Krause Fund Research Fall 2014 Telecommunications Recommendation: HOLD Analysts Anthony Russo Anthony-Russo@uiowa.edu Austin Will Austin-Will@uiowa.edu Clinton Vilks Clinton-Vilks@uiowa.edu David Bussey David-Bussey@uiowa.edu Company Overview Verizon Communications, Inc. (VZ) and its subsidiaries offer communication, information and entertainment products and services to consumers, businesses, and governments agencies in the U.S. and over 150 countries worldwide. Verizon provides wireless voice and data services over its 4G-LTE network, reaching 97% of Americans. Wireline services include broadband video and data, networking solutions, data center and cloud storage, and voice services. Broadband services are delivered via their FiOS brand, the nation s largest fiber optic network. Verizon has captured over 30% of the U.S. market share both segments by remaining a leader in coverage, data speed, and reliability. Stock Performance Highlights 52 week High $53.66 52 week Low $45.45 Beta Value 0.70 Average Daily Volume 14.12 m Share Highlights Market Capitalization $213.71 b Shares Outstanding 5.15 b Book Value per share $4.00 EPS 2013 $4.01 P/E Ratio 17.3 Dividend Yield 4.19% Dividend Payout Ratio 52% Company Performance Highlights ROA (ttm) 8.40% ROE (ttm) 40.69% Sales $120.55 b Verizon Communications Inc. (NYSE: VZ) November 18, 2014 Current Price $51.40 Target Price Range $49.58-54.68 Steady Returns for Telecom Giant 1 Established Industry and Resource Dominance With 35.9% market share in the wireless telecommunications industry, Verizon has the largest 4G LTE network, most FCC spectrum licenses, and more subscribers than any other provider. Their established industry dominance and wireless resources will enable them to accelerate into an enhanced financial position in the coming years. Economic Outlook In an economy that continues to recover from a recession, we expect the telecommunications industry to grow with increased climbs in GDP. While interest rates are expected to normalize, bringing up the cost of debt in a capital-intensive industry, we believe Verizon is in a great financial position with respect to other firms, which will enable them to counter the rise in rates. Subscriber Growth Although data plan price competition within the industry is slowing ARPU growth for Verizon, their annual subscriber growth is the main driver in revenue growth. From 2014-2019, we estimate total wireless subscribers to increase by 19%. Vodafone Interest Verizon s purchase of their 45% non-controlling interest in Cellco Partnership (Verizon Wireless) gives them full ownership of its operating cash flows, and will continue to build shareholder equity through accumulation of retained earnings. Consistent Dividend Growth With Verizon s steady dividend growth, they have proven themselves to be a reliable investment with constant returns. We project dividends per share to grow by 2.81% annually on average through 2019. One Year Stock Performance (Figure 1. Marketwatch.com)www.marketwatch.com/investing/stock/vz Financial Ratios Current Ratio 0.92 Debt to Equity 609.37%
2 Investment Summary Our analysis and valuation model affirms Verizon s position as the leader of the Telecommunications industry. However, we have issued a HOLD rating, as we find it to be correctly priced in today s market. Verizon has the key partnerships, financial stability, and innovative strategies that will drive modest, but healthy earnings growth in the future. Investment in new technologies accelerate its differentiation from competition and offset the industry-wide decline in traditional wirelines services. With the largest market share in the wireless telecom industry, Verizon has solidified their position with the largest 4G LTE network in the United States. We believe limited availability of network assets will make it difficult for any other company to reach Verizon s dominant position in the industry. As Verizon s aggregate revenue continues to grow with each earnings report, we expect the same out of their stock price, market capitalization, and dividends per share. heal iii. Our short-term growth reflects an economy that still remains vulnerable to a high levels of long-term unemployment. Moving forward, we expect an optimistic long-term GDP growth of 3.4% as the economy continues to climb after the recent recession. Recent growth in new housing units elicits stabilization in the housing market following the crash of 2008, likewise improving GDP growth. As the economy returns to a healthy state, personal consumption expenditures is also expected to increase proving beneficial to the telecommunications sector. As seen below the graph depicts a consistent positive growth in GDP since the end of the recession period. (Exhibit 2. Personal Consumption Expenditures Since 2006 iv ) Economic Outlook Gross Domestic Product (GDP) Real GDP is the measurement of economic growth, based on the value of goods and services produced in the United States. The overall health of the telecommunication industry will be closely linked to a consistent GDP growth. In the third quarter of 2014, GDP increased at an annual rate of 3.5%, compared to a second quarter increase of 4.6%. The third quarter increase in real GDP is primarily reflected upon the positive contributions from personal consumption, exports, nonresidential fixed investment, federal government spending, state and local government spending and a decrease in imports. The deceleration in percent change from the second to third quarter is a result of a downturn in private inventory investment and a deceleration in the positive contributors of GDP growth, excluding federal government spending i. The table below shows the U.S. Real GDP quarter-toquarter change over the last 4 years. (Exhibit 1. Real GDP Growth ii ) The 2 nd and 3 rd quarter of 2014 showed signs of recovery we anticipate the short-term GDP growth to decelerate to a steady 3.1%. The Federal Reserve remains hesitant to change interest rates, furthering our expectation that the economy is yet to fully Interest Rates The Federal Funds rate is used by central banks as the standard interest rate to make loans and currently sits at.1%. Prior to 2008, U.S. interest rates ranged from 2-5%. Following the recession in 2008, the Federal Reserve has kept the interest rate around.1% hoping to increase GDP by encouraging borrowing and stimulating the economy v. The Federal Reserve has been adamant about maintaining a low interest rate and patiently waiting to increase the interest rate until the economy fully recovers. The telecommunication sector is capital-intensive, meaning it s inherent that companies within the industry need a large amount of money to sell their products and services vi. Additionally, the extensive infrastructures they invest in require frequent maintenance to ensure quality to consumers. As a result, telecom companies closely monitor trends in the interest rate environment since their profit highly depends on the ability to raise debt capital. We expect that the Federal Funds rate will remain at a low.09-.14% until the mid-2015 as the economy continues to recover. We are confident the Fed will not abandon its strategy in the short-run, as no changes have come from recent discussions of raising rates. However, once the Federal Reserve feels the economy has reached a healthy state, we expect the Federal Funds rate to jump to 2.5-3%. We expect corporate debt interest rates will rise accordingly resulting in more expensive cost of debt for already highly-leveraged telecom companies, making it more difficult to produce economic profit. Important disclosures appear on the last page of this report.
3 Inflation Consumer Price Index (CPI) is the most common measure of inflation, it represents the change in prices of all goods and services purchased for consumption by urban households. Inflation is essentially a measure of the effectiveness of government policy, as it is often used by the Federal Reserve board to aid in formulating fiscal and monetary policies vii. The following graph displays the changes in the Consumer Price Index over the past 10 years viii. (Exhibit 3. CPI Growth Since 2006) (Exhibit 4. S&P 500 Total vs. Telecommunication Index x ) 250 200 150 100 50 S&P 500 and S&P 500 Telecommunication Services Index 0 S&P 500 Sector S&P 500 (TR) Our outlook for capital markets looking forward is positive, but less bullish than we have seen since 2009 due to upcoming changes in interest rates and inflation that will likely be brought on by policy changes from the Federal Reserve. Due to the fact that the Fed has control over interest and inflation rates, we don t anticipate any drastic changes in the short run that will detriment market growth. Over the past year, the consumer price index has increased by 1.7%, the growth was spurred by an increase in both the food and shelter indexes, as the shelter index reached 3.0% (first time since January 2008). Similar to interest rates, we believe that inflation will slowly rise. We expect CPI to grow 1-1.2% in the next six months, putting the index in the area of 240.00-241.00. In accordance with the long-term interest rates, we expect the long-run inflation to slowly normalize to a yearly growth rate of 3.0%, closer to the historical average. Current inflation rates pose no immediate threat to telecommunications real earnings as ARPU growth continues to outpace inflation. In the long-run, higher inflation may diminish real earnings in the competitive price environment of the telecom industry. Capital Markets Outlook The telecommunications sector is a mature value sector with growth rarely fluctuating too far from the S&P 500. As the U.S. economy has recovered since the recession in 2008, the telecommunication sector has improved as well. Given our expectations for future growth in GDP, we believe the telecommunication services index will move cyclically with the S&P 500 as it continues to reflect promising future economic outlook. The S&P 500 has returned 15.87% over the past year, while the telecommunication sector has provided a one year return of 9.26% ix. The following graph displays the 5 year historical prices of the indices. Industry Analysis Industry Description The telecommunication industry is service based, highly competitive, and cautiously regulated by the Federal Communications Commission. The industry is composed of companies that provide wireless services (cellular voice service, text messaging, data services), wireline communication (local and long distance telephony, wholesale network access, Internet access), Voice over Internet Protocol (Internet based communication service), and Internet Service. Telecommunication providers are capital intensive because of the scale of the network infrastructure needed to connect customer to service. Firms are required to obtain large amounts of capital to provide their respective products and services, creating high entry barriers. Markets and Competition The major players in the telecommunications industry are Verizon, AT&T, Sprint Nextel, and T-Mobile. Mergers and acquisitions are becoming an increasingly common defensive strategy to source the network assets necessary to provide capacity demanded by users. The reason for this emerging tactic is that providers want to expand their spectrum, increase subscriptions, and offset the growth in market penetration. (Exhibit 5. Wireless Telecommunications Market Players xi ) Important disclosures appear on the last page of this report.
