has been falling since its 2011 rate of 3.0% as seen in the graph below. Source: US Inflation Calculator 6 In keeping with TradingEconomics.com s estimates, we anticipate inflation increasing to 0.3% in Q and to gradually grow to 2.00% by Q This increase will result in a slight decrease on the telecom sector s earnings, but the decrease will be overshadowed by the anticipated increase in industry revenue discussed later in this report. Capital Markets Analysis Purchasing stock in telecom companies is typically a safe bet due to the sector s defensive nature. Low Volatility A main characteristic making the telecom sector defensive is its low volatility. Telecom corporations have proven to be less risky than the market with an average beta of 0.71 one of the lowest of the economic sectors. A testament to the defensive nature of this sector is the fact that telecom s beta fell back to its historical average after the recession in As a result, telecom companies have proven to be resilient to drastic economic change. High Dividend Yields Telecom companies are known to pay consistent, high dividends. This sector has historically paid a higher dividend yield than every sector except for utilities. These companies are able to provide such high returns to shareholders because of their stable cash flows. Consistent cash flows have been attained by the sector due to phone service becoming a necessity such as water and electricity. 3 As a result, investors can expect a steady return on their investments. INDUSTRY ANALYSIS Industry Analysis Industry Overview The telecommunications sector consists of corporations that develop hardware, create software, and offer services. The hardware consists of infrastructure that makes longdistance communications possible: radio towers, fiber-optic cables, phone lines, etc. These companies also produce software that allows the hardware to send and receive or eliminate background noise on a phone call. Lastly, telecom corporations provide services that enable the user to access the internet and make phone calls through wireless devices. 8 The telecommunications sector consists of three sub-industries: integrated telecommunication services, alternative carriers, and wireless services. Integrated services vastly dominates the others as shown below. 2 P a g e

4 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY towers that allows people to communicate wirelessly through radio signals. Wireless services became more popular after the launch of the 3G wireless network which allows users to access the internet from their portable devices. Source: S&P Capital IQ 9 The industry has a handful of participants, two of which control the majority of industry revenue: Verizon and AT&T. Their share is displayed in the graph below. Source: S&P Capital IQ 9 Business Segments The telecom industry operates through two main business segments: wireless and wireline. Wireless The wireless segment gains revenue by selling subscriptions for data plans and voice services accessed through devices such as smartphones. This segment provides services through a cellular network the infrastructure consisting of radio Wireline The wireline segment offers fixed-line infrastructure and data services to consumers that need more reliable communication and internet connectivity resources. Therefore, the primary consumers of this segment are businesses. Telecom corporations provide networking solutions and advanced video and voice communications through dedicated lines in this segment. 10 Industry Trends Cable Company Competition In an effort to counter voice service declines, telecom corporations are focusing on expanding wireline broadband. Due to pressure from regulators and competition with local cable companies, the total number of landlines to households has declined across the nation. To combat the efforts of local providers, the largest telecom carriers invested in upgrading speeds and offered discounted service bundles. As a result, telecom companies were able to secure 1.2 million new subscribers in Q We anticipate this trend to continue as cable providers still hold a major portion of broadband subscribers. 9 Fiber-Optic Cable The telecom industry is seeing a shift to providing more fiber-optic connections. Fiber optic cables offer faster speeds, more video and voice capabilities, and greater bandwidth than the traditional copper wires that connect to households. These characteristics put fiber optic cables in high demand as the need for faster connections becomes more prominent in today s fast paced society. Verizon has taken one of the first successful forays into offering fiber optic 3 P a g e

