Verizon's (VZ 0.78%) third quarter was its chance to prove what it's been saying for several quarters now is true. Management said it expected service revenue, which decreased for the 11th straight quarter in the second quarter, would start to show improvements in the second half of this year.
Sure enough, Verizon showed an improvement in its service revenue, climbing about 1.4% sequentially in the third quarter from the second quarter low. The turnaround was helped by a net addition of 274,000 postpaid phone subscribers. That's the second straight quarter where Verizon has added postpaid phone subscribers after several quarters of declining results.
The trend coincides with Verizon's decision to join competitors like T-Mobile (TMUS 0.17%) and Sprint (S) in offering an unlimited wireless data plan. Management also noted it expects the trend to continue in the fourth quarter.
Moving in the right direction
Competitive pressure from T-Mobile and Sprint resulted in Verizon losing a lot of postpaid phone subscribers and offering lower-priced plans to retain its existing customers. Combined with pressure from the switch from subsidized smartphone contracts to equipment installment plans -- where device and service billing are separated -- resulted in an extended decline in service revenue.
The good news for Verizon investors is that the last two quarters show several promising signs on all fronts. First of all, T-Mobile is becoming less aggressive as it's starting to focus on growing cash flow. A successful merger with Sprint would further lower competitive pressure, but significant hurdles still remain for the two companies to join forces.
Second, the percentage of Verizon's phone activations and customers on device payment plans has stabilized over the last four quarters. Forty-nine percent of Verizon subscribers are on a device payment plan and 77% of new activations are on a payment plan. Those numbers have been relatively flat over the past year. Thus, the pressure from the shift to service-only contracts appears to be over.
Perhaps the most promising trend is the return to growth in postpaid phone subscribers, which contribute much more in service revenue than connected devices. Verizon's unlimited plan is to thank, as management made clear in its first-quarter earnings call. Before introducing the unlimited plan, Verizon had lost nearly 400,000 postpaid phone subscribers in the first six weeks of the first quarter. It ended up losing just 289,000 that quarter, and it's added 358,000 and 274,000 in the subsequent quarters. Naturally, more customers mean more service revenue.
Keep an eye on costs
While service revenue is starting to head in the right direction, Verizon's cost of services is also increasing. In fact, cost of services was up 2.8% sequentially from the fourth quarter, growing twice as fast as service revenue.
The increase in cost of services likely stems from the unlimited plan as well. The new plan puts a strain on Verizon's network, especially considering the early adopters of the new plan are most likely to take full advantage of their new freedom to use as much data as they like. Verizon has already shown signs that its network is having trouble keeping up with the demand for data.
Verizon recently introduced a lower-tier unlimited data plan, which throttles video quality down and restricts speeds when using the phone to connect to the internet through another device. The move puts its plan and pricing nearly in line with T-Mobile's, and it should help reduce cost of services.
The line item will be one for investors to continue to monitor alongside continued increases in service revenue. If the growth in revenue doesn't eventually start outpacing the costs to provide that service, it's not doing a whole lot of good for investors.