What's Wrong With Verizon Communications, Inc. Today?

Image source: Verizon.

Thursday was a tough day at the office for Verizon Communications (VZ 0.88%) shareholders. First, Verizon reported strong sales and perfectly acceptable earnings for the fourth quarter of 2014. Then, investors dug deeper into the report and started a 2% sell-off on Verizon's shares.

If you're scratching your head over that market reaction, you're surely not alone. So let me explain what's going on here.

First, Verizon's fourth-quarter results really did hit the mark. Adjusted earnings rose 8% year over year to land at $0.71 per share, right in line with Wall Street's average estimates. Revenues increased by 7% to $33.2 billion, just a hair above analyst targets at $32.7 billion.

FiOS fiber-based services drove a modest increase in wireline sales, and Verizon Wireless added 2 million net new contract subscribers.

All of these numbers are perfectly fine, and in some cases downright great. Strong FiOS growth and 2 million postpaid wireless customers would fall in the second category.

So what's wrong with this report, then?

Analysts quickly pointed out that Verizon's reported results and forward guidance tell a grim tale about the company's profit margins. Verizon is relying too much on low-margin hardware sales, and not enough on high-margin service revenues. Wireless EBITDA profit margins fell 8% year over year, and there are no obvious signs of improvement.

Verizon prefers to put a positive spin on the margin pressures, of course. In a call with analysts, Verizon CFO Fran Shammo acknowledged "short-term pressure of significant device volumes in the fourth quarter." EBITDA margins in 2015 were guided to "a level consistent with full-year 2014 performance."

For Verizon bulls and insiders, that's good news because the margins aren't supposed to drop any further. On the bearish side of the fence, however, you could focus on how Verizon doesn't see a way out of this margin trough in 2015.

From that bearish point of view, Verizon just might have picked a terrible time to buy out Vodafone's (VOD) 45% interest in Verizon Wireless. The $130 billion megadeal gave Verizon full control right at the peak of the wireless division's earnings powers. If Verizon can't turn the shrinking profit margins around someday soon, Vodafone will have walked away with a top-dollar ransom for a terrible long-term business.

That's the thinking that led to Verizon's falling share prices on Thursday, in spite of a perfectly serviceable earnings report.

Blue skies ahead, or stormy weather just beyond this Verizon-owned cell tower? Image source: author.

Is that a fair reaction?

Well, you already know that smaller rivals T-Mobile USA (TMUS 0.47%) and Sprint (S) are putting pressure on Verizon's and AT&T's (T 1.30%) margins by offering lower-cost services and innovative customer-grabbing promotions. Verizon and Ma Bell have been able to defend their juicy profit margins by investing in high-quality voice and data networks, but that approach may not work forever.

For example, T-Mobile has found a workaround for its questionable wireless network quality by adding Wi-Fi calling features to all of its smartphones. As long as you're in range of a decent Wi-Fi network, you'll be able to enjoy good call quality on T-Mobile phones.

If this approach catches on, and Wi-Fi networks continue popping up on every street corner, T-Mobile customers might not care about the wireless network's quality much longer. If and when that happens, Sprint can't be far behind with a similar Wi-Fi plan. That would undermine Verizon's network-quality sales pitch even further, perhaps forcing Big Red to compete on plan prices like everybody else. And then today's Verizon bears would be proven right.

My crystal ball is unfortunately in the shop for an annual tune-up, so I don't have a perfect view of the wireless industry's future right now. What I can say for sure is that the second-tier major networks will continue their full-court press on Verizon and AT&T in 2015, and that they have a pretty good track record of driving business model changes in recent years.

So I'd be surprised to see Verizon defending its wireless EBITDA margins much longer, to say nothing of driving them further up. Then, in 2016, the next round of wireless spectrum auctions come along with strict bidding rules that will change the game in a hurry.

In short, I'd be very uncomfortable owning AT&T or Verizon shares right now -- or at any point in the last three years. There's drastic change in the wireless air, and that's never good news for the incumbent market leaders.