5 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY connections with their fiber-optic service (FiOS) package. They have seen rapid growth of this business line as subscribers increased from 6.2 million subscribers in 2014 to 6.7 in We foresee telecom competitors mimicking Verizon s efforts to offer the fastest speeds via fiber optic connections since Verizon has proven it to be a successful revenue stream. Competition Overview and Competitive Landscape The diversified telecommunications industry, heavily dominated by Verizon and AT&T, is known for its difficult barrier to entry due to abnormally high startup and fixed costs. As a result, these two companies make up over 90% of the entire industry and approximately 88% of the telecommunications sector. 11 The remaining companies in this sector include those such as Sprint, T-Mobile, and US Cellular, all trailing far behind the two major telecom players. With the majority of revenue generated in the telecom industry derived from mobile data plans, economies of scale play a large role in the difficulty level of entering the market as a new firm. Providing quality data networks requires a notably high amount of invested capital, and so many young firms desperate to earn a cut of the telecom market face many difficulties generating a consistent cash inflow. Threat of Existing Rivals and New Entrants Due to the high competitive level between Verizon and AT&T, it is essential to analyze various metrics which may yield a competitive advantage for one of the two companies. With the enterprise value, P/E ratio, P/S ratio, and cost of capital being nearly identical for the two companies, more intricate measures such as free cash flow and value creation through M&A activity are often helpful in defining a clear competitive advantage. In the relevant past, Verizon has paid a considerably lower dividend yield as a percentage of earnings, indicative of a strong reinvestment plan and the firm s willingness to dedicate current earnings to future capital expansion. Not only does Verizon have a higher reinvestment rate for earnings, but it has also generated stronger income per share in the past five years than AT&T, suggesting an even greater amount of earnings being reinvested and furthering its competitive advantage. Company AT&T Verizon T- Mobile Sprint Ticker T VZ TMUS Sprint Mkt Cap Price Sales NI EPS D/E P/E N/A Source: Statistics provided by Yahoo Finance 12 In accordance with the above metrics, it is clear that Verizon and AT&T have a strong advantage in terms of both market cap and net sales over their smaller rivals. This advantage is quantified when considering the two companies net income in comparison with the rest of the firms, indicating the economies of scale factor so relevant in the telecom industry. Catalysts for Growth and Change Shift to Installment Plans The telecom industry has seen a shift from the traditional subsidy plans to more flexible installment plans. The subsidy plan is where consumers enter into a contract with a telecom carrier, typically for two years, and pay an upfront cost as well as a monthly fee to use their phone. Under the installment plan, the carrier will cover the upfront cost of the phone and the customer will pay for their device in equal monthly payments contract-free. Consumers are frequently opting out of the subsidy plan for the installment plan. The latter plan makes it easier for clients to upgrade phones as they are not locked into a contract. As a result, consumers can use the newest and best smartphones as they are released, thus increasing demand for smartphones. 11 Since consumers can immediately 4 P a g e

6 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY change phones with the installment plan, it is likely that providers will strive to offer the greatest variety in brands. The carrier that can achieve a greater assortment of phone models will likely see a growth in revenue as consumers will flock to their wide selection. Wireless over Wireline The telecom industry will likely experience a complete diminishment of residential landline revenue as younger generations buy their own households. The wireless business segment has been seeing tremendous growth since 2008 as the capabilities of cell phones far surpass those of landline phones. Wireless phone plans usually contain unlimited minutes for local and longdistance calling as well as considerable data allotments for internet access all available from a device that can fit into a pocket. Younger generations that have grown up with a cell phone often do not see the need for a landline phone because their cell phone can do everything a home phone can do and more. As new generations acquire their own homes and apartments, it is probable they will opt out of paying for a landline phone. 9 We contend that residential landline revenue will almost completely be reduced in the next 20 years. Key Investments Positives or Negatives High Dividends The nature of the telecom industry allows it to offer an above average dividend yield. Since the products in this industry are now viewed less as luxuries and more as necessities, the telecom market is less susceptible to volatility in the overall market. As a result, investors can expect attractive returns. New Wireless Devices In recent years, there has been an increase in the variety of devices that can use a telecom carrier s wireless data services. Apple s first device to use data plans was their iphone, and they have since released more products capable of connecting to the internet via wireless data such as the ipad and MacBook. Since devices capable of internet connectivity are more readily available, it is likely that more consumers will purchase data plans. As a result, wireless sales for telecom carriers can be expected to increase. Interest Rates The Fed has been stating their desire to raise interest rates since the beginning of Telecom carriers are highly leveraged companies, and an increase in interest rates will increase expenses. As a result, net income would decrease therefore negatively impacting earnings. Potential Investment Opportunities Although there are many telecommunication companies that have sizable market shares within the U.S., two stand out in particular. These two mobile giants are Verizon and AT&T, and their combined market share comes out to just under 75% of the U.S. subscriber population. Aside from dominating the U.S. market by size of subscriber population, these two competitors also share many similar metrics such as market share, dividend yield, operating cash flow, enterprise value (EV), and capital expenditures. Per the table on the previous page, both companies have market caps of approximately $200 billion and sales revenue nearing $130 billion. Dividend yields for these competitors have floated around five percent in recent years, making them excellent sources of fixed income as well as valuable investments for stock price appreciation due to the fact that sales revenue for mobile companies will continue to rise over the years with expanding subscriber growth. COMPANY ANALYSIS Company Analysis Verizon is one of the top telecommunications providers in the United States. They have grown 5 P a g e