4 To describe the competitive landscape of the industry, we have provided Porter s 5-forces analysis. (Exhibit 6. Selected Company Highlights xiii ) Threat of New Entrants One of the largest barriers to industry entry is financing and investment activity. When interest rates are low firms are much more capable to enter and succeed within the industry. Despite the low-interest rate environment that exists today, the limited availability of FCC regulated wireless spectrum licenses adds greater difficulty for new-market entrants to obtain necessary operating assets to compete with large players who have already established ownership of large networks and license assets. Power of Suppliers Although telecom companies wouldn t be able to provide their services without crucial equipment such as fiber-optic cables, there are many suppliers in the industry. Therefore, vendors don t have much bargaining power because of the high competition to supply. The materials used in physical network build out are commoditized products subject to supply and demand for raw materials such as copper wire and glass fibers. On the other hand, the FCC has a large amount of control regarding the availability of unused and repurposed spectrum licenses. Some large players are being limited to participation in spectrum auctions and other smaller firms are unable to afford the increasing prices to obtain spectrum licenses. With insufficient network assets, companies will be unable to meet the consumer demand for wireless connection and lose market share. Power of Buyers The bargaining power of buyers is growing due to a diversified amount of telecom service providers in the market. Many phone and data plans are very similar across each company, creating price competition for customers demanding dependable service at a value cost. As a result, lower cost providers capture customer segments where premium services are not as highly demanded. Competitive Rivalry Competition is high in telecom, largely due to high adoption rates of cellular and smart-phone devices. There are over 335 million mobile internet connections in the United States, which exceeds the country s population (xi). This leads companies to try to differentiate themselves based on price, quality, network capacity, and additional services. Major Player Performance As depicted in Exhibit 6, Verizon and AT&T are the leading competitors in the telecom industry. These two companies generate the most revenue, have the largest market shares, most spectrum (FCC licenses), most subscribers, and lowest churn rates (percent of subscribers who switch to a different provider upon contract termination). Assuming the FCC doesn t restrict them from future purchases of spectrum, AT&T and Verizon are in the best cash positions for future growth. However, Sprint may see increased revenue growth after they announced a new affordable data plan ($60 unlimited data) that costs less than any of the competitors offerings xii. Important disclosures appear on the last page of this report. Company Verizon AT&T Sprint T-Mobile Ticker VZ T S TMUS Market Cap 213.71 B 186.21 B 19.98.3 B 23.05 B Shares Outstanding 4.15 B 5.19 B 3.95 B 807.35 M Revenue 123.64 B 130.37 B 35.41 B 24.42 B YTD EPS $ 3.03 $ 1.95 $ (0.53) $ (0.12) Total Debt (mrq) $ 111763 B $ 75.62B $ 32.27 B $ 25.56 B Current Ratio 0.92 0.65 1.06 1.55 FCC Licenses 75.7 B 59.7 B 20.3 B 18.1 B Subscribers (in millions) 125.3 118.7 54.8 52.9 ARPU (mrq) $ 55.42 $ 43.41 $ 50.19 $ 44.10 Churn Rate 1.27% 1.47% 2.90% 2.68% Regulation The U.S. Federal Communications Commission is the governing force behind the telecommunications industry. There has been recent speculation regarding net neutrality and the possibility of broadband internet becoming a regulated utility in the near future. This new regulation would not attempt to dictate prices charged by service providers but instead rid companies of paying for priority over its competitors in ways such as quicker mediums to potential consumers xiv. Large market share owner, AT&T has put a complete halt on fiber optic network projects due to uncertainty revolving possible new FCC regulation. Another development in industry regulation is the fight for wireless spectrum. Wireless providers compete with one another for the capacity of customers they can provide services to within their bandwidth. These bands of wireless spectrum are auctioned off and licensed by the FCC and give companies much more room to expand operations across the country. The concern is that almost all of the wireless spectrum available to wireless companies in the 700MHz to 2.6GHz spectrum is currently licensed and unattainable to competing companies until these licensed spectrums are put back up for auction by the FCC xv. The current auction that is in progress has already drawn $1.77 billion in bids which is just under 17% of the total reserve price set by the FCC xvi. As new technological innovations unfold, the demand for this spectrum will increase. This will lead to higher levels of data usage and serve as a catalyst for increased wireless revenue. We believe the important trend of spectrum control will continue in the future and the company that capitalizes on the current spectrum auction or inorganically acquires spectrum will be the company with the fiercest competition. There is a total of 65 MHz of spectrum available in the FCC auction. 15 MHz of paired spectrum, which is what most wireless companies are after, and 50 MHz available of unpaired spectrum which is what cable companies and other one-way broadband distributors will be interested in. We may see a dual effort in bidding, such as a wireless company and a cable company that combine funds due the multiple uses of this particular spectrum.
5 4G LTE and Coverage Both Verizon and AT&T have established LTE (Long-Term Evolution) as the chosen 4G technology for the quickest speeds for their customers. With the 4G LTE connection currently satisfying consumer s wants for high speed and reliability, we could see this technology pressuring households to abandon their wired services xvii. 4G LTE connection is currently the quickest service available for public use which has positioned both AT&T and Verizon nicely to not only maintain current but acquire new customers looking for the fastest coverage. New technologies like the 4G LTE connection are able to generate additional data traffic volumes increasing revenue from the wireless segment xviii. Additionally, this new value-added technology has increased margins within operations and sustained demand for the customers quick connections. Price Competition Carriers across the industry have recently updated service rates to focus on offering more value to customers. Most of these new offerings have large shareable group plans that allow for multiline access, but no longer make unlimited data usage options available. Verizon, AT&T, and T-Mobile all have new-contract incentive packages to cover the cost of leaving competitor contracts early xix. Voice quality and 4G data availability allow Verizon and AT&T to capture the majority of the market while charging higher rates than competitors, but reducing the barriers to switching carriers may lead to higher churn rates and ARPU growth slowing down to pace with inflation. (Figure 7. Carrier Pricing Comparison xix) (Exhibit 8. Projected Global Cellular Device Shipments xxi ) Industry Outlook We anticipate competition for spectrum space and the demand for devices using wireless data to largely dictate future telecommunications growth. Larger firms such as Verizon and AT&T that already have large blocks of spectrum licensing will likely maintain their majority market shares while seeing a slow, but steady decline in the growth of device sales and new connections as the market reaches its mature stage. Our forecasts project a 3-5% CAGR in wireless revenues for well-positioned firms. Following the trend in growth, we expect subscribership in traditional wireline services will decline as much as an average of 10% annually into our forecast horizon. Firms in the industry who are developing and brining new wireline technologies such as broadband and telematics services will off-set these substantial declines, bringing the total wireline growth to near 0%. Company Overview Smartphone Demand As of January 2014 90% of American Adults are owners of cellular phone and 60% are smart phone device users xx. Global smartphone demand is projected to grow at 11.85% CAGR through 2019, but with the U.S. having the third highest number of mobile phones per capita we expect more modest growth in US sales as the market becomes more saturated (xxi). Premium retailers such as Verizon and AT&T, who have smart phone adoption rates 10% higher than the national average, will near market saturation with almost 95% adoption by year 2019. Companies will likely investment in developing markets in South America and the Middle East where opportunities to acquire network assets through acquisitions present themselves. Organic device sales growth will otherwise slow nearly to the population growth rate beyond our forecast period. Verizon Communications, Inc. (VZ) and its subsidiaries offer communication, information and entertainment products and services to consumers, businesses, and governments agencies in the U.S. and over 150 countries worldwide. Founded in 1983, what was formerly known as Bell Atlantic Corporation officially became known as Verizon in 2000 when Bell Atlantic merged with GTE Corporation. Verizon provides wireless voice and data services over its 4G-LTE network, reaching 97% of Americans. Wireline services include broadband video and data, networking solutions, data center and cloud storage, and voice services. Broadband services are delivered via their FiOS brand, the nation s largest fiber optic network. Verizon has captured over 30% of the U.S. market share both segments by remaining a leader in coverage, data speed, and reliability. In 2013, Verizon s revenue totaled 120.5 b, with about 67% of revenues attributable to the wireless segments and the remaining 33% resulting from Mass Market, Global Enterprise, and Global Wholesale wireline sub-segments. Verizon serves over 100 million wireless customers on its vast network, with over $75 billion in wireless license assets. Important disclosures appear on the last page of this report.
