It should come as no surprise that investors looking for safety and income have turned to dividend paying stocks recently. A perennial favorite among dividend investors is the telecom sector. One of the leaders in this sector is Verizon Communications (NYSE: VZ). With its present yield roughly double that of a 10-year Treasury Bond, can investors trust this company to deliver on its dividend in the future?
The Story Behind the Numbers
The first issue that needs to be resolved to determine if Verizon’s dividend is sustainable is, can the company compete effectively against its peers? If we are looking for sustainability, it doesn’t make much sense to buy stock in a company that can’t keep up with its competition.
Verizon faces multiple competitors, but two of the most obvious threats are AT&T (NYSE: T) and Sprint (NYSE: S). On the one hand, AT&T carries a yield that is higher than Verizon. On the other hand, Sprint may offer investors capital gains, if the company’s underdog story succeeds.
In the wireless industry, carriers convinced themselves that equipment subsidies were holding back their growth. However, what they apparently didn’t anticipate is that service plan pricing would need to decline to move customers away from subsidies.
The end result is, carriers are reporting declining service revenue, and attempting to make up for this shortfall with increased equipment revenue. That being said, there is a clear separation between these three carriers when it comes to their wireless revenue growth.
Unfortunately for Sprint investors, the company’s aggressive price war with Verizon and AT&T is taking a toll. In Sprint’s recent quarter, the company’s service revenue declined by just over 10% year-over-year.
By comparison, AT&T’s service revenue declined by less than 1% last quarter, whereas Verizon’s decline came in at just over 2% annually. While AT&T showed better service revenue results, Verizon took the crown in both total wireless revenue growth, and equipment revenue growth.
The company’s overall wireless revenue growth of 5%, was better than AT&T’s 2% annual improvement. On the equipment side of things, Verizon crushed the competition reporting a 63% year-over-year jump, compared to AT&T’s 15% increase, or Sprint at 10%. Based on these results, it seems clear that the company is able to compete effectively in this new wireless era.
An Interest-ing Number
The second question facing Verizon investors is, does the company’s debt present too much of a burden to carry its dividend as well? It’s no secret that Verizon had to take on significant debt, to purchase the part of Verizon Wireless that it didn’t already own.
The good news for Verizon investors is, even with this additional debt load, Verizon’s interest payments are well covered. One of the best ways to gauge a company’s level of interest cost is by comparing interest expense to operating income. This is yet another situation where Sprint investors come out on the short end of the proverbial stick.
In Sprint’s last quarter, the company’s interest expense eclipsed its operating income by more than 160%. AT&T and Verizon seem to operate on a different level, showing interest as a percent of operating income of 16% and 15% respectively. In addition, Verizon’s has managed to maintain an interest to operating income percentage of less than 25% over the last year. Clearly, Verizon’s interest expense doesn’t appear to be an issue that would threaten the company’s dividend.
What Does the Future Hold?
The third question facing Verizon investors is, what’s next? On the one hand, Verizon’s wireless customers seem excited to upgrade their handsets early. Given that customers are generally signing a two-year payment contract when they upgrade their device, they have a good reason to stick with the carrier. Verizon and AT&T both reported wireless postpaid churn rates of around 1%. Sprint on the other hand, reported a postpaid churn rate of just under 2%.
Strong equipment upgrades, combined with low churn, would suggest customers are satisfied with Verizon Wireless. It seems that each company has plateaued with new service plan pricing. As this pricing becomes the new normal, customers’ willingness to upgrade their equipment will become the new growth engine.
Verizon is also improving its wireline performance, as this division’s operating margin has increased from just 1.5% last year, to 4.3% in April, to just over 5% in the last quarter. Last but not least, Verizon’s purchase of AOL.com should diversify the company’s revenue stream.
This acquisition is partially responsible, for the new Go90 service that Verizon Wireless expects to offer in late summer or early fall. The service reportedly will offer college sports, comedy, music videos, and more. In addition, Go90 is expected to initially be offered free to Verizon Wireless subscribers. For a wireless network that already sports the lowest postpaid churn, offering an exclusive video service should help Big Red to keep driving subscriber growth.
In the end, Verizon is growing its wireless division faster than its peers, and carries a manageable level of interest payments. As new and better devices are created, customers will upgrade, and the company will reap the equipment revenue growth. Combine all of this with a core free cash flow payout ratio (net income + depreciation – capex), compared to dividend expense) of 51% last quarter, and Verizon’s dividend looks like a solid contender for any income focused investor.
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