7 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY to be a major part of the sector by being an innovative company that leads in developing new communications technologies. Based upon multiple financial indicators such as the low P/E ratio, growing EBITDA and relatively high dividend yield in comparison to other carriers, we are issuing a buy recommendation for Verizon Wireless. Over the trailing four years, the Company has averaged an EBITDA of over 4%, presenting its strength in growing relevant earnings ( bare profits from continuing operations). Purchasing equity in Verizon has also deemed itself a stable investment for the long term, given its dividend yield of 5.07% and a price/earnings ratio that is nearly 42% lower than its largest competitor, AT&T. 12 Business Description Verizon Communications Inc. acts as a holding company, and through its acquired businesses offers its clients communications, information services, and entertainment products. The Company has two product segments for which it provides these services: wireless and wireline. Wireless communications products consist of cellular voice calling and internet data accessible from a mobile device. Through the wireline segment, Verizon provides broadband video and data, data centers, cloud services, and security as well as corporate networking solutions via local and long distance servers. 13 Corporate Strategy Verizon s strategy is to further develop their company by offering their services at the fastest speeds and by increasing capital investments/infrastructure. The Company is highly competitive for the fastest data speeds as they are tied with T-Mobile for the U.S. LTE speed crown. Reportedly, Verizon and T-Mobile offer speeds of close to 20 mps while their nearest competitor AT&T sits at speeds of 8 mps. 14 Verizon plans to continue the growth of their staple product segments, wireless and wireline. With steady investments in the Company s infrastructure, Verizon intends to acquire more wireless spectrum (the frequencies wireless data is offered through), activate those spectrums, and improve the fiber optic network that serves as the foundation of the wireless and wireline segments. By offering the fastest speeds and the broadest coverage, Verizon will continue to be one of the top telecommunications companies. 15 Products and Markets Verizon offers two product segments: wireless and wireline. Wireless The wireless segment is mostly composed of Cellco Partnership, who was formed in 2000, providing wireless services as Verizon Wireless. These services are offered through Verizon s extensive 4G LTE network which is accessible to 98% of the U.S. population covering 500+ markets and nearly 309 million people. The Wireline segment provides its primary consumers, carriers, businesses, and governments with a variety of video and data communication services and corporate networking solutions. 15 Wireless services are offered on a postpaid and prepaid basis. Much of Verizon s retail customers are subscribed to a retail postpaid account which includes monthly wireless services for a mix of connected devices. The client is billed a set monthly charge for a predetermined amount of data and usage, and for any data usage overage, the client is billed extra at the end of the month. As of December 31, 2014, 94% of its retail clients had service plans on a postpaid basis. The prepaid service plan grants consumers the ability to use wireless services without signing into a long-term contract by paying for all services in advance. 15 Wireline Wireline services includes providing direct highspeed internet through its data services. Verizon s FiOS broadband gives access to the 6 P a g e