6 (Figure 9. Verizon 2013 Revenue Distribution xxii ) 1.03 to 6.77 as a result of the new debt raised, common stock issued, and the reduction of Vodafone s minority interest in Verizon s Equity. As a result of the transaction Verizon has full ownership of its operating cash flows and will continue to build shareholder equity through accumulation of retained earnings after the payment of dividends. The availability of these cash flows will ensure that Verizon quickly regenerates healthy cash levels in 2014 and is able to make investments in network assets as they become available. We anticipate Verizon will not continue to seek additional debt capital in an effort to stabilize its current interest coverage ratio near 5.0 and maintain its BBB credit rating in light of the long term expectation of rising interested rates. Financial Summary Verizon s 2013 financial results included EPS of $4.01, record high earnings for the historically strong company. Total wireless revenues grew approximately 6.8% over year ending Dec. 31 2012(xxii). Despite strong growth in Verizon s FiOS broadband subscribership and revenues from cloud and machine-to-machine services, total wireless revenue decreased 1.4% from the year prior. Improvements in cost of goods sold as a percentage of sales were responsible for higher gross margins and pretax operating profits in 2013. We expect similar results in the future as a result of Verizon s Edge Service Plans. Verizon has steadily increased its quarterly dividends paid to common stock holders with an average growth rate of 2.5-3.0% annually. Current Verizon shareholders benefit from a 4.2% dividend yield and can expect the same steady dividend increases to continue into the future. Currently Verizon only uses about half of its earnings to pay dividends, a figure we expect to increase as necessary capital expenditures are curbed following the completion of its FiOS and wireless network build out. Corporate Strategy Verizon has commenced numerous strategic initiatives to fulfill their vision of being a globally-connected solutions company. Verizon is making efforts to increase their presence in consumer and enterprise video services, cloud services, security, and M2M telematics. Verizon is dedicated to finding innovative solutions through the investment of research-based strategies and the development of new technologies. Verizon has key partnerships with network vendors Alcatel-Lucent, Ericsson, and Nokia Siemens for the deployment of macro and small cell site infrastructure necessary for the reach of high-speed wireless services. Vodafone Interest In February, Verizon completed a transactions with Vodafone Plc. to purchase their 45% non-controlling interested in Cellco Partnership, d.b.a. Verizon Wireless. The deal, costing $130 billion consisted of $58.9 billion in cash and 1.275 billion shares of common stock. Verizon issued $49 billion in debt in 2013 and an additional $6.6 billion in 2014 to finance this purchase and maintain operating cash flows. Debt equity ratio increased from Important disclosures appear on the last page of this report. Life Cycle Total revenue growth slowed from 5.96% to 4.06% from 2011-2013, and we estimate that 2014 sales growth will remain steady at 4.13%. We believe the Wireless and Wireline business segments are in different stages of the life cycle. Accounting for 67% of revenue last year, the Wireless segment is in the growth stage. Average revenue per user (ARPU) grew 11.11% in 2013 from $49.49 to $54.99, and we expect the number of wireless subscribers to increase by 4.30% in 2014. We expect the wireless segment to move into a mature growth stage with annual growth rates nearing real GDP by 2019 as a result of high market saturation and price competition. Alternatively, the Wireline segment has entered the decline stage of the life cycle. While it only accounts for 33% of Verizon s total revenue, the segment s sales decreased from 2011-2013 by a total of 3.6%. Although wireline ARPU grew by 10.01% last year, we estimate that total wireline revenue will decline 1.18% on average through 2019. Verizon looks to combat sharp declines in traditional wireline services by adding additional broadband capabilities and other strategic services to slow wireline revenue declines to near 0%. Business Segments Wireless Verizon provides wireless services with both prepaid and postpaid contracts, with 94% of their connections being postpaid (xxii). These services include Internet access, messaging services, and data usage. To complement these services, Verizon offers wireless devices such as smartphones (Apple s iphone, Google s Android, etc.), tablets, and basic phones with limited internet accessibility. As previously mentioned, the wireless segment generates 67% of total company revenue. The sale of mobile devices accounts for only 10% of wireless revenue, while service subscriptions are the main driver of the business at 90% of sales. With the progression of the largest 4G LTE network, we expect Verizon s wireless revenue to grow by 6.92% in 2014, and total subscribers to increase to 104.8 million. This segment will continue to drive the company s business for many years to come. New Plans Attempting to provide more value to customers, Verizon introduced the Share More Everything plan in February of 2014.
7 This offer includes unlimited voice minutes, domestic and international text, video and picture messaging, and cloud storage on as many as 10 mobile devices. They also unveiled the Verizon Edge plan, which allows subscribers to upgrade their devices more frequently through a device payment plan. This plan requires customers to pay the full price of the phone over 24 months, but they are able to upgrade their device after six months as long as they return their old device and have paid it off by 50%. Verizon s cost of goods sold is reduced through this plan by spreading the cost of each device out into payments, but removing the purchase credit typically offered on new contract phones. By collecting the full price for the device, Verizon is able to increase its gross margins by as much as 2%. Intra-market Spectrum Swaps The ability to obtain spectrum licenses is the most important factor for any telecom company. Verizon currently owns $75.27 billion in spectrum licenses, making them the largest holder of spectrum in the United States. Wireless licenses establish the ability to use a portion of the spectrum, but do not entail ownership. Licenses last about 5-8 years and require renewal pending judgment by the FCC that the spectrum best serves the public interest xxiii. The large majority of Verizon s licensing expires past 2018, providing certainty that Verizon can continue its operations. Verizon s strong cash flows also allow it to enter into private transactions to acquire additional licenses where necessary. Wireline The wireline segment is structured into three sub-segments: Mass Markets, Global Enterprise, and Global Wholesale. Mass Markets This sub-segment offers broadband Internet, long-distance voice calls, and video service through their fiber-optic network to both household consumers and small enterprises. The main drivers of Mass Markets are FiOS Internet and Video services. Through FiOS Quantum, subscribers can reach download speeds of 500 megabytes per second on the Internet. Mass Markets accounted for 44% of Wireline s revenue (14.52% of total revenue) in 2013(xxii). We estimate Mass Markets sales to grow by 2.31% in 2014, mostly due to increased growth in FiOS subscriptions. Global Enterprise The Global Enterprise sub-segment offers its services primarily for other businesses. Strategic Services include private IP, Ethernet access, cloud services, and machine-to-machine services (enables businesses to connect equipment, and oversee the functionality of each machine). In addition to Mass Market growth, Strategic Service revenue growth continues to help offset the weakening Wireline segment. Global Enterprise makes up 12.54% of aggregate revenue (xxii). Global Wholesale This sub-segment offers data, voice, and local dial tone service mainly to local/long-distance carriers who use Verizon s facilities to deliver separate offerings to their customers. Global Wholesale is the smallest division of Wireline, its sales decreased by 11.32% in 2013(xxii), and we forecast it to continue to decline 10% annually until 2019. Catalysts for Growth and Change Key Partnerships/Increased Wireless Device Usage Partnerships with Qualcomm, VIA, and mobile device producers such as Apple are crucial for Verizon s future success (xxii). Verizon s innovation centers work hand-in-hand with these companies to ensure that cutting-edge technology reaches customers as fast as possible. This advantage is key since wireless