Verizon Communications (VZ -0.68%) is one of the most unloved stocks in the market today. Shares are trading for just 8 times earnings and they come with a 6.7% dividend yield. This is a very profitable business, but it also operates in a highly competitive space with high capital costs and high debt.
Investors who have been following Verizon closely know there's more to its investment thesis than meets the eye. Here are the three things you need to know about this stock.
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1. The network is the story with Verizon
We don't talk enough about how Verizon's network works. The company invests tens of billions of dollars to build out its wireless network, but each dollar of revenue it collects carries an incredibly high margin, a lot like software businesses.
In 2022, its service revenue fell by 0.7% to $109.6 billion, but the gross margin for that segment was 74%. Its wireless equipment segment, on the other hand, had a negative 12.1% gross margin.
In 2023, wireless service revenue is expected to grow by between 2.5% and 4.5%, so that segment is turning around -- and there's good reason.
2. Broadband is Verizon's point of leverage
When a company incurs high fixed costs to build a network, it needs to generate new ways to leverage that network. In Verizon's case, it's doing so by promoting its wireless broadband service -- or as the company calls it, fixed wireless.
In the fourth quarter, it added 379,000 net fixed wireless subscriptions, bringing the total to more than 1.4 million subscribers.
Not only is this an incremental revenue source, but bundling smartphone connections with broadband could allow Verizon to create a new bundle when streaming services are included. The company has begun streaming bundles with Apple and Disney, but that hasn't become a big piece of the business yet.
The point is that Verizon needs to continue leveraging its network. Any additional revenue it can generate from it will be a win given how high the margin= of that revenue is.
3. Debt is the biggest problem
The one drawback to Verizon's business model is the amount of debt it's carrying. At the end of 2022, the company had $150.6 billion in debt, and it paid $3.6 billion in interest last year.
Instead of aggressively paying down that debt, Verizon distributed $10.8 billion to investors in dividends last year, with a payout that yields 6.7% as of today. I would like to see Verizon shift its priorities to reducing its debt level, but dividend investors probably wouldn't be pleased with that.
In that respect, Verizon has painted itself into a corner. Income investors expect their payouts, but the costs of carrying debt will rise in the coming years. If Verizon's earnings don't increase rapidly, this could become a bigger and bigger problem.
Risks and rewards with Verizon
If Verizon can grow its services revenue on the back of its fixed wireless business, and also cut its capital expenditures (which are expected to fall from $23.1 billion in 2022 to around $17 billion in 2024), this could be an even better cash flow business. But it operates in a highly competitive space, and it won't be alone in seeing these opportunities.
I think the risk is worthwhile relative to the upside, given Verizon's low price-to-earnings ratio and the high dividend yield investors are getting today.