8 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY Internet at high speeds, close to 50 mps. As consumers connect more devices and stream more video, higher broadband speeds will be in demand. To help with that demand, Verizon offered its FiOS quantum Gateway Wi-Fi router, which allows the user a smoother experience when using the Web in conjunction with multiple devices. 15 As consumers continue to vie for the convenience of a wireless connection, they will turn away from their wireline connections and opt for wireless services. As a result, wireline revenues will decrease while wireless revenues will grow. Analysis of Recent Earnings Verizon has continued to pay steady and growing dividends to its investors since The company saw a decrease in total assets of $41.4 billion from 2013 to This dip provided an inflow of cash and allowed Verizon to pay $8.49 billion in dividends in June 2015, the highest amount in recent memory for Verizon. 16 Production & Distribution Going forward through 2015 and into 2016, Verizon Wireless expects to face increased manufacturing costs primarily due to capital expansions and rising global smartphone usage. With competing carriers focusing so heavily on broadband growth and faster data retrieval speeds, it is essential for Verizon to keep up by investing a great portion of earnings and existing capital to this area. Hot assets in the telecommunications industry such as high-speed fiber optics and cloud services are becoming the standard among companies, and in turn are rampantly increasing manufacturing costs just to remain competitive. Another cost source that has become a growing struggle to contain is the rising price of smartphones and the perplexity it creates of whether to carry this cost over to the customer or to absorb it. On the distribution side, Verizon has taken a stance on attracting postpaid retail customers to increase revenue and the amount of long-term contract holders in its network. This is being accomplished by offering customer agreements focused on low-cost, extensive wireless coverage that provide for reliable communication and data retrieval. However, placing a focus on this new method of sales brings lower margin data plans and higher customer service costs and therefore poses a challenge to remain profitable. Competition Although the U.S. wireless telecommunications industry is highly dominated by two major carriers, AT&T and Verizon, competition between these two firms has grown significantly over the past decade. It has not only turned into an arms race of which company has the highest amount of capital assets such as towers and retail stores, but also a race in acquiring smaller, more specialized telecommunications firms. Offering data plans that give customers the most coverage for the lowest cost has also become a major focus for these competitors, as switching between company plans has become more simplified for customers over recent years. Verizon has primarily dominated the U.S. market for highest network coverage and has clearly drawn attention from many corporate customers as a result since the plans the Company offers are typically in the higher price range when put up against its competitor. Source: Elloitback.com 19 In the acquisition territory, Verizon has certainly held its own in making an effort to expand both its product diversity and size in recent years. Just 7 P a g e

9 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY this past June, it closed an acquisition of AOL, a telecommunications company specializing in media technology and therefore providing an edge over more distant competitors such as Google and Microsoft. By purchasing AOL and its media streaming proficiency, the Company was able to gain a competitive advantage in a decade where streaming live media is a musthave for technology consumers. Verizon has also taken to new acquisition strategies that do not focus so much on media and data technology, but on companies that gain most of their revenue from individualized advertising, or advertising that is customized to fit each customer s search history and purchasing habits. Earlier this month, subsidiary AOL completed an acquisition of technology company Millennial Media Inc. that focuses primarily on mobile advertising (mostly through online media streaming) and has provided a tool for Verizon to expand and diversify its revenue streams. 20 On the financial spectrum, rival AT&T has bested Verizon in size by amounting to a market cap of over $200 billion, but in a market where efficiency over sheer size has become a new stronghold for technology companies this number has become less significant. Over the past twelve trailing months, Verizon has earned nearly $2.40/share (5.46%) in comparison to AT&T s $1.01/share (3.15%), a figure that shows the profitability each company is able to generate with a given amount of invested capital. Another figure demonstrating Verizon s strong earnings growth in recent years is its EBITDA figure of $36.74 billion over the past twelve months, topping AT&T s $30.38 billion and further proving its ability to generate a large amount of income given its level of capital through invested equity. At an operating margin of 15.92%, Verizon secures over 50% more of its income through operating activities by efficiently providing services and managing costs of service. Other Topics of Interest With increased government regulation over data streaming these past few years and a focus on net neutrality, Verizon has faced a number of challenges in providing quality data to consumers while being limited by new regulations. Perhaps the most controversial governmental topic in recent years is net neutrality, and it has certainly put a spin on the way Verizon is sealing deals with business partners who request faster data speeds for their websites at an expensive price. While the Company would like to provide such services for their major corporate customers, it is being held back by the U.S. government and so far has been disallowed to proceed with these agreements. This has caused such a stir within the company that it had pressed legal charges to sue the F.C.C. for abrasive net neutrality laws that seem to be outdated and anti-innovative for internet providers. Verizon ended up winning the case in a U.S. appellate court this past March, ultimately setting an agenda against government regulation over data streaming and corporate contracts. Catalysts for Growth and Change Verizon has long been a leader in network innovation and technology. The Company looks to uphold this reputation with its progress in developing the nation s first 5G network. On September 23, 2015 Verizon announced it is partnering with Intel to hasten the nextgeneration wireless technology. 17 Consumers today want the fastest download speeds available and will migrate to whichever company can offer instant internet access. Once Verizon develops and launches its 5G network, they will see a boost in revenue as competitor s clients make the change to the fastest provider. The Company is entering a niche of the interactive entertainment market by investing in content delivery networks (CDNs) to offer enhanced streaming services. Through the use of Multimedia Broadcast Multicast Service technology, Verizon will be able to offer live 8 P a g e