device usage is increasing every year, and Verizon has the ability to attract new and current customers to new devices and maintain continued positive equipment growth above the population growth rate. Important disclosures appear on the last page of this report. FiOS Quantum Capabilities Verizon has established a massive fiber-optic cable infrastructure that will enable download speeds of 500 Mbps and uploads at 100 MBps, the fastest on the market. These quantum capabilities give Verizon a competitive advantage, and will continue to reduce the impact of declining wireline revenues. Verizon Telematics Verizon Labs Through Verizon Labs, Verizon is working on the development of the next generation of machine-to-machine products (M2M). This allows mobile device users to easily communicate to various machines, such as their automobile or washing machine. Verizon will benefit since inter-device communication is dependent on their wireless service for mobile devices and wireline broadband for fixed in-home devices. We anticipate that these services will contribute to strategic services revenue growing slightly above the rate of GDP growth over the next 3 years, as Verizon has entered contracts with automobile producers that make use of these services. Valuation Analysis The conclusion of our valuation analysis of Verizon Communications, Inc., a HOLD rating, was determined by the used of discounted cash flows (DCF) and economic profit (EP), discount dividend (DDM), and Price Earnings Relative Multiple valuation models. Based on these valuation methods we estimate Verizon s target price range $49.58-54.68. Discussion of Key Assumptions Revenue Decomposition We began by breaking Verizon s Revenues down into their two reportable segments Wireless and Wireline. Wireless services and device sales account for approximately 67% percent of Verizon s total revenue and this share proportion continues to grow as wireless devices and data service demand remain positive. We forecasted revenues looking 5 years into the future, the point at which we believe smart phone user growth in the U.S. will slow to about 4.3% near our projected GDP growth outlook. Industry studies demonstrate that Global cell phone ownership will reach about 85% of the total population in developed markets by 2019. Due to the adoption rates of technology in U.S. and Verizon s position as a premium service provider, it report smart phone device ownership rates approximately 10% above the current
8 global rate of 63%. Based on this adoption spread, we believe Verizon will reach approximately 95% adoption by 2019 and see total equipment growth just slightly above the population growth rate. We believe service revenue, the 85% majority of total wireless revenues to be driven by two main factors, average revenue per user (ARPU) and subscriber growth. We project average wireless subscriber growth to increase as a function of real GDP and the population growth rate in the next two years before moving toward a slower 2.0% steady state. We also project ARPU to grow as a function of inflation with a price premium achieved by recent price plan updates and increasing data demand, outpacing inflation by 1-2%. We believe that price competition among wireless carriers will limit Verizon s ability to increase ARPU in the long-run, and Verizon s ARPU growth will fall below the inflation rate in the continuing value period. WACC Cost of Equity To determine Verizon s cost of equity we used the Capital Asset Pricing Model. We believe that the current 30-year U.S. Treasury rate most accurately depicts the risk-free rate, due the virtually non-existent default risk of the U.S. federal government. The market risk premium was determined using Domodaran s expected return of the market, an assumption used by Krause Fund Analysts for fair comparison across companies. Finally, we determined Bloomberg s raw beta using weekly return comparison s to the S&P 500 since 2012 to be an accurate estimation. We believe this calculation to be statistically significant and representative of the actual market risk Verizon faces given its recent issue of new debt. Cost of Debt Verizon s cost of debt was calculated by taking the weighted average interest rate of the outstanding debt obligations on Verizon s debt schedule. We believe this is an accurate depiction of Verizon s long-term cost of debt, as Verizon still maintains a BBB credit rating following its large debt issue in 2013. The aftertax cost of debt was calculated using Verizon s 35% corporate marginal tax rate. Weight of Equity The market value of equity used to determine the weight assigned to cost of equity reflects the additional 1.275 billion shares of common stock issued in Verizon s transaction with Vodafone Plc. Verizon capital structure has undergone significant changes as a result of these issued share and the additional debt issued for the transaction. We do not predict any major changes in Verizon s capital structure in the forecast period. Cost of Goods Sold In 2013, Verizon demonstrated improvements in its cost of goods sold as a percentage of sales metric, leading to higher gross margins. We attribute these improvements to the launch of their new Verizon Edge pricing plan which finances the full cost of devices sold over a 24 month period in place of offering purchase credits on new devices. We believe this improvement to be sustainable as adoption of the Edge plans increase, leading to higher operating margins. Deferred Taxes During 2014, Verizon has made significant increases to its deferred tax-liability account on the balance sheet. This increase in deferred taxes of $13.65 billion follows a $58.9 billion cash expenditure in the acquisition of Vodafone s interest in Verizon Wireless in order for Verizon to maintain necessary operating working capital. We believe Verizon will steadily pay down this liability with the cash flows that will now become available as a result of the transaction, reaching levels near to the historical account balances in the 3 years prior to 2014 in the steady state. If Verizon s management saw fit to maintain the current level of deferred tax liabilities, the actual cash taxes paid would decrease, leading to higher after-tax operating profit and stock price. Discounted Cash Flow & Economic Profit After calculating value drivers including net after-tax operating profit based on our projected earnings and invested capital, we computed the intrinsic value of Verizon s common stock shares by discounting the free cash flow by our weighed average cost of capital and adjusting for the 11 months gone by in 2014. The intrinsic stock value today calculated from these models was $54.68. Verizon currently trades at $51.40, demonstrating that the stock is undervalued. We believe the 6.4% premium represented by this model to be a conservative estimate as result of our assumptions regarding the repayment of deferred taxes and continuing value growth rate of 1.46%, which falls below the projected rate of inflation. Our continuing value ROIC is also a conservative estimate as a result of increasing PP&E and intangibles asset to meet customer demand, despite slow growth average revenue per user (ARPU). We believe with the support of our sensitivity analysis that this model is the most accurate depiction of the intrinsic value of Verizon s stock today. Discount Dividend Model The DDM derives an intrinsic stock value by discounting the expected dividends paid to shareholders by the cost of equity. Our DDM yielded an intrinsic stock price of $47.36 after conducting a partial year adjustment. This price is 7.85% below the current share price of Verizon Wireless. We believe this model output to be significant in our analysis because the dividends we forecasted pay out over 50% of Verizon s earnings, which is the typical payout ratio. We still conclude that our dividends are a conservative forecast of the payout policy decisions made my Verizon s management. We based these projected dividends on the 8- year trend of Verizon s management to increase dividend by 2.5-3.0% annually. Simultaneously, our balance sheet projections demonstrate the availability of excess cash above the 2% normal cash level in all of the forecast year. We reserved these cash flows in order to maintain a demonstrable ability to meet future debt obligations despite declining revenue growth and high leverage. We believe the conservative EPS growth of 1.36% is realistic and achievable based on the revenues and operating margins we forecasted. The model may be appear artificially low as a result of the large CV ROE. This is a result of the effect on total equity rooted from the increased debt and additional shares issued following Important disclosures appear on the last page of this report.
