Those who follow Warren Buffett are well aware of his aversion to technology companies. Outside of IBM, and more recently VeriSign, he has typically steered clear of technology investments. However, it was reported in May that his company Berkshire Hathaway had bought approximately 11 million shares of Verizon Communications (NYSE:VZ). While on the surface there are reasons to be concerned about the telecom giant, shrewd value and income investors should seriously consider following "The Oracle" into this investment.
But that debt...
Admittedly, Verizon's debt gives investors reason to pause. As of its most recent filing, Verizon's long-term debt-to-equity ratio was an astounding seven times. Coming off the largest debt offering ever, which saw the company place nearly $50 billion in paper, Verizon now appears to be in a much riskier position as far as its balance sheet is concerned.
But debt used correctly can be beneficial for shareholders. The reason for this large debt issuance was Verizon Communications' acquisition of the crown jewel of its business: Verizon Wireless. Verizon Wireless had been a jointly owned entity, with Verizon owning 55% and Vodafone owning the other 45%. What initially started as a friendly joint agreement in the early 2000's quickly became a detriment to Verizon shareholders amid the huge growth in wireless telecommunications.
Verizon took out the loan (and also issued shares) in order to fund a $130 billion buyout of Vodafone's stake of the wireless unit. The money was not excessively expensive in this low-rate environment: The bundle of notes ranged from a three-year note priced at 2.5% to a 30-year note priced at 6.55%.
What investors should keep an eye on
Does debt make the equity investment riskier? Sure--now Verizon has to pay new debt holders before that money can float down to the income statement as shareholder earnings. This requires continued strong operations from its newly fully acquired wireless segment. That might be easier said than done--while Verizon Wireless is the largest carrier in the United States, but it must watch the competition. A particularly pesky rival has been John Legere's reinvigorated T-Mobile (NASDAQ:TMUS).
Through its "Un-carrier" initiatives, T-Mobile is shaking things up. In addition to growing subscriptions (commonly referred to in the industry as subs), T-Mobile is forcing other carriers to present better deals to customers. And in this rather specific example, there is a direct and negative correlation between customers and shareholders. As average revenue per account goes down, less money is available for both debt holders and then shareholders. How has Verizon Wireless held up recently?
In the scheme of things, Verizon's retail postpaid subscriber accounts -- the Holy Grail of smartphone revenue drivers -- are holding up well. The average revenue per account has risen on the back of more lines being added to accounts. It is something to watch as T-Mobile continues to hammer the entrenched duopoly of AT&T and Verizon, but not anything to be overly concerned with right now.
Another important figure is churn rate -- the percentage of subscribers who discontinue their service during a particular period. For what it's worth, on a seasonally adjusted basis, Verizon appears to be remarkably stable in the mid-0.90% range -- although it does typically jump above 1% in Verizon's first quarter due to seasonality issues. While this is also something Verizon investors should be aware of, at the moment the company is handling competition well.
Warren Buffett is one of the shrewdest investors alive. He's made himself a billionaire and many early investors millionaires many times over. So when he focuses his attention on an investment it's a good idea for you to pay attention as well. What he sees in Verizon is a reinvented company of sorts that increased its net income on a year-over-year basis in the latest quarter by 87%; even with recent share dilution, EPS increased by nearly 30%.
On top of that you have the classic signs of a value play, a price-to-earnings ratio under 11 on a trailing-12-month basis, and an excellent yield of 4.3% in this yield-starved environment. Buffett once said "[i]t's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." But when you can buy a wonderful company at a wonderful price, it's time to take notice.
Editor's Note: Verizon's P/E ratio was incorrectly referred to as the P/S ratio in a previous version of this article. The Fool regrets the error.