10 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY video streaming with nearly no buffering, independent of how many devices are connected to the data account. To compete with the increasing number of online streaming services, Verizon also intends to launch its own Internet Protocol television service. These services are expected to launch in Being able to offer streaming videos that have practically no load time is very attractive to clients as they crave instant access to favorite shows and clips. However, launching an internet television service may not be beneficial to Verizon, as the streaming services market is dominated by the wellestablished services of Netflix, Hulu, and Amazon Video. Verizon has entered the connected car market with the Verizon Hum. This device allows users to equip their car with OnStar-like capabilities. The device has two pieces of hardware that are easily installed and requires a monthly subscription fee. 16 We believe this is part of the Company s initial steps into providing an Internet data service to vehicles. The demand for Internet connectivity in personal vehicles is likely to increase as consumers strive to have internet access at all times, even on the road. By offering their internet services to vehicles, Verizon can anticipate growth in wireless service revenues. With this venture into providing Verizon s services to cars, it is likely for Verizon to expand more of its wireless Internet services to vehicles. Key Investment Positives and Negatives Investment Positives Investments in which Verizon has historically excelled include their ability to create customer awareness and retention as well as growing their broadband network to surpass competitors such as AT&T and T-Mobile. Examples of the Company s competitive advantage when looking at the wireless network it provides is its unique FiOS system, which allows for high-speed data retrieval on the retail consumer level. i This connects back to its focus on investing in infrastructure that adds value to Verizon when comparing it to other companies in the telecommunications industry. The Company achieves its high customer retention rate primarily through allocating a great amount of its revenue to staffing and customer service, allowing its customers a highly accessible, helpful outlet for solving and assisting common inquiries and problems. With such a strong focus in the telecommunications industry on growing data networks and to satisfy a larger amount of customers each year, Verizon has positioned itself to excel being that it has invested much of its capital in infrastructure and customer awareness. It has also pursued many acquisitions in the past twelve months to both increase the size of the Company and to explore new potential areas of growth in the media streaming and advertising line. An example of one of these strategic acquisitions are mentioned above in the Competition section in which Verizon acquired AOL for its media streaming capabilities and thereafter Millennial Media Inc. Investment Negatives Although Verizon has historically offered excellent data coverage and higher speeds when compared to rivals, it also demands a higher price for comprehensive plans. While securing a large portion of the market due to its excellent service, customers have consistently relied upon better data packages and more innovative product lines as a result. This forces Verizon to invest large amounts of capital in its infrastructure and R&D, or customers will likely switch to a lower priced carrier. There are also certain locations in the world where it has not typically placed a large focus in, many of which are outside the Americas. Though this may be due to its higher priced plans, it still must present an effort to enter these foreign markets if it hopes to expand in a way that competes with other carriers. Staff turnover has also presented a threat in Verizon s history, being that so many of its 9 P a g e