9 the Vodafone transaction. Additionally, we project a higher.7 beta attached to Verizon because of higher market sensitivity inherent when increasing leverage as Verizon has over the past two years. This beta s effect on the cost of equity may overstate the actual default risk, which we believe to be low. We predict that unless new information regarding Verizon s default risk is released, the price should not decrease from its current level. Relative PE The relative multiple valuation compares Verizon s projected earnings per share metric to peer firms to determine a comparable price. We chose to compare Verizon to AT&T, China Mobile Limited, Telefonica Brasil, and Deutsche Telekom AG as they are major players in their respective markets similar to Verizon. Although Verizon s strongest pure-play comparison comes from AT&T we chose additional firms with similar operations and large market caps to get a broader view of how Verizon compares to others. Based on the current stock price and our projected earnings per share for the 2014 fiscal year, Verizon s relative multiple valuation derives and intrinsic value of $51.47, nearly matching its current $51.40 share price as of November 18, 2014. The implied price declines in 2015 as a result of slightly lower earnings offsetting the average multiple. These lower earnings are a product of the assumption built into our model that Verizon s effective tax rate in the forecasted period will equal the marginal corporate tax rate of 35%. Verizon s management strategically reduces its effective tax rate, but the transaction could not be forecasted into the model. Consequently, we believe that Verizon s relative multiple valuation confirms the validity of our target price range of $49.58-54.68. Sensitivity Analysis The target prices derived from our valuation models to changes in the key assumptions on which the models are built. Below is a discussion of the effect of changes in these assumptions to our weighted average cost of capital and Target Price. Weighted Average Cost of Capital Market Risk Premium and Beta The weighted average cost of capital is determined in large part by the cost of debt as a result of the high weight it carries in Verizon s capital structure. Outside of the risk-free rate, which we have determined to be the 30-year U.S. Treasury Yield, market risk premium and beta determine the cost of debt via CAPM. Should Verizon s market risk change as a result of further increasing lever or paying down debt, we find that the weighted average cost of may reasonably vary between 5.19-5.63%. Due to the fact that much of Verizon s cost come from large fixed, assets we expect beta to remain at its current level. Similarly, should capital market outlooks change as a result of increased or diminished economic activity we expect WACC to stay within this range. We are confident in our assessment of market conditions given in the slow improvement we have seen following the economic downturn of 2008. Below we will further discuss the implications of these potential changes in WACC on our calculated intrinsic value. Important disclosures appear on the last page of this report. Credit Rating and Risk-Free Rate To assess the potential changes in Verizon s weighted average cost of capital we created a table demonstrating the expected changes in cost of debt that would result from upgrades or downgrades by corporate bond rating agencies. We used Verizon s cost of debt and adjusted it based on the implied default risk interest percentage at each subsequent debt rating. We do not predict Verizon s debt rating to change as they have strict debt covenant s with their current lender, but should Verizon decrease its current interest coverage ratio or face financial distress and move up or down a rating, we would still see a WACC between 5.28% and 5.64% due to the lower weight of debt in the WACC calculation. Similarly, recent market correction have led investors to move funds from the equity market into safer treasury securities. Should the treasury rates, which we use as our estimated risk-free rate change as a result of demand shifts, we would still reasonably expect to see WACC within the same range. Target Price CV NOPLAT Growth and Cost of Capital The target price of our model is very sensitive to changes in the terminal growth rate of net after-tax operating profits. There are many assumptions in our model including income taxes, deferred taxes, revenue growth, and operating margins that could have an adverse effect on our NOPLAT growth rate. We believe that our model provides a conservative estimate, and any changes in NOPLAT growth would beat expectations. Additionally, we examined the effect of the potential changes in weighted average cost of capital demonstrated in the other tables. Based on our earlier analysis we determined our reasonable range of WACC to be within 5.19% and 5.64%. Within this range we still see a target price between $48.81 and $59.14, further affirming our confidence in our target intrinsic value. Cost of goods sold and SG&A Expense Due to our assumptions about Verizon Edge s effect on operating margins, we have analyzed the price changes that would occur should our estimates vary from actual outcomes. The cost of goods sold is a conservative assumption forecasted at 38.5% of total sales, above the actual 37.24% in 2013 but slightly below the average historical looking back 3 years. We were slightly more aggressive with our selling, general, and administrative costs as a percentage of sales with 26.8% since we project future decreases in device sales. Even if our estimates vary from actual costs, we still expect to fall within our target price range. Both costs would have to increase by over 1.5% to illicit a sell rating. CV Wireless and Wireline ARPU Growth The largest drivers of revenue growth for Verizon and similar telecom companies is a combination of average revenue per user and subscriber growth rates. We feel that our already conservative estimates on the growth of ARPU for both wireless and wireline users can sustain a desirable intrinsic value and a hold rating even if they miss expectations. It would take a major economic downturn or the development of a new technology that
10 made Verizon s current offering obsolete to effect a significant change and move the implied price below our target. CV Wireless Subscribers and Residential Access Lines Growth Despite the steady decline in residential wireline access, Verizon is working to slow the deterioration of wireline revenues by introducing new technologies to the market. Despite these efforts, we still project residential access lines to decrease by 3.9% year over year in the continuing value state as we continue to move into a mobile world. We still believe that Verizon s intrinsic value falls within our target price range even if the decline is sustainable at 4.9% a year. We would only expect to see this type of change if unemployment and GDP growth slowed by more than 1% and consumers turned cancelled wireline services in favor of mobile data and voice services. In addition, we expect that wireless subscriber growth will steady around 2%. This assumption, below real GDP and inflation, but higher than the population growth rate, is more sensitive to fluctuations because wireless revenues are such a large proportion of total revenues. If the market does reach a higher level of saturation to the point where subscriber growth slows to the population growth rate of.7% annually, we would change our view on Verizon and issue a sell rating unless ARPU growth offset this low growth rate. Important disclosures appear on the last page of this report.
11 Important Disclaimer This report was created by students enrolled in the Security Analysis (6F:112) 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. i "News Release: Gross Domestic Product." News Release: Gross Domestic Product. N.p., n.d. Web. 17 Nov. 2014. ii "Gross Domestic Product (GDP) Graph." BEA :. N.p., n.d. Web. 17 Nov. 2014. iii "Fed s Dudley: It Would Be Premature to Hike Interest Rates Soon." Real Time Economics RSS. N.p., n.d. Web. 16 Nov. 2014. iv "Graph: Personal Consumption Expenditures." FRED. N.p., n.d. Web. 17 Nov. 2014. v "Selected Interest Rates (Weekly) - H.15." FRB: H.15 Release--Selected Interest Rates--November 10, 2014. N.p., n.d. Web. 17 Nov. 2014. vi Zino, Angelo, CFA. "Industry Surveys Telecommunications." S&P Capital IQ NetAdvantage. McGraw Hill Financial. Web. 08 Sept. 2014. vii "Consumer Price Indexes Overview." U.S. Bureau of Labor Statistics. U.S. Bureau of Labor Statistics, n.d. Web. 17 Nov. 2014. viii "Consumer Price Index for All Urban Consumers: All Items." - FRED. N.p., n.d. Web. 17 Nov. 2014 ix "S&P 500 Telecommunication Services." S&P Dow Jones Indices. N.p., n.d. Web. 17 Nov. 2014. x Telecommunication Services." S&P Dow Jones Indices. N.p., n.d. Web. 17 Nov. 2014. xi Kahn, Sarah. "IBIS World Industry Report 51332." IBIS World. N.p., n.d. Web. 16 Nov. 2014. xii "Sprint Doubles the Data For Low-End Data Users." MarketWatch. N.p., n.d. Web. 17 Nov. 2014. xiii Selected Data from Yahoo! Finance. N.p., n.d. Web. xiv Wyatt, Edward. "Obama Asks F.C.C. to Adopt Tough Net Neutrality Rules." Nytimes.com. N.p., 10 Nov. 2014. Web. xv Reardon13, Marguerite. "Wireless Spectrum: What It Is, and Why You Should Care - CNET." CNET. N.p., 13 Aug. 2012. Web. xvi "First round of FCC's AWS-3 Auction Draws $1.77B in Bids, Nearly 17% of Total Reserve Price." FierceWireless xvii "2014 Outlook on Telecommunications." Deloitte. N.p., n.d. Web. 15 Sept. 2014. xviii Kahn, Sarah. "Wireless Telecommunications Carriers in the US." Ibisworld.com/reports/us/industry. N.p., n.d. Web. xix "We Compare Cell Phones & Plans." Compare Here. It's How to Buy Happy. WhistleOut.com, n.d. Web. xx "Mobile Technology Fact Sheet." Pew Research Centers Internet American Life Project RSS. Pew Research Centers, Jan. 2014. Web. xxi "Global Smartphone Shipments Forecast 2010-2018 Statistic." Statista. N.p., 2014. Web. xxii Verizon Communications Inc.- -Form 10-K. Www.Sec.gov. Web xxiii Reardon, Marguerite. Wireless Spectrum: What it is, and why you should care- CNET. CNET. 16 Sept.2014 Important disclosures appear on the last page of this report.
