Verizon Intiating Coverage Report

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INITIATING COVERAGE REPORT William C. Dunkelberg Owl FundFebruary 5th, 2014

Jesse Worek: Lead Analyst

[email protected]

Nathan Clark: Associate Analys

[email protected]

Ryan Rinaldi: Associate Analyst

[email protected]

COMPANY OVERVIEW

Verizon Communications Inc. is one of the worlds leadingproviders of communications, information and entertainmentproducts and services to consumers, businesses andgovernmental agencies. Verizon has two primary segments,

Wireless and Wireline. Wireless communications productsand services include wireless voice and data services andequipment sales, which are provided to consumer, businessand government customers across the United States. Thissegment makes up 67.4% of 2013 revenue and 77.4% ofEBITDA. Wirelines voice, data and video communicationsproducts and enhanced services include local and long distance

voice, broadband Internet access (FiOS) and video, corporatenetworking solutions, data center and cloud services, andsecurity and managed network services. Wireline makes up32.6% of 2013 revenue and 22.6% of EBITDA.

INVESTMENT THESIS

After investors were unresponsive toVerizonsstrong fourth

quarter earnings, the company became undervalued to its own

history. Investors are cautious of Verizons market share andoutlook because of wireless pricing competition, a bearish

outlook for smartphones, Wireline concerns, and a significant

debt increase. Looking forward, Verizon is going to benefit

from restoring stability in its Wireline segment, purchasing the

remaining stake in Verizon Wireless from Vodafone, and the

continuing transition into data driven phones. We expect

multiples to appreciate as investors take advantage of a strong

dividend, impressive earnings from removing Vodafones stake,

and Verizons competitive advantage in the protective

Telecommunications sector.

Teleco

mmunica

tions

TECHNOLOGY

Verizon Communications, Inc.Exchange: NYSETicker: VZTarget Price: $53.95

Sector Outperform

Recommendation: BUYKey Statistics:Price $48.02 52 Week Low $43

Projected Return 16.8% 52 Week High $54

Shares O/S (bn) 2.86 Yield 4.4

Market Cap $136.32 Enterprise Value $23

Earnings History:

Earnings Date EPS Revenue YoY Pric

1Q13 $0.68 4% 2.77%

2Q13 $0.73 4% -1.52%3Q13 $0.77 4% 3.49%

4Q13 $0.66 3% -1.34%

Earnings Projections:

Year Q1 Q2 Q3 Q4 Tota

2012 $0.59 $0.64 $0.64 $0.38 $2.2

2013 $0.68 $0.73 $0.77 $0.66 $2.8

2014 $0.82 $0.90 $0.94 $0.82 $3.4

2015 $0.98 $0.98 $1.01 $0.83 $3.8

2016 $1.04 $0.98 $1.00 $0.89 $3.9

One Year Price:

All prices current at end of previous trading sessions from date of repor

Data is sourced from local exchanges via CapIQ, Bloomberg and other

vendors. The William C. Dunkelberg Owl fund does and seeks to do

business with companies covered in its research reports.
mailto:[email protected]:[email protected]


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CATALYSTS

Verizon Wireless Deal.Purchasing the remaininginterests in Verizon Wireless (VZW) from Vodafone

will bring future revenue and flexibility to Verizon.

VZW is the largest wireless service provider in the U.S.This segment, which grew 6.8% from 2012 to 2013,

will continue to drive revenue for Verizon. In the past,

Verizons net income was decreased by 76% in 2011,

92% in 2012, and 51% in 2013 due to minority

interests. This minority interest payment has increased

by 24% each year over the past 3 years. Purchasing

Vodafones 45% stake in Verizon will greatly decrease

the amount of net income that Verizon loses due to

minority interests and drive its bottom line. Verizon

executives have also noted that the purchase of VZW

will allow future flexibility since they will no longer

have to consult Vodafone when making decisions.

Copper to Fiber.Following Hurricane Sandy, Verizonhad decided to replace copper lines with fiber optics.

Fiber has proven to deliver better service in terms of

voice quality and fewer dropped calls. Upgrading to

fiber will bring cost savings to Verizon in regards to

maintenance as well. The change to fiber also allows

Verizon to offer its FiOS products to customers.

