Verizon: Close, But Not Quite There Yet

Verizon Communications (NYSE:VZ) stock has been badly beaten down this year. At a time when the broad market indexes have mostly risen, VZ stock has declined 21% in price. As a telco, Verizon has a large amount of debt, which becomes more costly when interest rates rise. All telcos are in roughly the same boat here-communications is a capital intensive industry by nature-but VZ has fared worse than Comcast (CMCSA) and T-Mobile (TMUS), both of which are up for the year.

The question is, why is Verizon getting hit so much harder than others in its sector?

VZ stock has been battered so severely at this point that it now has an 8.4% yield. That's a lot of income potential, and the company's payout ratio is only 53%. It definitely looks like investors who buy Verizon today have a shot at receiving the dividend they think they'll receive. Earnings could decline 47% from here, and VZ would still be able to pay its dividend without borrowing money to do it.

Additionally, Verizon has an admittedly attractive valuation at today's price. According to Seeking Alpha Quant, it trades at the following multiples:

• 6.5 times earnings.

• 0.99 times sales.

• 1.4 times book value.

• 3.5 times operating cash flow.

All of these multiples are very low. Additionally, if you discount VZ's trailing 12-month free cash flow at an 8% discount rate, assuming no growth, you get a $36.38 price target-that's a 13.75% upside. The 10-year treasury is currently yielding 4.8%, so this calculation incorporates a sizable 3.2% risk premium.

So, Verizon has an upside even in a no-growth scenario. It all looks very promising, but again we have to think about the interest rates. Verizon has $177 billion in net debt, and some of it is variable rate. The interest expense on the variable rate debt immediately rises when benchmark yields rise, fixed rate debt may too become more expensive when rising rates force it to be refinanced more expensively.

What all this means is that, in the near term, Verizon may not be able to achieve 0% growth. The rise in treasury yields seen this week will likely cause interest expenses to rise-immediately for the variable rate portion of the debt, later for the fixed rate portion-and that will take a bite out of earnings. Additionally, last quarter's revenue performance would tend to indicate that even without higher costs, VZ will have trouble growing its cash flows. In the second quarter, revenue declined 3.5% year-over-year. Earnings per share ("EPS") also declined. So, in addition to the risk of higher rates taking a bite out of earnings, there's a risk of some weakness on the top line too.

That's not to say that Verizon is a clear sell at any price. To the contrary, it's beginning to get interesting. The second quarter had some encouraging operational metrics, such as 418,000 net broadband subscriptions and a 3.8% increase in revenue from the wireless segment. If we see another 17% selloff in VZ's stock price, the yield will be above 10%. At that yield, VZ stock is undeniably interesting. For the time being, though, the best approach for investors would be to sit back and wait for a better entry point. The stock is far from a clear short, but it still isn't so cheap as to be a sure thing.

Competitive Dynamics

All of these characteristics make Verizon an overall strong company, able to retain subscribers and win new ones. On the other hand, economists have described the U.S. telco industry as on the whole a competitive one, with a lot of competition between established players. The end result has been a gradual decline in the rates charged to consumers-a win for the consumers themselves, but a loss for the Telcos and their shareholders. It's a tough industry to compete in, although Verizon has a leading place within it.

Balance Sheet Health

One fact about Verizon that gives pause is the state of its balance sheet. As of the most recent reporting period, VZ had:

• $37.4 billion in current assets.

• $51 billion in current liabilities.

• $83 billion in common equity.

This handful of metrics alone yields some pretty major red flags. The ratio of current assets to current liabilities gives us a 0.7333 current ratio-above 1 is ideal for this metric. The ratio of debt to equity yields a 1.80 debt to equity ratio-below 1 is ideal for this metric. So, there are reasons to be concerned about Verizon's liquidity and solvency just after taking a very brief look at a few balance sheet metrics.

The real issue with the debt here is the interest expenses that come with it. Interest rates are rising, and that means interest paid on variable rate debt is increasing. In the trailing 12-month period, Verizon had $4.2 billion in net interest expense. In fiscal year 2022, interest expense was only $3.4 billion. So, the company is feeling the effects of higher rates.

Profitability

Now, we can turn to a factor that looks more favorable for Verizon:

Profitability.

Verizon is an undeniably profitable enterprise, with sky-high gross margins and fairly strong margins in other categories. According to Seeking Alpha Quant, it has the following profitability ratios:

• A 58% gross margin.

• A 22% EBIT margin.

• A 15.5% net margin.

• An 8.5% free cash flow margin.

• A 23% return on equity.

VZ scores an "A+" on profitability because these ratios are much higher than those seen in the telco industry as a whole. High interest rates are making their presence known at all telcos, but Verizon is managing them better than its peers are.

The growth picture is less rosy. According to Seeking Alpha Quant, Verizon only grew its revenue 0.5% in the most recent 12-month period. Earnings declined about 5%, although free cash flow grew 47%. It was a mixed showing.

The long-term averages are a little more encouraging. Over the last 10 years, VZ has grown at the following CAGR rates:

• 1.99% in revenue.

• 29.7% in net income.

• 24.8% in diluted EPS.

• 5.5% in assets.

• 15% in levered free cash flow.

Overall, the long-term picture is better than the recent past. The challenge for Verizon is to get its growth rates up without sacrificing profitability. In a rising rate environment, that will be tough, which is why I rate the stock a 'hold' for the time being.

The Bottom Line

The bottom line on Verizon is that it is a very profitable company that unfortunately just isn't growing. Thanks to its recent selloff, it now throws off buckets of yield. Unfortunately, it seems like there's a possibility that the dividend will be all investors get here. Although VZ trades at unbelievably low multiples, its earnings have been declining, and the recent rise in treasury yields points to higher interest expenses in the future. The company's valuation implies that it has an upside if earnings grow just 0%, the trouble is that the earnings growth for the next few years may be worse than 0%: it may be negative.

That isn't to say that Verizon is a clear sell at any price. To the contrary, it would be a decent buy just 17% lower than today's level. After a 17% decline, VZ would be trading at $26.54. At that point, the dividend yield would go above 10%. At such a rock bottom valuation, the stock would likely be worth the price of admission. Here, if you assume that earnings decline slightly for a few years before leveling off to 0%, you still get a slight upside in a discounted cash flow model-plus you're collecting a 10% yielding dividend, that is so well covered it can continue being paid even if earnings do decline. So, I'd say Verizon is worth the investment in the mid to high twenties. We're close, but we're not quite there yet.