Warren Buffett Bought Verizon Communications Inc: Has He Lost His Mind?

Is Warren crazy to buy a slow-growth telco with a huge debt pile?

Jun 13, 2014 at 11:01AM

When it was revealed that investing guru Warren Buffett bought nearly 11 million shares of Verizon (NYSE:VZ), the result was a proverbial head-scratch. What did he see in this low-growth telephone company -- enough so to put $530 million to work in it?

Before we begin, it's important to reiterate that Warren Buffett is considered the foremost value investor. What is he seeing that the market isn't in this seeming debt-bloated, stodgy telecom that's averaged only 2.8% top-line growth postrecession (2009) and that's recently issued nearly 1.3 billion shares? Is Warren crazy? Yes, like a fox.

About that debt ...
As it's been reported, and reported again, Verizon sold $49 billion of bonds in the largest corporate debt offering ever in September at an average yield to maturity of approximately 5%. This move increased its debt-to-equity ratio to nearly 15 -- a figure that should give most CFOs heartburn.

So, you have an investment that is struggling to match inflation with top-line growth, balance-sheet-busting debt issuance, and on top of that it's watering down shareholders too. What gives Warren?

A little history on Verizon
Before we begin, it is important to understand that Verizon Communications is a parent company with multiple lines of business in the broadband and telecommunications space. Those lines of business include wireless, residential and small business service, and enterprise services. But the crown jewel of Verizon Communications is Verizon Wireless -- but it didn't even own that business entirely.

In early 2000, Verizon Communications started as a merger between Bell Atlantic and GTE, but prior to this Vodafone (NASDAQ:VOD) and Bell Atlantic had a joint venture to establish a wireless company. The end result was the start of Verizon Wireless -- 55% owned by Verizon Communications and 45% owned by Vodafone.

Suffice to say, the communications landscape was much different then and this joint venture quickly turned into a windfall for Vodafone at the expense of Verizon Communications and its shareholders.

Here's why Warren's right
Just to show how big of a windfall this is, Verizon Communications reported $12 billion in minority earnings on its last 10-K. For reference, its total net income (ex-minority earnings) was $11.5 billion. The majority of that $12 billion is going directly to Vodafone -- and not to Verizon Communications shareholders. As a hypothetical, if Verizon had no minority interests the company would have reported $8.19 per share in earnings.

Of course, this doesn't work in a vacuum. Vodafone needs remuneration for that investment. And, you got it, that's exactly why Verizon Communications issued both debt and stock.

The best way to determine these effects on Verizon's income statement is to adjust the income statement to reflect these changes. So as an apples to apples, ceteris paribus comparison, let's look at an appended 2013 income statement both on an actual and pro forma basis considering Verizon owns its wireless segment entirely.

Line ItemVerizon ActualVerizon (pro forma)
Net Income to Company $23,547 $21,534*
Net Income to Non-Controlling ($12,050) ($2,250)**
Net Income $11,497 $19,284
Weighted Average Shares 2,866 4,140***
Net Income Per Share $4.01 $4.66

Source: 10K, pro forma author's calculations, units in millions
*Deducted new interest income, net of taxes. **Author's Calculation ***Included new share issuance

So it appears that Verizon will increase their earnings around 16% from the switch, although these figures do include an estimate of net income to noncontrolling pro forma. For comparison, Verizon's management seems a little less sanguine on the prospects, stating "the transaction is immediately accretive to Verizon's earnings by approximately 10%, excluding any non-operational adjustments." Either way, not bad for a company only trading at a price-to-earnings ratio of 11.

Now, about that top-line growth ...
The last issue is one of revenue growth. Although investors ultimately pay for earnings, and we've just covered how Verizon immediately improved them, we'd all like to see a company improving their top line as well. What's Verizon going to do in the face of other wireless carriers like T-Mobile and Sprint waging aggressive price wars? Listening to the analyst chatter, one would assume there is a race to the bottom in terms of cell phone contract pricing that will only get worse if the FCC allows T-Mobile and Sprint to merge. It's a simple story, but it isn't true.

If Sprint and T-Mobile are cleared for a merger, the end result is an oligopoly -- a market defined by a few major players. Typically, oligopolies are characterized by inflexible pricing and collusive pricing arrangements -- the exact opposite of what the Street assumes.

In addition, savvy investors should keep an eye on what happens in the net neutrality space. Aside from the tit for tat Netflix is having with Verizon, many have already forgotten that Netflix is paying Verizon for faster speed. If further decisions are made to weaken net neutrality, look for more websites to pay Verizon for faster delivery.

Final Foolish thoughts
Time after time, Warren Buffett has outperformed the Street by applying a simple fundamental approach: buy great companies at a discount. Once again, he's found a jewel in Verizon and investors would be wise to look into this dividend-paying value play. As for me, as soon as trading rules allow I'm putting my money to work with Warren in this investment.

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Jamal Carnette has no position in any stocks mentioned. The Motley Fool recommends Netflix and Vodafone. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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