Altogether, the wireline shift into fiber optics will bring

higher quality, cost savings, (predicted to be more than

$100 million) and more revenue from customers who

purchase FiOS products. 4G LTE Coverage. Verizon has the largest 4G LTE

network in the U.S. with coverage of over 97% of

Americans. As of the end of 2013, approximately 69%

of the Verizons wireless traffic was on this network.

Over the past couple years there has been a migration

from 3G to 4G LTE. Verizons network helps capture

those customers wishing to increase their coverage and

has helped offset losses due to a market that is

saturated by smartphones.

Spectrum. Spectrum (also known as public airwaves)is essential for the telecom business. Licenses are

needed in order to use the airwaves and are very limited.Verizon has the upper hand on AT&T, T-Mobile, and

Sprint when it comes to the amount of licenses it holds.

Due to the low supply and high demand, Verizon is

positioned to take advantage of its vast amount of

licenses that it currently holds.

Risks

Verizon Wireless.With the upcomingacquisition of Verizon Wireless from

Vodafone, there is the chance of Verizon over

paying for the remaining stake in VerizonWireless. This is a significant risk because of

the record breaking debt ($41.7 billion) the

company has issued for the deal.

Smartphone Saturation. United Statessmartphone saturation is projected to reach

around 82% by the end of 2014. We expect

this to lead to declining smartphone sales in

the future.

Increased Wireless Competition.T-Mobileas begun a new campaign targeting mid to

low-end customers and has caused other

wireless providers to reduce prices and createnew plans. This could be a threat for

Verizons dominating market share.

Economic Moats

Spectrums. Verizon enjoys a surplus ofspectrum (public airwaves) licenses while

demand in the industry is sharply increasing.

Smaller competitors like Sprint and T- Mobile

are fighting to acquire licenses that Verizon

currently owns but are not used. This

prevents competition from stealing market

share in key wireless locations.

Contracts.Verizon operates in an industrywith medium to low barriers to entry because

of contracts. Contracts secure customers for

several years or require a fee to cancel the

contract early.

4G LTE Coverage.Verizon has the largest4G LTE coverage in the US and is able to

provide to 97% of the US population. This

provides a wide, stable moat because

competitors are unable to enter this space

without costly capital expenditures. Wireline Bundles.Verizons wireline

segment offers bundles that include FiOS TV,

FiOS Internet and FiOS digital voice. Having

all these services in one makes customers less

likely to cancel services.


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T h e W i l l i a m C . D u n k e l b e r g O w l F u n d Pag

INDUSTRY OVERVIEW

The telecom industry is facing several headwinds and tailwinds. Wireless (three year CAGR of 6.3%) has been driving

industry growth for the past several years due to affordability for customers and wider margins for service providers.

Smartphones and improvements in data have driven wireless growth the past several years. Approximately 56% of

wireless customers had smartphones in May 2013 and is expected to reach 82% by the end of 2014. The industry is

worried that this will lead to smartphone saturation. In order to fight this, telecom companies are bringing a stronger

focus to tablets and other data driven devices in order to drive revenue. The wireless industry has faced increasing

pricing competition due to T-Mobile lowering rates. This has caused other providers to reduce prices and create new

service packages. This is expected to shift market share in the wireless segment. Wireline (three year CAGR of 0.04%)has been flat in recent years. There has been a shift from voice revenue into video and internet services. The number of

wireless households has grown to 39.4%. In order to hedge against this, service providers have started bundling voice,

video, and internet services in order to retain customers.

FINANCIALS

Verizon Wireless Deal:

Vodafone holds a 45% stake in Verizon Wireless and receives a significant portion of Verizons income. On January

28th, Vodafone approved to sell the stake for $130 billion. Verizon will pay for this stake in $58.9 billion in cash, $60.2

billion in Verizon stock, and $11 billion in smaller transactions. The deal has to be reviewed by regulators but is

expected to go through with no problems. The financial details of the deal will be released on February 21st.

