I once considered both Verizon (VZ +0.27%) and AT&T (T 0.40%) to be stable sources of income and solid defensive plays in tumultuous times. However, I recently decided to sell Verizon and keep AT&T, since the growing rift between the two telcos indicates that the former could fare worse than the latter over the next few years.
Verizon's digital expansion plans are risky
My main reason for selling Verizon is my lack of faith in its digital expansion strategy. Verizon is currently trying to reinvent itself as a digital content provider and ad platform, and that transformation is a pricey and risky endeavor.
Last June, it spent $4.4 billion on AOL, a company which eMarketer estimates controls less than 2% of the U.S. digital ad market. AOL then took over Microsoft's (MSFT 1.33%) display ad business in exchange for switching AOL's default search engine from Alphabet's Google to Bing. However, the deal simply looked like Microsoft was dumping a dying business. eMarketer estimates that Microsoft's share of the U.S. digital ad market will fall from 4.5% in 2015 to 4.2% in 2017.
Verizon then acquired mobile ad and app monetization company Millennial Media for $250 million, which eMarketer estimates accounts for just 0.3% of U.S. mobile ad revenues. Based on those estimates, the three ad businesses that Verizon gained might generate about $4.3 billion in sales this year. However, that would only account for about 3% of the telco's projected sales for 2016.
Verizon's Go90. Image source: Verizon.
Verizon then launched Go90, a data-free streaming video platform similar to T-Mobile's Binge On, but the company admitted during last quarter's conference call (as transcribed by Thomson Reuters) that the service remained in the "very early stages of gaining traction and engagement." It also recently acquired 50% of Complex Media, an online magazine covering music, styles, pop culture, and sports, sharing it with media giant Hearst. It's unclear how Verizon plans to pull all these pieces together to coherently expand its digital ecosystem.
The shopping spree hasn't ended
But Verizon's spending spree isn't over -- analysts have speculated that the company might spend billions more on Yahoo, or even scoop up troubled music streaming services like Pandora.
There are two big problems with Verizon's growth plan. First, it's assembling an army of also-rans, similar to what Microsoft did by acquiring online advertiser aQuantive and Nokia's handset business -- which both resulted in billion dollar writedowns. Second, Verizon's total debt hit $109.9 billion last quarter, giving it a debt to adjusted EBITDA ratio of 2.2. Selling various landline services has helped extinguish some debt, but those divestments might not be sufficient to cover bigger purchases down the road.
AT&T has a slightly higher ratio of 2.3, but it doesn't seem interested in pursuing any more big acquisitions after its $49 billion takeover of DirecTV. Buying DirecTV makes AT&T the top pay TV provider in the world, offsets its loss in landline-tethered U-Verse customers, and gives it new growth opportunities in Latin America, all while boosting its free cash flow -- which translates to solid earnings and dividend growth. Those benefits are much easier to understand than Verizon's scattergun attempt to build a digital content and advertising ecosystem.
Verizon has also had a much rockier history with unions than AT&T. While AT&T quickly reached new agreements with wireline unions earlier this year, Verizon engaged the unions in a lengthy, PR-damaging standoff. In late May, Verizon finally warned that the strike could hurt its second quarter earnings, before finally agreeing to raise wages and create new jobs.
AT&T has better growth prospects
Analysts currently expect AT&T's revenue and earnings to respectively improve 12.5% and 5.5% this year. That growth is expected to be fueled by robust demand for its pay TV services, wireless gains in domestic and overseas markets, and new services for connected cars and other Internet of Things devices. The company is also expected to grow its annual earnings by 8.2% over the next five years -- which outpaces the domestic telecom industry's projected growth rate of 6.4%.
Verizon is expected to post a 2.7% decline in revenue and a 1% decline in earnings this year. The company's attempts to grow inorganically are expected to weigh heavily on both the top and bottom lines, and the new businesses could cause big writedowns if they aren't properly integrated. Over the next five years, Verizon's annual earnings are expected to grow just 3.6%.
The key takeaway
I still think Verizon and AT&T are both decent long-term investments for conservative investors. But if you own both stocks, you might want to consider selling the former and keeping the latter. Verizon might be biting off more than it can chew, and its investors could be burned if its digital expansion plan falls apart.