11 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY employees are either unhappy in their careers or that there are not enough opportunities to excel, creating a paradox for its staffers and managers. Employee satisfaction is a necessary factor in creating a strong services company, and so Verizon must invest additional capital in creating opportunities for these members to add value to their customers. F.C.C. regulation poses another challenge to Company executives with net neutrality becoming such a major topic and the business relationships it inhibits with corporate customers. VALUATION ANALYSIS Valuation Analysis We have decided to issue Verizon Communications a buy rating based primarily on the outcomes of our numerous valuation models and our positive outlook on the telecommunications industry as a whole. With an increasing necessity in both the personal and corporate universe for extensive data plans and faster, more powerful information streaming, the demand for services offered by Verizon in particular has grown substantially and will most likely continue to grow in the coming years. In accordance with our derived valuation from the DCF and EP model and the sensitivity analysis, our target price for Verizon Communications falls between $57.61 and $ Revenue Decomposition To accurately forecast revenue for Verizon through its carrying value in 2019, we split revenue into two major segments: wireless and wireline revenue. We found the total number of subscribers to be the primary driver of wireless revenue, since this number is derived from the average revenue per user (ARPU) multiplied by the number of customers with contracts. Due to an increasing demand for extensive data coverage plans and a wider variety of smartphone purchasing plans, we have sufficient evidence to believe that the average revenue each contract generates will continue to increase through Verizon s terminal value. Another factor driving revenue over our forecasted time period is a growing number of users, driven largely by a decline in the age at which the average user begins using a smartphone in recent years. This trend not only indicates a growing number of customers, but that the need for extensive data coverage plans due to the fact that younger users are likely to use social media and surf the web more often than adult customers. 21 Wireline revenue, on the other hand, is expected to largely shift from household contracts to corporate contracts to accommodate an increasingly lower number of U.S. households having landline phone plans. In turn, Verizon has instead shifted its focus on corporate customers seeking wideranging databases that incorporate enormous flows of information on a daily basis. The firm has even created a new service called FiOS, an innovative and exceptionally fast data streaming service utilizing fiber optic cables to delivery information faster than previously thought possible. The combination of both optimistic wireless and wireline revenue forecasts has lead us to determine the carrying value for revenue growth to be 4.5%, a rather high estimate given the very competitive nature of the telecommunications industry. 22 Dividend Discount Model Assuming moderate growth in declared dividends through 2019 based on trends over the past five years and backed by increasing earnings per share, our model has calculated an intrinsic value of $58.09 per share. This assumes no repurchase plans taking place over the next five years, as implied in the footnotes of Verizon s latest 10-K. EPS is expected to grow at the carrying value of 2.50% after reaching a steady state in 2019, at which point the company will generate earnings stable enough to support a long-term dividend plan. The discount rate used in this model is the cost of equity, which is explained in the WACC calculation below, and is used to derive the present value of future dividends based on Verizon s current capital structure. 10 P a g e

12 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY WACC Cost of Equity To compute the cost of equity, we used the Capital Asset Pricing Model. We set our risk-free rate equal to the 30-year Treasury bond yield because of the low chance the Treasury would default. In order to find the market risk premium, we trusted the rate that finance professor Aswath Damodaran has calculated of 5.35%. The beta value was the beta reported for Verizon on Yahoo! Finance. It was held constant due to telecom corporations historic low volatility. Cost of Debt In calculating the cost of debt, we found Verizon s debt rating to be BBB as reported by StreetInsider.com. 3 This rating coincides with a default spread of 1.75% which was then added to the risk free rate established for the cost of equity computation. The marginal tax rate for Verizon of 38% was then applied to the sum resulting in the after-tax cost of debt. Weight of Equity The market value of equity was set equal to the market cap reported on Yahoo! Finance. This value represents the stock price of Verizon on that respective day multiplied by the total shares outstanding. Weight of Debt The market value of debt was calculated by adding the line item short term debt and current portion of long term debt to long-term debt. Return on Invested Capital Due to the nature of the telecom sector, it is common for companies such as Verizon to have high amounts of invested capital as we have forecasted. Even though Verizon s invested capital is high, our ROIC estimates gradually increase due to the increase in revenue which drives the NOPLAT estimates up. Thus, Verizon is expected to have a higher ROIC than WACC which signifies an increase in value in the forecasted years. DCF and EP Models In determining Verizon s intrinsic value, we used our calculated drivers to perform a discounted cash flow analysis. Free cash flows were found by subtracting the change in invested capital from our NOPLAT forecast. The cash flows were then discounted to the present value using our estimations for WACC. The CV of cash flows for the last year of the forecast was also found and discounted to its present value. These values were added and then adjusted for a partial year to today s date. Our intrinsic value was calculated to equal $61.64; a 33% increase over today s share price. SENSITIVITY ANALYSIS Sensitivity Analysis Overview The purpose of a sensitivity analysis is to observe the impact of fluctuating variables on the intrinsic value of an equity security. These variables include, but are not limited to, the WACC, tax rate, risk-free rate, earnings growth, and many more which play a role in determining the value of a firm s operating assets and ultimately its intrinsic value. By conforming these data tables to the model, it is possible to adjust such variables and view the outcome without actually tampering with the original model. ROIC CV vs. WACC CV The ROIC, or return on invested capital, is a multiple commonly used in valuation models to determine a company s profitability based on existing capital. This in turn shows how well a company will be able to generate cash flows in the future according to its current and forecasted investment rates. The WACC, on the other hand, is a measure of how much each additional dollar of capital costs based on a company s capital structure. In order for a company to not only be profitable but generate growth, the ROIC must surpass the WACC benchmark so that it is creating 11 P a g e

