Verizon Communications: An Uncertain Consolidation Effort With Frontier
Contributor since 2011 / 26186 Followers
Summary:
- Verizon Communications Inc.’s planned $20 billion acquisition of Frontier Communications adds 2.2 million fiber subscribers but increases debt and regulatory uncertainty, impacting short-term profitability.
- The deal aims for $500 million in synergies by year three, with earnings accretion expected from 2027, after initial financial challenges.
- Verizon’s stable stock is supported by a low valuation and a near 7% dividend yield, despite higher interest expenses and stagnant revenue growth.
- The acquisition positions Verizon as a solid bond proxy, with potential support from lower future interest rates amidst a stable business environment.
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Shares of Verizon Communications Inc. (VZ) hit the newswires, as it is looking to drive further consolidation in an already consolidated industry. A potential deal for Frontier adds more debt to Verizon, while adding limited near term profitability. The regulatory approval process will be tough and will create some uncertainty for a while to come.
All this will likely create an overhang on the shares for some time, yet the overall non-demanding valuation and dividend should support a stable stock from here.
Going After Frontier
Verizon Communication announced that it has reached a definitive deal to acquire Frontier Communications (FYBR) in a $20 billion all-cash deal.
The deal will add 2.2 million fiber subscribers across the country to Verizon, extending its reach to 25 million premises across some 31 states. On top of adding scale, there is a real financial component to the deal as well. The company targets cost synergies to the tune of $500 million by year three post closing, driven by scale, distribution synergies and network integration benefits.
Other benefits include the takeover of net operating losses of Frontier, as well as refinancing of debt, likely resulting in substantial interest costs savings. Despite these benefits, accretion to earnings per share is only seen from 2027 onwards, with this statement not being quantified.
Following a 43% premium offered for the shares, the transaction involves the purchase of the shares at $43.50 per share, as well as the assumption of substantial net debt as well. The company expects some challenges in the regulatory process, as anticipated closing is only seen 18 months from now.
On top of the anticipated financial benefits, the company stresses that the deal adds to its focus on mobility and broadband offering as well. Based on the second quarter results, Frontier is set to generate nearly $6 billion in annual revenues, as the business is modestly profitable on an operating basis, with expensive and out-sized debt yielding net losses to Frontier’s current investors.
Meanwhile, the company reaffirmed the full-year guidance. The business appears stagnant, and the acquisition news comes a day after the company hiked the quarterly dividend by 1.25 cents to $0.6775 per share, for an annual payout of $2.71 per share, for a near-7% dividend yield.
Putting The Deal Into Perspective
At the start of the year, Verizon reported its 2023 results, a year in which revenues were down 2% to $134 billion. Service revenues were flat at $110 billion, with wireless equipment revenues down 10%, thereby responsible for the decline in sales.
Reported operating earnings fell by a quarter to $23 billion, largely driven by a near $6 billion goodwill impairment charge. With interest expenses on the rise, net earnings were down 44% to $12.1 billion, with earnings per share down to $2.76 per share, largely in line with the current dividend payouts.
The company guided for relatively modest growth in 2024, with wireless service revenues up between 2.0% and 3.5%, and EBITDA seen up by 1-3%. Adjusted earnings are seen at $4.50-$4.70 per share, down from $4.71 per share in 2023 as a higher yield curve gradually works its way through the profit and loss statement from Verizon.
Cash flow conversion was set to improve again, with capital spending seen between $17.0-$17.5 billion in 2024, down from $18.8 billion in 2023, which in turn was down from 2022 already. Better yet, this is roughly at par compared to a $17.6 billion depreciation charge posted in 2023.
Through July, the company has been largely delivering on its promises. While reported revenues were essentially flat in the first half a year, service revenues were up nearly 2%, offsetting continued declines in wireless equipment revenues. GAAP earnings were down nine cents to $2.18 per share, due to a higher interest bill.
With 4.2 billion shares of Verizon trading around the $40 mark, Verizon commands a $168 billion equity valuation, as another $147 billion net debt load works down to a $315 billion enterprise valuation. With standalone EBITDA trending close to $60 billion, leverage ratios are seen in the mid-2s, with the company tracking at just over 5 times EBITDA, with equity of the company trading at 8-9 times adjusted earnings.
The Implications
A $20 billion deal is a substantial deal for Verizon, equal to about 7% of the current enterprise valuation. The cash assumption will increase net debt quite a bit, yet it will only be completed (according to plan) in about 18 months time, giving the company plenty of time to manage leverage. Moreover, given the incremental EBITDA brought to the business, leverage ratios will only inch up small.
Furthermore, the deal comes at a period in which organic capital spending has been coming down, after the company incurred massive spending recently, in preparation for 5G, among other things. This is welcomed, given the pressure on free cash flow generation, with higher interest expenses now hurting the ability to deleverage (with these expenses up 30% to a run rate of $7.5 billion). This offsets the benefit from lower capital spending, as dividends are still (modestly) on the increase.
What Now?
The reality is that Verizon continues to move along. The deal for Frontier will likely cast an uncertainty overhang on the shares for some time, which might be distracting. On the positive side is still a low earnings multiple at 8-9 times earnings, a steep dividend near 7%, as the business remains quite stable.
This dividend is now getting more compelling amidst pressure on the yield curve. For now, earnings power is pressured, with higher interest expenses hurting the bottom line, offsetting the benefit of lower current capital spending. Verizon is even lucky in all this, as it has quite a layered debt profile, so it stands to benefit from interest rates potentially moving lower again, of course, limiting the growth in the expected interest bill from here.
Having held a modest position, mostly collecting dividends instead of obtaining capital gains, I see no reason to alter this position anytime soon. The current dividends are enticing enough to collect a decent yield and while I do not expect massive capital gains, investors are fine off amidst a stagnant share price.
Quite frankly, I am surprised to see no real action in the share price following the deal announcement for Frontier. The added debt and deal uncertainty could have easily sparked a negative reaction, but this is not observable in Verizon’s share price. Given all this, I view Verizon Communications Inc. as a solid bond proxy, with lower interest rates over time having the potential to provide some underlying support for the shares from here onwards.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of VZ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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