PEER GROUP IDENTIFICATION

Wireless Services

AT&T, Inc. (NYSE: T) -AT&T Inc. providestelecommunications services to consumers, businesses,and other providers in the United States and

internationally. The company operates in two segments

Wireless and Wireline.

Wireline Services

CenturyLink, Inc. (NYSE: CTL) - CenturyLink, Inc.operates as an integrated telecommunications company

in the United States.

Comcast Corporation (NASDAQ: CMSCA) - ComcastCorporation operates as a media and technology

company worldwide. It operates through Cable

Communications, Cable Networks, Broadcast Televisio

Filmed Entertainment, and Theme Parks segments.

TARGET PRICE

Our target price is derived from multiplying a weighted average

of Verizonscompetitors forwardearnings multiple times the

companys NTM EPS of $3.46. It should be noted that Verizonhas historically traded at a premium to AT&T. In order to

capture this premium, we multiplied AT&Ts forward multiple

by the historic spread of 1.266 that Verizon has traded (See

Appendix). After factoring the companys 4.45% dividend

yield, we arrived at a projected return of 16.8%. (See Appendix

for comprehensive walkthrough)

Peer Analysis Target Price= $53.95

Relative Target Multiple =15.59xNTM Forecasted EPS= $3.46


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Verizon Wireless Deal (cont.):

Fully controlling Verizon Wireless is a strong move for Verizon. Although the company took on $41.7 billion to finance

the deal, Verizon will no long have to give earnings to Vodafone and will significantly improve VZs bottom line. In a

qualitative sense, Verizon will be able to have increased flexibility for decision making in its Wireless segment.

Revenue:

Wireless accounted for 67.4% of FY 2013 revenue and grew 6.8% YoY. As of 2008, Wireless has been the Verizons

dominant segment with sales growing at a five year CAGR of 10.4%. Superior coverage and the transition from basic to

smartphones has allowed Verizon to experience Wireless growth. Looking forward, we expect the wireless pricing war

to attract more customers to Verizon as it lowers rates for data plans. This will drive revenue and lock more customers

into contracts, securing future revenues. We expect Wireless revenue to increase 6% in 2014. In 2013, Wireline made

up 32.6% of revenue and declined 6.3% YoY. Revenue from Wireline services has been declining since 2006 at a CAGR

of -3.6%. This decline can be attributed to the increasing number of wireless households (12.8% in 2008 and 39.4% in

2013) and decline in business demand. Recently Verizons Strategic Services segment has been able to capitalize on

businesses entering emerging markets, creating revenue growth to stabilize the declining business segment. In addition,

Verizon has begun to bundle its home services (phone, internet, and cable) to attract more customers. We expect

Wireline revenue to decline 0.9% in 2014, improving from 6.3% decline experienced in 2013.

Margins:

Verizons margins improved dramatically in 2013 with its

EBITDA margin growing from 25.6% to 40.3% and profit

margin improving from 0.76% to 9.54% (2011 profit

margin was 2.17%). This improvement can be attributed to

managementsanticipation of demand which helped

dramatically lower operating expenses. The EBITDA

margin for 2014 is expected to be around 36%. Due to

Verizons planned acquisition of Vodafones stake in

Verizon Wireless, we believe that profit margin will

improve substantially. In 2012, Verizon lost 91.7% of its

income to minority interests and depleted its earnings.

Profit margin for 2014 is estimated at 10.7%. We believe that 2014 profit margin will much higher considering because

Vodafone historically received around 90% of Verizons minority interest ($12 billion in 2013), which has been growing

at 24% the past three years. Within segments, we expect the Wireless EBITDA margin to remain flat around 49%. The

Wireline segment plans to go through cost cutting procedures to improve its EBITDA margin from 22% to around 25%.

Dividend:

Verizon holds a 4.45% dividend yield. Verizons dividend

has declined in the past three years. In 2011, the dividend

yield was 5% and as high as 5.3%. The dividend reached

its lowest in 2013 (at almost 4%), but has been increasingever since. Verizon is expected to recover its dividend

and bring it back to historic levels. By 2017, Verizons

dividend yield is expected to reach 4.8%. The companys

dividend payout ratio is at a three year low of 30%. This

shows that Verizon has the opportunity to give more back

to shareholders and we view it as reassurance that it will

increase its dividend in the future.