13 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY more value with each dollar than it costs to obtain that dollar of additional capital. Verizon carries an especially high amount of debt to finance its capital expenditures. Growth CV vs. Cost of Equity The carrying value of growth is a measure portraying how much a company is estimated to grow once it reaches a steady state. This largely impacts a company s operating assets at its terminal value since long-term growth determines how valuable a company will be after its years of volatility. In terms of cost of equity, Verizon proved to be rather similar to the market given its beta of.62, signifying that it does not stray far from the market premium. Given a relatively stable cost of equity, the growth variable turned out to have much larger of an impact on the overall price of the security. Effective Tax Rate vs. SG&A Upon conducting the sensitivity analysis comparing the effective tax rate (ETR) with the SG&A expense rate (based on sales), the tax rate proved to provide much more of an impact on the intrinsic equity value of Verizon. This outcome is due to the fact that the effective tax rate not only influences net income but generates a tax shield on the cost of debt, effecting interest expense and the deduction it allows for actual taxes paid as well as the debt portion of the WACC. In fact, with each three-percent increase in the ETR, the intrinsic value of each of Verizon s share is expected to decrease by approximately four dollars. Beta vs. Risk-Free Rate With both the beta and the risk-free rate having an effect on the overall cost of equity as derived through the CAPM, the sensitivity analysis proved each to have a similar impact on intrinsic share value. Although each variable carried a similar weight on the value per share, the overall bearing of these measures is not quite as significant as one would think due to the highly leveraged nature of the telecommunications industry. The effective tax rate and cost of debt proved to influence the average cost of capital considerably more since 12 P a g e

14 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY Sources 1. Bureau of Economic Analysis. (2015, October 29). Gross Domestic Product (GDP). Retrieved from nal/gdp/gdp_glance.htm 2. The World Bank. (n.d.). Global Economic Prospects. Retrieved from The World Bank: n/global-economic-prospects/summarytable 3. Sinton, D., & Teufel, A. S. (2011). Fisher Investments on Telecom. Hoboken, New Jersey: Wiley. 4. Board of Governors of the Federal Reserve System. (2008, December 16). Press Release. Retrieved from Board of Governors of the Federal Reserve System: nts/press/monetary/ b.htm 5. Amadeo, K. (n.d.). FOMC Meetings: Summary and Schedule. Retrieved from About News: mentagencies/fl/fomc-meetings.htm 6. US Inflation Calculator. (n.d.). US Inflation Calculator. Retrieved from Current US Inflation Rates: : flation/current-inflation-rates/ 7. Trading Economics. (2015, November 16). United States Inflation Rate Forecast. Retrieved from Trading Economics: ted-states/inflation-cpi/forecast 8. The Editors. (2012, December 3). Industry Overview: Teleocmmunications. Retrieved from Wet Feet: stry-overview-telecommunications 9. Zino, A. (2015, July). Telecommunications. Retrieved from S&P 500 Capital IQ: dpoors.com/nasapp/netadvantage/sh owpublication.do?dataposition=0&spid = Sheffer, R. (2015, January 16). An overview of the US telecom industry. Retrieved from Market Realist: view-us-telecom-industry/ 11. Sikka, P. (2014, September 12). Some of the must-know trend shifts in the telecom industry. Retrieved from Market Realist: t-know-trend-shifts-happeningtelecom-industry/ 12. (2015, October 15). Retrieved from Yahoo! Finance 13. Verizon Communications Inc. (VZN) Company Profile Reuters.com.Reuters. Thomson Reuters, n.d. Web. 23 Sept Goldstein, Phil Verizon Ties T-Mobile for U.S. LTE Speed Crown, OpenSignal Finds, but Overall U.S. Lags Rest of the World. N.p., 23 Sept Web. 23 Sept Verizon Communications 10K Annual Report FactSet accessed 9/22/ Bloomberg; NR Newswire; Intel joins Verizon s 5G Technology Forum to accelerate development of 5G, nextgeneration wireless technology 13 P a g e