12 VERIZON COMMUNICATIONS Revenue Decomposition (In Millions) Fiscal Years Ending Dec. 31 2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019CV Total Wireless Subscribers 108,667 98,230 102,799 107,219 111,026 114,689 117,557 119,790 122,186 Postpaid 87,382 63,733 69,033 72,001 74,557 77,018 78,943 80,443 82,052 % Change 5.12% 27.06% 8.32% 4.30% 3.55% 3.30% 2.50% 1.90% 2.00% Prepaid 4,785 5,700 6,047 6,307 6,531 6,746 6,915 7,046 7,046 % Change 8.50% 19.12% 6.09% 4.30% 3.55% 3.30% 2.50% 1.90% 0.00% Average Wireless Subscribers 105,487 103,449 100,515 104,837 108,559 112,141 114,945 117,129 119,471 % Change 10.22% 1.93% 2.84% 4.30% 3.55% 3.30% 2.50% 1.90% 2.00% Postpaid Churn % 0.95 0.91 0.97 0.95 0.95 0.95 0.95 0.95 0.95 Total Churn % 1.26 1.19 1.27 1.25 1.25 1.25 1.25 1.25 1.25 ARPU (Wireless Monthly) 52.69 49.49 54.99 56.75 58.05 59.22 60.28 61.19 61.92 % Change 2.29% 6.07% 11.11% 3.20% 2.30% 2.00% 1.80% 1.50% 1.20% Wireless Revenues Service Revenue 59,157 63,733 69,033 74,521 79,216 83,573 87,501 90,913 93,186 Retail Services 56,660 61,440 66,334 71,608 76,119 80,305 84,080 87,359 89,543 % Change 1.85% 8.44% 7.97% 7.95% 6.30% 5.50% 4.70% 3.90% 2.50% Other Services 2,497 2,293 2,699 2,914 3,097 3,267 3,421 3,554 3,643 % Change 8.17% 17.71% 7.95% 6.30% 5.50% 4.70% 3.90% 2.50% Equipment Revenue 7,457 8,023 8,111 8,188 8,261 8,331 8,398 8,462 8,523 % Change 4.13% 7.59% 1.10% 0.95% 0.90% 0.85% 0.80% 0.76% 0.72% Other 3,540 4,112 3,879 3,918 3,957 3,997 4,037 4,077 4,118 % Change 16.16% 5.67% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% Total Wireless 70,154 75,868 81,023 86,627 91,434 95,901 99,935 103,452 105,827 Total Wireline Subscribers Residential Access Lines 12,626 11,849 12,229 11,507 10,874 10,320 9,834 9,411 9,044 % Change 7.27% 6.15% 3.21% 5.90% 5.50% 5.10% 4.70% 4.30% 3.90% Total Cable Subscribers 4.2 4.7 5.3 5.9 6.6 7.0 7.4 7.8 8.2 % Change 20.00% 11.90% 12.77% 12.00% 12.00% 6.00% 5.00% 5.00% 5.00% Broadband Internet Subscribers 8,670 8,795 9,015 9,240 9,471 9,708 9,951 10,200 10,455 % Change 3.31% 1.44% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% FiOS Internet 4,817 5,424 6,072 6,801 7,617 8,074 8,477 8,901 9,346 % Change 18.01% 12.60% 11.95% 12.00% 12.00% 6.00% 5.00% 5.00% 5.00% FiOS TV 4,173 4,726 5,262 5,893 6,601 6,997 7,347 7,714 8,100 % Change 20.19% 13.25% 11.34% 12.00% 12.00% 6.00% 5.00% 5.00% 5.00% ARPU (Wireline Monthly) 93.07 101.77 111.96 122.10 131.56 139.79 143.28 146.58 140.86 % Change 9.19% 9.35% 10.01% 9.05% 7.75% 6.25% 2.50% 2.30% 3.90% Wireline Revenues Mass Market 16,337 16,702 17,328 17,728 18,007 18,124 17,718 17,321 17,051 Consumer Retail 13,606 14,043 14,737 15,201 15,544 15,723 15,377 15,038 14,723 % Change 1.39% 3.21% 4.94% 3.15% 2.25% 1.15% 2.20% 2.20% 2.10% Small Business 2,731 2,659 2,591 2,526 2,463 2,401 2,341 2,283 2,329 % Change 3.74% 2.64% 2.56% 2.50% 2.50% 2.50% 2.50% 2.50% 2.00% Global Enterprise 15,622 15,299 14,703 14,454 14,240 14,097 13,944 13,728 13,854 Strategic Services 7,607 8,052 8,420 8,799 9,151 9,517 9,821 10,018 10,218 % Change 15.22% 5.85% 4.57% 4.50% 4.00% 4.00% 3.20% 2.00% 2.00% Other 8,015 7,247 6,283 5,655 5,089 4,580 4,122 3,710 3,636 % Change 8.02% 9.58% 13.30% 10.00% 10.00% 10.00% 10.00% 10.00% 2.00% Global Wholesale 7,973 7,240 6,714 6,293 5,962 5,708 5,521 5,396 5,328 % Change 8.84% 9.19% 7.27% 6.27% 5.27% 4.27% 3.27% 2.27% 1.27% Other 750 539 478 430 387 348 314 282 282 % Change 17.49% 28.13% 11.32% 10.00% 10.00% 10.00% 10.00% 10.00% 0.00% Total Wireline 40,682 39,780 39,223 38,905 38,596 38,277 37,497 36,728 36,515 Intersegment Revenues 39 198 304 0 0 0 0 0 0 Total Operating Revenue 110,875 115,846 120,550 125,532 130,030 134,178 137,432 140,180 142,342
13 Key Assumptions Revenue Wireless 2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019CV Service Revenue 59,157 63,733 69,033 74,521 79,216 83,573 87,501 90,913 93,186 % Change 6.34% 7.74% 8.32% 7.95% 6.30% 5.50% 4.70% 3.90% 2.50% GDP Growth 3.64% 3.47% 4.57% 4.30% 4.30% 4.30% 4.30% 4.30% 4.30% U.S. Population Growth 0.70% 0.70% 0.70% 0.70% 0.70% 0.70% 0.60% 0.60% 0.60% Inflation 0.03% 2.07% 1.47% 1.20% 1.30% 1.50% 1.80% 2.00% 2.30% Inflation Price Premium 2.00% 2.00% 2.00% 2.00% 1.00% 0.00% 0.00% 0.00% 0.00% Subscriber Growth Factor 10.22% -1.93% -2.84% -0.25% -1.00% -1.00% -2.00% -3.00% -3.00% Total Service Revenue Growth 6.37% 8.24% 8.74% 7.95% 6.30% 5.50% 4.70% 3.90% 4.20% Equiptment Revenue 7,457 8,023 8,111 8,188 8,261 8,331 8,398 8,462 8,523 % Change 41.39% -27.04% 1.10% 0.95% 0.90% 0.85% 0.80% 0.76% 0.72% U.S. Smartphone User Growth 48.24% 31.47% 18.44% 13.43% 11.41% 7.72% 6.61% 4.91% 4.32% Less: U.S. Population Growth 0.70% 0.70% 0.70% 0.70% 0.70% 0.70% 0.60% 0.60% 0.60% Real U.S. Smartphone User Growth 47.54% 30.77% 17.74% 12.73% 10.71% 7.02% 6.01% 4.31% 3.72% U.S. Smartphone Ownership 35.00% 46.00% 56.00% 63.13% 69.89% 74.79% 79.29% 82.71% 85.78% Verizon User Smartphone Ownership 58.00% 67.00% 70.00% 73.13% 79.89% 84.79% 89.29% 92.71% 95.78% Adoption Spread 23.00% 21.00% 14.00% 10.00% 8.00% 6.00% 5.00% 5.00% 2.00% Devices Sales/Wirelss Sales 10.63% 10.57% 10.01% 9.48% 8.97% 8.49% 8.04% 7.61% 7.20% Total Equpment Growth 2.44% 2.22% 1.40% 0.95% 0.90% 0.85% 0.80% 0.76% 0.72% Other Revenue 3,540 4,112 3,879 3,918 3,957 3,997 4,037 4,077 4,118 % Change 16.16% -5.67% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% Total Wireless Revenue 70,154 75,868 81,023 86,627 91,434 95,901 99,936 103,452 105,827 Total Wireless Growth 8.14% 6.79% 6.92% 5.55% 4.89% 4.21% 3.52% 2.30% Wireline Mass Market 16,337 16,702 17,328 17,728 18,007 18,124 17,718 17,321 17,051 Consumer Retail Revenue 13,606 14,043 14,737 15,201 15,544 15,723 15,377 15,038 14,722 % Change 1.39% 3.21% 4.94% 3.15% 2.25% 1.15% -2.20% -2.20% -2.10% Total Subscribers 24,137 22,503 21,085 19,841 18,749 17,793 16,956 16,193 15,529 % Change -6.77% -6.30% -5.90% -5.50% -5.10% -4.70% -4.50% -4.10% ARPU (Wireline Monthly) 93.07 101.77 111.96 122.10 131.56 139.79 143.28 146.58 149.51 % Change 9.19% 9.35% 10.01% 9.05% 7.75% 6.25% 2.50% 2.30% 2.00% Total Consumer Retail Growth 2.58% 3.71% 3.15% 2.25% 1.15% -2.20% -2.20% -2.10% Small Business Revenue 2,731 2,659 2,591 2,526 