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Can Verizon Throw Enough Cash at These 2 Challenges?

By Chad Henage – Jul 21, 2014 at 12:00PM

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Saturation is a scary word for this company.

Verizon (VZ -1.67%) investors are rightfully excited about the company's now full ownership of Verizon Wireless. It's hard not to get excited when you hear that a company will have "significantly greater" cash available than last year. However, there are two changes occurring in the wireless market place that could challenge the company's growth going forward.

The great news
On one hand, if you are looking to buy Verizon's stock, it's hard to argue with the company's cash flow generation. Compared to its competition like AT&T (T -0.47%) or CenturyLink (LUMN 2.19%), Verizon plays in a league of its own.

In its most recent earnings, AT&T reported a core free cash flow payout ratio of 92% and using this same measure, CenturyLink's dividend is covered by a 48% payout. With three months free cash flow of about $2.6 billion at AT&T and $640 million at CenturyLink, the companies appear to be doing well.

There is just one problem. Verizon generated roughly $6 billion in core free cash flow during this same timeframe. To make the comparison even more stark, Verizon's payout ratio came in at just 25%. Verizon's acquisition of the rest of Verizon Wireless added shares and debt to the company's balance sheet, being able to keep the 45% of Verizon Wireless' cash flows would seem to make the trade-off worth it.

Everyone already has one of those
Verizon is a cash-generating machine, and if that were the end of the story then investors could buy the company's stock and sleep well at night. However, the first challenge Verizon faces is the domestic wireless market seems to be closing in on a smartphone saturation point.

Both AT&T and Verizon mentioned in their respective conference calls that smartphones made up the lion's share of new postpaid activations. AT&T went one step further to say that 70% of its Cricket prepaid customers are using smartphones.

The challenge for both companies will be to continue growing this business, in particular when the domestic market appears to be nearing smartphone saturation. Verizon reported that more than 70% of their postpaid subscribers were using smartphones, and AT&T stands at nearly 80%.

No matter how easy to use they are, there will always be some base of subscribers who don't choose a smartphone because of the extra up-front cost or the additional monthly costs.

With this challenge, Verizon sees a challenge where smartphones become less important and tablets and other connected devices become more important. This could be a problem for "Big Red" because Verizon has traditionally relied on postpaid smartphone subscribers for growth and tablets while other devices have taken a backseat.

This challenge extends to CenturyLink because the company partnered with Verizon Wireless to bundle wireless service with CenturyLink landline, video, and high-speed Internet service. With AT&T adding thousands of tablets to its mix of customers and Verizon needing to shift its message that tablets are important to the company as well, this could be an issue if smartphone sales growth slows down.

Will customers get the edge?
The second problem facing Verizon is the fact that the company's EDGE upgrade program where customers pay for their phone on an installment basis seems to be receiving a tepid response in the marketplace.

The company said its EDGE smartphone percentage take rate was "less than 2%." While Verizon's management does expect this figure to double this year, it seems like the message that Verizon doesn't want to pay expensive subsidies isn't getting through.

Given that Verizon now owns 100% of Verizon Wireless, the company has to take the good with the bad. If customers aren't willing to pay in installments for their phones, subsidies may just be a fact of life.

AT&T is going a slightly different route to try and stoke its growth in the future with the potential merger of DirecTV. The company wants to expand its business beyond its current focus on mobile and shift into video as well.

CenturyLink is doing a good job of expanding its offerings to business and enterprise customers and witnessed business revenue increase by 3.6%, while high-speed Internet growth was acceptable as well.

The point is, Verizon is known as the 800lb gorilla in the telecom room. The company generates huge free cash flow today, but if the domestic smartphone market is saturated and the company can't get customers to move away from subsidies then future growth could be constrained.

Chad Henage owns shares of Apple, CenturyLink, and Verizon Communications. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Stocks Mentioned

AT&T Stock Quote
$19.19 (-0.47%) $0.09
Verizon Communications Stock Quote
Verizon Communications
$38.33 (-1.67%) $0.65
Lumen Technologies Stock Quote
Lumen Technologies
$5.59 (2.19%) $0.12

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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