15 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY 18. Ziegler, Chris. Verizon s Hum Will Turn Your Beater into Connected Car. The Verge. N.p., 26 Aug Web. 23 Sept Chart uploaded from elliottback.com 20. Verizon's AOL to Buy Millennial Media for About $250 Million by Bloomberg Business 21. Verizon Follows Google With New Company Logo Ending Big Red Bloomberg Business ons/2014/11/25/verizon-launches-newfios-package-targeting-cord-cutters/ 23. "S&P Lowers Outlook on Verizon Communications (VZ) to Stable Following Wireline, Tower Sales."StreetInsider.com. N.p., 6 Feb Web. 17 Nov P a g e

16 VERIZON COMMUNICATIONS INC. (NYSE:VZ) BUY Important Disclaimer This report was created by students enrolled in the Applied Equity Valuation (FIN:4250) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report. 15 P a g e

17 Verizon Communications Inc. Revenue Decomposition All figures in billions of U.S. Dollar, except per share items Year/Year growth Fiscal Years Ending Dec E 2016E 2017E 2018E 2019CV Wireless Revenues Wireless Revenue Wireless Service Revenue Wireless Equipment Revenue Subscribers Total Wireless Subscribers (RGU) Wireless Subscribers-Postpaid Wireless Subscribers-Prepaid Average Wireless Subscribers Monthly Average Revenue per User Wireless Average Revenue Per Unit (ARPU Wireline Revenues Wireline Revenue Wireline Residential Revenue Wireline Business Revenue Strategic Services Revenue Subscribers Total Wireline Subscribers (RGU) Residential Access Lines Broadband Internet Subscribers Wireline ARPU Monthly Other Income Income

18 Verizon Communications Inc. Income Statement All figures in billions of U.S. Dollar, except per share items Year/Year growth Fiscal Years Ending Dec E 2016E 2017E 2018E 2019CV Sales COGS excluding D&A Depreciation Amortization of Intangibles Gross Income SG&A Expense EBIT (Operating Income) Nonoperating Income - Net Interest Expense Unusual Expense - Net Pretax Income Income Taxes Income Tax Credits Consolidated Net Income Minority Interest Net Income EPS (diluted) Total Shares Outstanding Dividends per Share Payout Ratio EBITDA EBIT Depreciation & Amortization Expense

19 Verizon Communications Inc. Balance Sheet All figures in billions of U.S. Dollar, except per share items Year/Year growth Fiscal Years Ending Dec E 2016E 2017E 2018E 2019CV Assets Cash Only Total Short Term Investments Short-Term Receivables Inventories Other Current Assets Total Current Assets Property, Plant & Equipment - Gross Accumulated Depreciation Net Property, Plant & Equipment Total Investments and Advances Long-Term Note Receivable Intangible Assets Net Goodwill Net Other Intangibles Other Assets Total Assets Liabilities & Shareholders' Equity ST Debt & Curr. Portion LT Debt Accounts Payable Dividends Payable Accrued Payroll Miscellaneous Current Liabilities Total Current Liabilities Long-Term Debt Provision for Risks & Charges Deferred Tax Liabilities Other Liabilities Total Liabilities Common Stock Par/Carry Value Additional Paid-In Capital/Capital Surplus Retained Earnings ESOP Debt Guarantee Cumulative Translation Adjustment/Unrealized For. Exch. Gain Unrealized Gain/Loss Marketable Securities Other Appropriated Reserves Treasury Stock Total Shareholders' Equity Accumulated Minority Interest Total Equity Total Liabilities & Shareholders' Equity