2,463 2,401 2,341 2,283 2,329 % Change -3.74% -2.64% -2.56% -2.50% -2.50% -2.50% -2.50% -2.50% 2.00% Total Mass Market Growth 2.23% 3.75% 2.31% 1.57% 0.65% -2.24% -2.24% -1.56% Global Enterprise 15,622 15,299 14,703 14,454 14,240 14,097 13,944 13,728 13,854 Strategic Services Revenue 7,607 8,052 8,420 8,799 9,151 9,517 9,821 10,018 10,218 % Change 15.22% 5.85% 4.57% 4.50% 4.00% 4.00% 3.20% 2.00% 2.00% Other Revenue (Global Enterprise) 8,015 7,247 6,283 5,655 5,089 4,580 4,122 3,710 3,636 % Change -8.02% -9.58% -13.30% -10.00% -10.00% -10.00% -10.00% -10.00% -2.00% Total Global Enterprise Growth -2.07% -3.90% -1.70% -1.48% -1.00% -1.09% -1.55% 0.92% Global Wholesale 7,973 7,240 6,714 6,293 5,962 5,708 5,521 5,396 5,328 % Change -8.84% -9.19% -7.27% -6.27% -5.27% -4.27% -3.27% -2.27% -1.27% Other Revenue 750 539 478 430 387 348 314 282 282 % Change -17.49% -28.13% -11.32% -10.00% -10.00% -10.00% -10.00% -10.00% 0.00% Total Wireline Revenue 40,682 39,780 39,223 38,905 38,596 38,277 37,497 36,727 36,515-2.22% -1.40% -0.81% -0.79% -0.83% -2.04% -2.05% -0.58% Intersegment Revenue 39 198 304 0 0 0 0 0 0 % Change 407.69% 53.54% -100.00% 0.00% 0.00% 0.00% 0.00% 0.00% Total Revenue 110,875 115,846 120,550 125,532 130,030 134,178 137,432 140,180 142,342 Growth Rate 4.48% 4.06% 4.13% 3.58% 3.19% 2.43% 2.00% 1.54%
14 VERIZON COMMUNICATIONS Income Statement (In Millions) Fiscal Years Ending Dec. 31 2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019CV Sales 110,875 115,846 120,550 125,532 130,030 134,178 137,432 140,180 142,342 COGS excluding D&A 45,875 46,235 44,887 48,330 50,062 51,659 52,911 53,969 54,802 Depreciation 14,991 14,920 15,019 15,567 15,754 15,959 16,661 17,055 17,396 Amortization of Intangibles 1,505 1,540 1,587 1,686 1,549 1,569 1,593 1,622 1,654 SG&A Expense 29,670 32,145 33,599 33,642 34,848 35,960 36,832 37,568 38,148 Operating Income 18,834 21,006 25,458 26,306 27,817 29,032 29,435 29,966 30,342 Non operating Income (Expense) 430 408 254 1811 0 0 0 0 0 Interest Expense 2,827 2,571 2,667 4,867 5,801 5,801 5,801 5,801 5,801 Unusual Expense (Income) 5,954 8,946 (6,232) 757 0 0 0 0 0 Pretax Income 10,483 9,897 29,277 22,494 22,016 23,231 23,634 24,165 24,542 Income Taxes 285 (660) 5,730 5,623 7,706 8,131 8,272 8,458 8,590 Consolidated Net Income 10,198 10,557 23,547 16,870 14,311 15,100 15,362 15,707 15,952 Minority Interest 7,794 9,682 12,050 2248 400 400 400 400 400 Net Income 2,404 875 11,497 14,622 13,911 14,700 14,962 15,307 15,552 EPS 0.85 0.31 4.01 3.52 3.34 3.52 3.58 3.65 3.70 Total Shares Outstanding 2,834 2,836 2,866 4,152 4,162 4,172 4,182 4,192 4,201 Dividends per Share 1.98 2.03 2.09 2.16 2.18 2.26 2.33 2.41 2.47
VERIZON COMMUNICATIONS Balance Sheet (In Millions) Fiscal Years Ending Dec. 31 2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019CV Assets Cash 13,362 3,093 53,528 12,186 12,278 13,132 13,876 13,812 14,855 Short Term Investments 592 470 601 635 635 635 635 635 635 Short Term Receivables 11,822 12,598 12,439 13,400 13,510 13,633 13,963 14,242 14,462 Inventories 940 1,075 1,020 1,043 1,080 1,073 1,099 1,121 1,139 Other Current Assets 4,223 3,999 3,406 3,500 3,500 3,500 3,500 3,500 3,500 Total Current Assets 30,939 21,235 70,994 30,764 31,004 31,973 33,073 33,311 34,591 Net Property, Plant & Equipment 88,434 88,642 88,956 90,023 91,194 92,562 94,228 96,112 97,362 Total Investments and Advances 3,448 3,401 3,432 1,000 1,000 1,000 1,000 1,000 1,000 Long Term Note Receivable 1,864 1,455 0 0 0 0 0 0 0 Intangible Assets (non goodwill) 79,128 83,677 81,547 81,041 81,116 81,203 81,309 81,429 81,570 Goodwill 23,357 24,139 24,634 24,634 24,634 24,634 24,634 24,634 24,634 Deferred Tax Assets 0 0 0 0 0 0 0 0 0 Other Assets 3,291.0 2,673.0 4,535 5,112 5,178 5,256 5,351 5,458 5,583 Total Assets 230,461 225,222 274,098 232,574 234,126 236,627 239,595 241,944 244,740 Liabilities & Shareholders' Equity ST Debt & Curr. Portion LT Debt 4,849 4,369 3,933 1,603 1,603 1,603 1,603 1,603 1,603 Accounts Payable 4,194 4,740 4,954 17,653 17,017 16,906 17,316 17,102 17,366 Income Tax Payable 0 0 0 0 0 0 0 0 0 Other Current Liabilities 21,718 17,847 18,163 8,231 8,231 8,231 8,231 8,231 8,231 Total Current Liabilities 30,761 26,956 27,050 27,487 26,851 26,740 27,150 26,936 27,200 Long Term Debt 50,303 47,618 89,658 109,950 109,950 109,950 109,950 109,950 109,950 Employee Benefit Obligations 32,957 34,346 27,682 25,770 25,770 25,770 25,770 25,770 25,770 Deferred Tax Liabilities 25,060 24,677 28,639 42,289 39,289 36,289 33,289 30,289 27,289 Other Liabilities 5,472 6,092 5,653 5,750 5,750 5,750 5,750 5,750 5,750 Total Liabilities 144,553 139,689 178,682 211,246 207,610 204,499 201,909 198,695 195,959 Common Stock (Par Value + APIC) 38,216 38,287 38,236 11,797 12,134 12,472 12,810 13,147 13,485 Retained Earnings 1,179 3,734 1,782 10,214 15,082 20,374 25,611 30,854 36,064 Accumulated Other Comprehensive Income 1,269 2,235 2,358 1,250 1,250 1,250 1,250 1,250 1,250 Defferred Compensation 308 440 421 433 414 397 380 363 348 Treasury Stock 5,002 4,071 3,961 3,465 3,465 3,465 3,465 3,465 3,465 Total Shareholders' Equity 35,970 33,157 38,836 20,228 25,416 31,028 36,585 42,149 47,681 Accumulated Minority Interest 49,938 52,376 56,580 1,100 1,100 1,100 1,100 1,100 1,100 Total Equity 85,908 85,533 95,416 21,328 26,516 32,128 37,685 43,249 48,781 Total Liabilities & Shareholders' Equity 230,461 225,222 274,098 232,574 234,126 236,627 239,595 241,944 244,740 15
16 VERIZON COMMUNICATIONS Cash Flow Statement (In Millions) Fiscal Years Ending Dec. 31 2011 2012 2013 Operating Activities Net Income / Starting Line 10,198 10,557 23,547 Depreciation, Depletion & Amortization 16,496 16,460 16,606 Deferred Taxes & Investment Tax Credit (223) (952) 5,785 Other Funds 5,588 5,824 (7,115) Funds from Operations 32,059 31,889 38,823 Extraordinaries Changes in Working Capital (2,279) (403) (5) Net Operating Cash Flow 29,780 31,486 38,818 Investing Activities Capital Expenditures (16,244) (20,110) (17,184) Net Assets from Acquisitions (494) Sale of Fixed Assets & Businesses Purchase/Sale of Investments (1,983) (886) 63 Other Funds 977 494 2,782 Net Investing Cash Flow (17,250) (20,502) (14,833) Financing Activities Cash Dividends Paid (5,555) (5,230) (5,936) Change in Capital Stock 241 315 (68) Issuance/Reduction of Debt, Net 1,183 (3,351) 40,861 Other Funds (1,705) (12,987) (8,407) Net Financing Cash Flow (5,836) (21,253) 26,450 Net Change in Cash 6,694 (10,269) 50,435
