Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
2017 has not been a great year for Verizon Communications (NYSE:VZ) shareholders. Verizon stock has lost 15% of its value since the year began, and with barely a month remaining in the year, there's not much time left for Verizon to make up for lost ground.
Next year, however, could be another matter.
Earlier this morning, investment banker Wells Fargo announced it is upgrading Verizon stock to outperform and assigning the stock a $50 price target over the next 12 months. If the analyst is right, 2018 could see Verizon make up much of its losses from 2017, and deliver a 10% profit -- and Verizon's generous 5.2% dividend yield on top of that.
Here are three things you need to know.
1. What's wrong with Verizon today
Verizon reported its fiscal Q3 earnings numbers last month. Revenue inched up only 2.5% year over year to $31.7 billion, and profits were flat at $0.89 per diluted share. Within the company's two main business segments, however, results differed wildly.
Verizon's biggest business segment is wireless, with $21.6 billion in revenue last quarter. But while overall revenue grew at Verizon, revenue in the wireless segment declined 2.4%, and revenues from wireless service in particular declined 5.1%. Operating profit was also down 0.6%, but margins remained robust at 35.2% operating profit margin for the quarter.
Things were both better, and worse, in Verizon smaller wireline business (landlines and Fios). Here, Verizon boasted a 1.1% revenue growth rate, but profits declined 11% year over year, and wireline still remains mired at a minuscule 0.8% operating profit margin.
In short, the news was not great at Verizon last quarter. And yet, according to Wells Fargo, now that Q3 is in the rearview mirror, "much of the bad news is behind the stock." In Wells' opinion, the wireless business is in a trough right now. But going forward, Wells Fargo believes that more "rational pricing" among competing wireless providers will boost revenue in Verizon's wireless division.
If Wells is right about that, the strong profit margins that Verizon earns in wireless should yield substantial profit growth as revenue resumes growing.
As TheFly.com explains today in a note on Wells Fargo's upgrade, however, the analyst sees the greater opportunity for improvement in Verizon's wireline division. According to the analyst, Verizon's continued investments in fiber technology should "generate material cost savings" for the company. Fiber may even reduce Verizon's costs of constantly acquiring new customers to replace old customers lost due to customer churn.
Earlier this month, J.D. Power and Associates surveyed more than 26,000 cable and internet users and concluded that Verizon's television and internet services are "Highest Ranked by Customers for Residential Internet and Television Service Satisfaction in the East." Polling customers on such subjects as network performance and reliability, cost of service, billing, communication, customer service, and programming choices, J.D. Power found that even in an industry as disliked as cable television, customers at least seem to prefer Verizon over alternatives such as Comcast, Cox, and Charter.
(For the record, and to be fair, both Charter and Cox topped J.D. Power's rankings in the American South and West regions, respectively. In the North, AT&T trumped all comers. But in the one region where Verizon was allowed to compete head to head with these rivals, it came out on top.)
Verizon by the numbers
On top of all this, Wells Fargo also argues that with its 15% decline in share price since the year's beginning, Verizon's valuation is looking more attractive today -- but it's here that I fear Wells Fargo's reasoning breaks down.
Wells Fargo starts off by describing Verizon as an "attractive yield play" based on the company's 5.2% dividend yield -- well and good. The problem is that Wells Fargo then goes on to praise Verizon for its improved free cash flow, and arguing that this, too, is a mark in Verizon stock's favor.
But it isn't.
Over the past four reported quarters, Verizon has earned just over $15.9 billion in reported net income under GAAP, resulting in an enticingly low (-seeming) P/E ratio of just 11.7. Problem is, Verizon's free cash flow number entirely fails to back up that reported profit. Cash from operations at Verizon over the past year has amounted to $22.2 billion. Unfortunately, minus $16.9 billion in capital expenditure, that leaves free cash flow of only $5.3 billion for the period. Divided into Verizon's $185.3 billion market capitalization, this results in a price-to-free cash flow ratio of 35 -- much more expensive than the stock's low P/E ratio makes it appear.
Whatever the prospects for a revival of revenue growth at Verizon's wireless division, and whatever Verizon's chances of pulling its wireline operating profit margin back above 1%, I simply don't believe these prospects are great enough to justify paying 35 times free cash flow for Verizon stock today. If you ask me, Verizon Communications stock simply costs too much.
Wells Fargo is wrong to recommend it.
Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool recommends Comcast. The Motley Fool has a disclosure policy.