Fran Shammo doesn't want to be in the financing business. The Verizon (NYSE:VZ) CFO was the last major holdout in the shift from smartphone subsidies to smartphone financing. Until last quarter, he would bundle up all of the company's phone installment contracts into securities and sell them to banks.
But Shammo is changing things up. Verizon is looking to issue a $1.2 billion bond on the public market backed by those phone contracts. The move will have a major impact on Verizon's financial reporting, and Shammo hopes it will reduce the company's overall credit costs.
Changes in financial reporting
Importantly, the cash raised by the bond offering won't show up in the company's cash flow from operations. When Verizon sold its securitized contracts to banks, that cash went through cash flow from operations. However, that cash generally comes at a higher cost than the cash generated by its regular operations of selling wireless and TV services.
The bond will show up instead on Verizon's cash flow from financing activities and appear on its balance sheet -- though, the precise structure of the bond offering has yet to be determined, so details like its interest rate or its structure on the balance sheet are still unknown.
Why does Verizon want to put more debt on its balance sheet?
For a company that already has over $100 billion in debt on its balance sheet, it may seem odd to investors that Verizon would pile more on top of that. Shammo says it sells an average of $2 billion in securitized smartphone loans to banks every quarter, so that implies Verizon will add another $16 billion or so -- $2 billion per quarter for two years -- to its total debt when it's fully transitioned to the on-balance-sheet financing.
Shammo believes that the structure of the deal will reduce Verizon's borrowing costs. Fitch found that nearly one-third of the loans backing the bonds were made to borrowers with subprime credit ratings and up to 40% of the pool could become subprime -- though Verizon expects a default rate of just 5%. The bond has three tranches with the lowest tranche protected from the first 18.7% of losses. That means Verizon could very likely achieve lower interest payments than with its legacy securitization method.
Expect other carriers to follow
The move is extremely smart for Verizon, and investors should expect other carriers, such as AT&T (NYSE:T) and T-Mobile (NASDAQ:TMUS), to follow suit. T-Mobile has fewer subscribers than Verizon and AT&T, but every handset it sells is through financing. Comparatively, Verizon sold only 68% of its phones through installment plans in the first quarter, and AT&T says 90% of smartphone activations in the first quarter were either financed or the customer brought their own device.
AT&T may, in fact, benefit more than Verizon if it can sell similar asset-backed bonds. It caters to a similar high-end customer base, which should produce similar default rates for the loans backing the bond. With more phone installment plans, AT&T is probably carrying a larger amount of unsecured debt (as the credit rating agencies see it) than Verizon, dragging down its overall credit rating.
T-Mobile historically caters to customers with lower credit ratings. Last year it started running a promotion whereby if you pay your T-Mobile bill on time for 12 months straight, you can qualify for a $0 down, 0% interest loan on a new phone regardless of your credit score. That's going to affect T-Mobile's cost of financing one way or the other, but it could certainly make it less attractive by comparison to investors in the public market.
Still, investors should expect T-Mobile and other carriers to follow Verizon's lead.
Editor's note: A previous version of this article said Verizon expects a credit ratings increase based on CFO Fran Shammo's comments. A spokesperson says that is not the case, and the transition will not impact the company's credit rating.
Adam Levy owns shares of Verizon Communications. The Motley Fool owns shares of and recommends Verizon Communications. 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.