The 5G Dream Could Turn Into a Nightmare for Verizon

Verizon Communications (VZ -0.53%) has been a leader in the wireless space for so long that many believe the company will retain its lead once 5G goes mainstream. Customers and investors alike are reminded constantly about Big Red's network dominance. While Verizon seems to be the leader in 4G, the 5G race is far from over. The company relies on premium wireless pricing to generate significant free cash flow. If the company loses its network lead, Verizon's slow growth could turn negative as subscribers look for a better value elsewhere. Verizon's stock hasn't exactly set the world on fire over the last few years and this was with the benefit of a better network and pricing power. If the 5G race isn't led by Verizon, the company may be forced to cut prices to compete. Slower or negative growth, coupled with lower free cash flow, could leave Verizon investors seeing red.

When best becomes a relative term

When cellphones were mainly for phone calls, the best voice network was of utmost importance. As more people move away from traditional phone calls to Marco Polo, FaceTime, games and more, voice coverage is still important, yet data speeds are nearly as critical.

Image source: Getty Images

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According to WhistleOut , Verizon offers the best nationwide 4G coverage. Verizon's CEO seems to agree, saying the company received  "confirmation from RootMetrics that our 4G network is clearly the best in the market." However, the Verizon lead has narrowed over the last few years and appears ready to narrow even further.

The same study suggested that AT&T (T 1.88%) gives its users reliable coverage and its network provided the fastest download speeds of the major carriers. In the past, T-Mobile (TMUS 0.57%) seemed stuck permanently in third place. However, the story changes when we combine Sprint and T-Mobile under one roof. T-Mobile was found to be only 0.50% less reliable than Verizon. The difference between the Opensignal study and the future of these companies is tied heavily to 5G coverage. According to recent information , the combination of T-Mobile and Sprint, "owns more radio spectrum than AT&T or Verizon."

With an inferior network, T-Mobile just posted the 25th consecutive quarter (over 8 years!) leading the industry in branded postpaid phone net customer additions. T-Mobile put Verizon and the rest of the industry on notice in its 2019 annual report. The, "New T-Mobile's network will be able to offer unmatched value to consumers, with better service at lower prices." In short, the company plans to continue offering value pricing, but has a chance to combine this with a leading 5G network. Verizon has historically competed on network dominance, if it cedes that crown to T-Mobile, this creates another challenge of maintaining its premium pricing model.  

Verizon's pricing power problem

"The next generation of wireless technologies...promises blazing-fast data transmission speeds. ... Its higher data speeds could make smartphones much more comparable to PCs, giving them better multimedia and gaming capabilities." It might surprise you to know that these statements are from an article about 4G that is nearly ten years old.

In the last five years, Verizon has essentially owned the 4G market when it comes to coverage.  However, the stock price's compound annual growth rate is a less-than-inspiring 3.3 %. It's true that the stock has offered a decent yield, yet T-Mobile's compound annual rate of return during this same time frame exceeds 20%. In short, while Verizon had the clear network advantage,  T-Mobile's stock has been the superior investment.

For years T-Mobile has undercut its peers on pricing while Verizon took the high road. In 2017, T-Mobile's unlimited plan was called, "the best value in this (unlimited) category." In 2018, T-Mobile's One Plus plan was cheaper at multiple points than either AT&T or Verizon's similar plans. Late last year, Fortune talked about unlimited plan pricing saying that T-Mobile, "has already (been) charging less than its two larger rivals." Given that Verizon was able to generate net additions to its customer base during this time, clearly Verizon's superior network provided the company pricing power. If we look at how Verizon's plans are priced today, we find history repeating itself. 

(Data source: AT&T, T-Mobile, and Verizon. Table by author.)

It's not surprising that T-Mobile has been adding customers in droves  given the pricing difference between the big three carriers. At $5 to $10 cheaper per month, per line, T-Mobile already seems like a better deal. When you add the iPhone 11 at a price $149 to $349 cheaper, customers are getting a much better deal. The company has been generating positive cash flow and significant growth in the current 4G race. T-Mobile has been growing fast by taking value hunting customers from other carriers. The company's potential to lead 5G would suggest T-Mobile can continue to grow subscribers while keeping its value pricing. Given the saturation in the domestic market, it's hard to imagine Verizon undercutting others to continue growing subscribers if it doesn't have the superior network. 

Growth and income or better returns? The choice seems obvious

Given the significant disruption that COVID-19 has caused in the marketplace, it seems reasonable to compare financials from the end of 2019. We will use the new T-Mobile's calculated numbers from the separated T-Mobile and Sprint.

Let's get the obvious out of the way first: AT&T offers investors a yield of roughly 7%, and Verizon currently pays about 4.5%, while T-Mobile has no dividend. Looking at each company's financials, we get a sense of each company's strength and opportunities.

(Data source: AT&T, T-Mobile, Sprint, and Verizon. Table by author. *T-Mobile figures are the combination of end of year financials and customer counts from T-Mobile  and Sprint  – Adjusted Free Cash Flow = net income + depreciation – capital expenditures)

Verizon's lead in Mobility Service revenue is clear and this high margin business contributes significantly to the company's superior adjusted free cash flow. Many investors own or acquire Verizon stock due to the company's strong yield. If Verizon isn't able to maintain its lead in wireless coverage into the 5G era, its Mobility Service revenue would suffer. On the flip side, the New T-Mobile is only projecting free cash flow to "be in the range of $1.3 to $1.5 billion for 2020. ." Of course, that isn't the full story as the company expects to achieve over $40 billion in synergies over the next several years. T-Mobile already is growing its postpaid phone subscribers faster than its peers without Sprint. The New T-Mobile could end up with the better network, better pricing, and faster postpaid subscriber growth.

In the end, the 5G dream that Verizon investors are having could turn into a nightmare. If T-Mobile can turn its superior spectrum ownership into superior 5G coverage, Verizon loses its most powerful pricing tool. Investors looking for a better dividend may begin to turn to AT&T as it carries a premium yield and has a more diverse revenue stream. Between AT&T's better yield and T-Mobile's better growth potential, it's challenging to recommend acquiring Verizon at this time.