17 VERIZON COMMUNICATIONS Forecasted Cash Flow Statement (In Millions) Fiscal Years Ending Dec. 31 2014E 2015E 2016E 2017E 2018E 2019CV Cash Flow From Operations Net Income 14,622 13,911 14,700 14,962 15,307 15,552 Adjustments to Net Income: Depreciation 15,567 15,754 15,959 16,661 17,055 17,396 Amortization 1,686 1,549 1,569 1,593 1,622 1,654 Change in defferred taxes 13,650 (3,000) (3,000) (3,000) (3,000) (3,000) Funds From Operations 45,525 28,214 29,228 30,216 30,984 31,602 Changes in working Capital Short term recievables 961 110 122 331 279 220 Inventories 23 37 (7) 26 22 17 Other Current Assets 94 Change in Current Liabilities Accounts Payable 12,699 (636) (110) 410 (215) 264 Other Current Liabilites (9,932) Net Cash from Operations 47,214 27,430 29,003 30,270 30,468 31,629 Cash flows from investing activities Capital Expenditures 16,635 16,924 17,327 18,327 18,940 18,646 Change in short term investments 34 Investments in advances (2,432) Long Term Note Receivable Other intangible assets 1,180 1,624 1,657 1,699 1,742 1,795 Other assets 577 66 78 95 107 126 Other liabilities 97 Net cash used for investing activites (15,897) (18,615) (19,061) (20,121) (20,789) (20,566) Cash flows from financing activities ST and Current LT Debt (2,330) Long term debt 20,292 Employee benefit obligations (1,912) Dividends paid in cash 6,191 9,042 9,408 9,725 10,064 10,342 Common Stock (26,439) 338 338 338 338 338 Treasury Stock 496 Change in deferred compensation 12 (19) (18) (17) (16) (16) Accumulated Comprehensive Income (1,108) Non-controlling interest (55,480) Net cash from Financing Activities (72,660) (8,723) (9,088) (9,405) (9,743) (10,020) Beginning Cash 53,528 12,186 12,278 13,132 13,876 13,812 Change in cash position (41,342) 93 854 744 (63) 1,043 Ending cash 12,186 12,278 13,132 13,876 13,812 14,855
18 VERIZON COMMUNICATIONS Common Size Income Statement (In Millions) Fiscal Years Ending Dec. 31 2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019CV Sales 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% COGS excluding D&A 41.38% 39.91% 37.24% 38.50% 38.50% 38.50% 38.50% 38.50% 38.50% Depreciation 13.52% 12.88% 12.46% 12.40% 12.12% 11.89% 12.12% 12.17% 12.22% Amortization of Intangibles 1.36% 1.33% 1.32% 1.34% 1.19% 1.17% 1.16% 1.16% 1.16% SG&A Expense 26.76% 27.75% 27.87% 26.80% 26.80% 26.80% 26.80% 26.80% 26.80% Operating Income 16.99% 18.13% 21.12% 20.96% 21.39% 21.64% 21.42% 21.38% 21.32% Non operating Income (Expense) 0.39% 0.35% 0.21% 1.44% 0.00% 0.00% 0.00% 0.00% 0.00% Interest Expense 2.55% 2.22% 2.21% 3.88% 4.46% 4.32% 4.22% 4.14% 4.08% Unusual Expense (Income) 5.37% 7.72% 5.17% 0.60% 0.00% 0.00% 0.00% 0.00% 0.00% Pretax Income 9.45% 8.54% 24.29% 17.92% 16.93% 17.31% 17.20% 17.24% 17.24% Income Taxes 0.26% 0.57% 4.75% 4.48% 5.93% 6.06% 6.02% 6.03% 6.03% Consolidated Net Income 9.20% 9.11% 19.53% 13.44% 11.01% 11.25% 11.18% 11.20% 11.21% Minority Interest 7.03% 8.36% 10.00% 1.79% 0.31% 0.30% 0.29% 0.29% 0.28% Net Income 2.17% 0.76% 9.54% 11.65% 10.70% 10.96% 10.89% 10.92% 10.93%
VERIZON COMMUNICATIONS Common Size Balance Sheet (In Millions) Fiscal Years Ending Dec. 31 2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019CV Assets Cash 12.05% 2.67% 44.40% 9.71% 9.44% 9.79% 10.10% 9.85% 10.44% Short Term Investments 0.53% 0.41% 0.50% 0.51% 0.49% 0.47% 0.46% 0.45% 0.45% Short Term Receivables 10.66% 10.87% 10.32% 10.67% 10.39% 10.16% 10.16% 10.16% 10.16% Inventories 0.85% 0.93% 0.85% 0.83% 0.83% 0.80% 0.80% 0.80% 0.80% Other Current Assets 3.81% 3.45% 2.83% 2.79% 2.69% 2.61% 2.55% 2.50% 2.46% Total Current Assets 27.90% 18.33% 58.89% 24.51% 23.84% 23.83% 24.07% 23.76% 24.30% Net Property, Plant & Equipment 79.76% 76.52% 73.79% 71.71% 70.13% 68.98% 68.56% 68.56% 68.40% Total Investments and Advances 3.11% 2.94% 2.85% 0.80% 0.77% 0.75% 0.73% 0.71% 0.70% Long Term Note Receivable 1.68% 1.26% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Intangible Assets 71.37% 72.23% 67.65% 64.56% 62.38% 60.52% 59.16% 58.09% 57.31% Deferred Tax Assets 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Other Assets 2.97% 2.31% 3.76% 4.07% 3.98% 3.92% 3.89% 3.89% 3.92% Total Assets 207.86% 194.41% 227.37% 185.27% 180.05% 176.35% 174.34% 172.60% 171.94% Liabilities & Shareholders' Equity ST Debt & Curr. Portion LT Debt 4.37% 3.77% 3.26% 1.28% 1.23% 1.19% 1.17% 1.14% 1.13% Accounts Payable 3.78% 4.09% 4.11% 14.06% 13.09% 12.60% 12.60% 12.20% 12.20% Income Tax Payable 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Other Current Liabilities 19.59% 15.41% 15.07% 6.56% 6.33% 6.13% 5.99% 5.87% 5.78% Total Current Liabilities 27.74% 23.27% 22.44% 21.90% 20.65% 19.93% 19.76% 19.22% 19.11% Long Term Debt 45.37% 41.10% 74.37% 87.59% 84.56% 81.94% 80.00% 78.43% 77.24% Provision for Risks & Charges 29.72% 29.65% 22.96% 20.53% 19.82% 19.21% 18.75% 18.38% 18.10% Deferred Tax Liabilities 22.60% 21.30% 23.76% 33.69% 30.22% 27.05% 24.22% 21.61% 19.17% Other Liabilities 4.94% 5.26% 4.69% 4.58% 4.42% 4.29% 4.18% 4.10% 4.04% Total Liabilities 130.37% 120.58% 148.22% 168.28% 159.66% 152.41% 146.92% 141.74% 137.67% Common Equity 43.36% 43.44% 43.38% 13.38% 13.77% 14.15% 14.53% 14.92% 15.30% Total Shareholders' Equity 32.44% 28.62% 32.22% 16.11% 19.55% 23.12% 26.62% 30.07% 33.50% Accumulated Minority Interest 45.04% 45.21% 46.93% 0.88% 0.85% 0.82% 0.80% 0.78% 0.77% Total Equity 77.48% 73.83% 79.15% 16.99% 20.39% 23.94% 27.42% 30.85% 34.27% Total Liabilities & Shareholders' Equity 207.86% 194.41% 227.37% 185.27% 180.05% 176.35% 174.34% 172.60% 171.94% 19
20 VERIZON COMMUNICATIONS Weighted Average Cost of Capital (WACC) Estimation Rf is equal to 30 Year Treasury VZ VERIZON COMMUNICATIONS Price $51.40 D $122,749,842,569 S.O. 4,152,180,195 E $213,422,062,000 Leases $11,196,842,569 wd 0.37 Long Term Debt $109,950,000,000 we $ 0.63 ST Debt & Curr. Portion LT Debt $1,603,000,000 Beta e 0.70 t 35.00% rd 5.20% re 6.47% mrp 4.64% rf 3.22% r* 5.34%