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Debt:

In order to finance the purchase of the remaining Vodafone stake, Verizon raised $41.7 billion in debt in 2013 and

recently issued $500 million in January to take advantage of lower interest rates. Including interest payments, Verizons

total debt reaches $167.5 billion dollars. In the next five years, Verizon will be facing $55.4 billion in debt, and $94.2

billion in the next ten years. $6.2 billion, or 3.7% of total debt, is floating debt which will reach maturity in 2017.

Verizons debt to equity is 98.1%, after having a five year average of 65.1%. Verizon is actually one of the least leveredcompanies in the telecommunications industry. The debt to equity of the S&P 500 Telecom Index is 101.2%. With an

interest coverage ratio of 12x and cash flow from operations that can handle some of the largest debt payments, we

believe that Verizon will be able to effective manage this debt.

VALUATION

VZ is currently trading at a P/E discount to its own history on a one- and three-year basis. The company has been

expanding margins and is more efficient than the companies in its comp group. Verizon is also well above its comp

group when it comes to return on assets and return on equity. With the countrys strongest 4G LTE coverage map,

Verizon is now very attractive due to the increase in demand for 4G LTE as 3G becomes obsolete. We believe that this

discount is unjust due to the ability of Verizon to keep customers within its growing network. It has a much lower

churn (turnover) than its wireless competitors.With improvements in the wireline segment, the purchase of Vodafones

stake, and Verizons vast 4G LTEnetwork, we believe that Verizon will reach its target multiple. It should be noted that

this is a conservative estimate since the target multiple is below Verizons three year average

TickerMarket LTM LTM Forward Forward LTM Margins Debt/Equity

Cap P/E EV/EBITDA P/E EV/EBITDA Gross EBITDA Profit MRQ

CMCSA 140814 17.89x 8.80x 18.79x 8.10x 69.6% 33.2% 10.5% 92.0%

CTL 17236 22.60x 5.00x 10.89x 5.30x 61.3% 41.2% -1.4% 123.1%

T 174287 24.40x 8.40x 12.60x 5.70x 60.0% 38.0% 14.2% 81.8%

Mean 110779 21.63x 7.40x 14.09x 6.37x 63.6% 37.5% 7.8% 99.0%

VZ 136317 16.91x 4.80x 15.58x 5.20x 62.8% 40.3% 9.5% 98.1%


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Verizon Three Year P/E with Average Line:

Verizon One Year P/E with Average Line:


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Verizon and Comp Group Three Year P/E:

Verizon Three Year EV/EBITDA with Average Line:

APPENDIX:


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Verizon and AT&T Historic Three Year P/E Spread:

Target Price Walkthrough

Verizon Three Year Price and Quarterly EPS:

AT&T Forward P/E:12.60x

Mean Spread: 1.2656RelVal Forward P/E:

15.95x

AT&T RelVal Multiple:15.95x

Wireless % of Sales:67.4%

Wireless Target Multiple:10.74x

CMSCA and CTL AverageForward P/E: 14.84x

Wireline % of Sales:32.6%

Wireline Target Multiple:4.84x

Wireless Target Multiple:10.74x

Wireline Target Multiple:4.84x

Target Multiple: 15.58x

Target Multiple: 15.58x NTM EPS: $3.46 Target Price: $53.92


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T h e W i l l i a m C . D u n k e l b e r g O w l F u n d Page

DISCLAIMER

This report is prepared strictly for educational purposes and should not be used as an actual investment guide.

The forward looking statements contained within are simply the authors opinions. The writer does not own any

Verizon Communications, Inc. stock.

TUIA STATEMENT

Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his

tireless dedication to educating students in real-world principles of economics and business, the William C.

Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging,

practical learning experience. Managed by Fox School of Business graduate and undergraduate students with

oversight from its Board of Directors, the WCD Owl Funds goals are threefold:

Provide students with hands-on investment management experience Enable students to work in a team-based setting in consultation with investment professionals. Connect student participants with nationally recognized money managers and financial institutions

Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs

and partial scholarships for student participants.

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Verizon Intiating Coverage Report