Verizon (NYSE:VZ) is betting as much as $7 billion on the prepaid wireless industry. The wireless carrier recently announced its proposed acquisition of TracFone Wireless from America Movil. The deal seems like a smart move by Verizon, as it gives the company millions of new customers at what seems like a reasonable cost. If Big Red can cross-sell these customers postpaid plans or high-speed internet, this will have been a steal.

What happened?

Verizon is spending $3.1 billion in cash and $3.1 billion in stock to acquire TracFone. In addition, Verizon will pay additional $650 million to America Movil, depending on the performance of TracFone. In total, Verizon would be on the hook for $6.9 billion.

The deal will still need to go through regulatory approval, which could be a concern for investors. T-Mobile (NASDAQ:TMUS) already has over 20 million prepaid subscribers, and AT&T (NYSE:T) has about 18 million. However, 4 million existing  Verizon prepaid customers, added to 21 million TracFone subscribers, means Verizon will jump into first place in the prepaid market.

Image of a man holding a cell phone showing interaction with apps.

Image source: Getty Images.

Given  that Verizon already holds the lead in postpaid  subscribers, regulators may be hesitant to have the same company leading in both postpaid and prepaid wireless. TracFone sells prepaid wireless under the TracFone, Straight Talk, and Simple Mobile brands. It's possible that regulators could decide that one of these brands must be spun off or sold. While investors should keep an eye on this, it doesn't present an immediate threat to Verizon's stock.

TracFone has been buying network capacity from Verizon along with other  carriers for its service. This deal puts Verizon in the driver's seat as theoretically TracFone's sole network provider. TracFone should provide a funnel of prepaid customers that Verizon can potentially upsell on 5G service, postpaid plans, high-speed internet, or even Fios TV.

Is TracFone competitive?

Verizon investors looking at the potential benefit of the TracFone acquisition, should first consider if the prepaid wireless carrier is competitive. After all, if TracFone doesn't offer competitive pricing, or offers worse coverage than its peers, this acquisition may not be worth Verizon's time or money. Happily, whether we look at a TracFone plan, Metro prepaid by T-Mobile, or AT&T Prepaid, the companies offer similar plans and pricing.

Aside from the Metro plan by T-Mobile, most prepaid plans offer a data cap to keep costs down. There are other considerations such as smartphone pricing and short-term promotions, but TracFone's 21 million subscribers suggest the company is doing something right. Since TracFone runs its subscriber calls through the largest networks, there are millions of TracFone customers already using the Verizon network. When it comes to network quality, Verizon just won RootMetrics's overall network performance award for the 13th consecutive time. Verizon's reputation for quality service should virtually eliminate concerns about coverage.

Does the deal make sense for Verizon?

With a maximum deal cost of $6.9 billion, divided by 21 million new customers, Verizon's average cost per customer is $328.57. This math seems favorable, given that most of the popular prepaid plans are around $30 to $35 per month, which equates to $360 to $420 per year. These figures suggest a revenue payback period of less than one year.

In addition, investors shouldn't overlook the customer acquisition costs that Verizon avoids with this acquisition. When signing up a new customer, the wireless carrier often pays a subsidy for the device, as well as paying a commission to the store or agent making the sale. In addition, Verizon must foot the marketing costs to get the customer in the door.

Across the industry, the estimated cost to acquire a new wireless phone subscriber is at least $350 to $400 . With Verizon getting TracFone customers at $328.57, the company is starting off at a lower cost basis than if it tried to organically win these accounts.

If we look at what TracFone customers could generate in revenue and income at different levels of churn, we get a sense of how this deal could affect Verizon's top and bottom lines. Most prepaid carriers report annual churn of 3% to 4%; TracFone brings in $30 per month or $360 per year in revenue per customer; and Verizon reported a net margin of 15.4% in its most recent quarter:

Churn Factor

TracFone Customers

Total 12-Month Revenue

Implied Net Income

With 3% Churn 

20.4 million

$7.3 billion

$1.13 billion

With 4% Churn

20.2 million

$7.26 billion

$1.12 billion

(Source: Author's assumptions based on TracFone acquisition and pricing.)

Issuing $3.1 billion of new shares at current prices of about $59, would create 52.5 million new shares -- about 1.2% of Verizon's current 4.14 billion shares -- for a new total share count of 4.19 billion shares. 

Verizon

Q2 2020 Reported

Q2 2020 Adjusted for TracFone

Revenue

$30.4 billion 

$32.2 billion

Net income

$4.8 billion

$5.1 billion

Diluted weighted-average shares outstanding

4.14 billion

4.19 billion

Diluted Earnings Per Share

$1.16 

$1.22

(Source: Verizon. Author's calculations for adjusted figures.)

Even with 4% churn, Verizon generates roughly $300 million in additional quarterly net income. With a $3.1 billion cash cost to the TracFone acquisition, this suggests a cash payback in just a little over 10 months. From all angles, this looks like a solid deal for Verizon, and gives growth and income investors yet another reason to consider adding the telecom giant to their portfolios.