2014 did not end on a bright note for Verizon Communications (VZ 3.13%). While the company produced satisfactory growth throughout 2014, investors were nevertheless selling the stock as the year drew to a close. Verizon's stock price fell roughly 6% just in the final month of the year. This was based on fears over what the fourth quarter holds for the company's margins, due squarely to recent tactics employed by Sprint (S). In December, the No. 3 wireless carrier unveiled a "Cut Your Wireless Bill in Half" promotion in which Verizon and AT&T customers can switch to Sprint for a comparable plan at half the cost. As a kicker to the offer, Sprint will also cover early termination fees and activation fees.
Sprint's move led Verizon to offer its own promotions in the fourth quarter to retain customers, which means Verizon's margins are likely to contract this quarter and growth in certain metrics like average-revenue-per-account is slowing down somewhat. For example, Verizon's ARPA grew at just 3.5% last quarter, year-over-year, which was below the historical rate of around 5%. Sprint launched its limited-time half-off deal on Dec. 5. For the fourth quarter, Verizon management warned investors to expect slightly lower wireless margins and higher-than-normal churn. However, Verizon is confident it will return to historical levels in the first quarter of 2015. Verizon's margin compression should be a short-term issue and not a long-term problem.
Verizon's core objective remains intact
Investors should remember that even if margins contract slightly for one quarter, Verizon still carries industry-leading margins in wireless. To that end, Verizon's wireless EBITDA margin stood at 49.5% last quarter, compared to AT&T's 43% in the same period. Verizon's mission is to attract "high-quality" customers, not necessarily the most customers, because so-called high-quality customers purchase high-quality 4G and 4G LTE services, which carry higher margins. Verizon stated on Jan. 6 that wireless margins will very likely return to normal next quarter. Verizon had reported strong customer service upgrades, which coincide with new device launches. While customer churn will be higher than normal for the quarter, and the company says wireless margin will suffer slightly, this is all no reason for Foolish investors to sell the stock.
In December, Verizon reported strong momentum for customer growth and adoption, which contradicts the assumption that Sprint's price war strategy will deal its rival a serious blow. New models of phones and tablets are fueling just the type of upgrades that Verizon is after. Verizon noted in early December that 75% of fourth-quarter upgrades were high quality, which describes either a high-quality customer or someone upgrading from 3G to 4G. After all, Verizon Wireless is the nation's largest 4G LTE network, and Verizon has now rolled out its ultra-fast XLTE network, which offers double the bandwidth of 4G LTE, in more than 400 U.S. markets.
Another mitigating factor is that even customers who have trouble with Verizon's premium pricing are being offered measures of flexibility. Nearly one-quarter of upgrading customers are choosing the Verizon Edge program, double the rate from just the previous quarter. Verizon Edge allows customers to upgrade their phones early and pay for the devices over a two-year period rather than immediately.
The caveat to this, of course, is that Verizon can only retain high-quality customers at premium pricing if its network remains of higher quality than its rivals'. If not, then Verizon subscribers would have little incentive to stay. What makes this a short-term issue is that carriers can only undercut on price for so long. As Verizon Chief Financial Officer Fran Shammo said in a Q&A session at the UBS 42nd Annual Global Media and Communications Conference on Dec. 9, promotional activity in the telecommunications industry is inherently temporary.
Carriers can only sustain the quality of their networks if they are generating enough cash flow to reinvest in the network. Sprint's strategy might lure a certain number of customers, but without enough profitability from those customers, the company's network investments bear the brunt. Before long, customers will remember the merits of paying above-average pricing for Verizon's network. Indeed, Sprint readily acknowledged that customers who switch over as part of its promotion will likely face usage limitations, as existing customers take precedence for bandwidth availability, and that data throughput could be limited or reduced. Plus, Verizon has already seen promotional activity wind down as the fourth quarter ends, which suggests 2015 will be a return to more normal operating conditions once Sprint blinks first.
Hold through the rough period
On a valuation basis, Verizon looks attractive. The stock trades for about nine times trailing earnings and 12 times forward earnings estimates. These multiples are cheaper than both the overall market and Verizon's closest competitor, AT&T, which trades for 10 times trailing and 13 times forward earnings-per-share estimates. Moreover, Verizon's valuation multiples are very close to their five-year lows, which indicates the market isn't giving the company much credit for what it does right. And let's not forget Verizon's juicy 4.8% dividend yield, which pays you well to wait for the rough patch to pass.
While Sprint's strategy will bring down Verizon's wireless margin in Q4, as Verizon has to some degree resorted to margin-eroding promotions to keep customers, this is likely to be a short-term issue. Furthermore, Verizon continues to accelerate high-quality customer upgrades to 4G. It is also worth noting that Verizon still expects margin expansion this year in its wireline business, which represents nearly one-third of its total revenue, thanks to FiOS adoption. When combined, these mitigating factors should keep Verizon's long-term earnings growth intact. This is why it would be foolish (with a small-f) for investors to sell Verizon right now.
