Investors may be concerned about how much Verizon (VZ +1.20%) paid to acquire the rest of Verizon Wireless from Vodafone. With a $130 billion purchase price, investors have a right to worry that Verizon may have spent too much to take complete control over Verizon Wireless. That being said, there are at least three reasons to believe this acquisition was the correct strategy, and investors should be excited about the days ahead.
One of these things is not like the other
In the wireless industry, Verizon and AT&T (T +1.75%) are fighting a battle every day for postpaid subscribers. Verizon has more than 97 million postpaid subscribers, whereas AT&T has about 73 million. In the last three months, both companies witnessed strong wireless performance, yet Verizon outperformed its peer in a number of ways.
This is the first reason to believe the Verizon Wireless acquisition was a wise move. Verizon and AT&T both reported 7% growth in wireless revenue. However, Verizon reported a 4.4% growth rate in postpaid subscribers, whereas AT&T reported a 3.6% growth rate. What is even more important, Verizon's higher growth rate is coming from a subscriber base that is 30% larger.
In addition, Verizon Wireless has a better growth rate in average revenue per user, or ARPU, and the division's operating margin is 23% higher than AT&T's. Many investors see AT&T and Verizon as interchangeable, but as we've seen, one of these things is not like the other.
From weakness comes strength
The second reason to believe the Verizon Wireless acquisition was the right move is that without this distraction, Verizon can now focus on its wireline operating efficiency. Unlike other areas where Verizon leads its competition, the company's wireline operating margin is woefully low.
Compared to the more locally focused CenturyLink (CTL +4.54%) or AT&T's wireline operations, it seems clear that Verizon has some work to do. In its most recent quarterly report, CenturyLink's operating margin was 15%. AT&T managed a 10% margin. Given that Verizon's operating margin came in at a measly 1.5%, some might believe the company is having trouble competing.
Nothing could be further from the truth. When it comes to core metrics like high-speed Internet additions, video subscribers, or voice line losses, Verizon holds its own. As one point of comparison, the company reported 10% in net additions to its high-speed Internet subscribers, which was significantly higher than CenturyLink's 2.4% or AT&T's 0.1%.
The good news for investors: Verizon can focus on making its wireline operations more efficient now that it doesn't have to worry about making sure Vodafone is happy with its part of the Verizon Wireless business. Given that Verizon generates nearly $10 billion in wireless revenue, if Verizon is able to raise its operating margin to even 5%, this would add more than $300 million to operating earnings.
Nearly 700% more relative debt, but it's not a problem
To say that Verizon took on some debt to acquire what it didn't already own of Verizon Wireless is an understatement. Mainly due to this transaction, Verizon's debt-to-equity ratio jumped from under 1 to nearly 8 in the last year.
By comparison, CenturyLink's debt-to-equity ratio is just 1.2, whereas AT&T's ratio sits at less than 1. However, just looking at a debt-to-equity ratio doesn't paint the whole picture. A better way to compare Verizon's debt cost is by looking at the company's interest cost as a percentage of operating income.
If a company can't afford to pay its interest income from its operating income, it's unlikely the company will be able to afford to expand or pay dividends. For investors worried about Verizon's new debt profile, they need to realize that the company is only using 17% of its operating income on interest payments.
By comparison, AT&T uses about 14% of operating income on interest, but CenturyLink uses nearly 50%. As you can see, Verizon may have a higher relative debt-to-equity ratio, but the company's interest expense doesn't look worrisome at all.
The bottom line
Verizon is growing its most important division -- wireless -- and outperforming its peers. The company has the opportunity to improve its cash flow even further by making its wireline operations more efficient. Last but not least, even though Verizon has more debt, the company is a cash-flow-producing machine. Investors who worry about Verizon's $130 billion acquisition have nothing to fear. Verizon is doing well, and long-term investors have several reasons to buy more.
