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Verizon Communications (NYSE: VZ) reported another strong quarter of earnings Tuesday, as the company continues to benefit from the decision to completely buy out Verizon Wireless two years ago.
Before then, Verizon held a 55% majority stake in Verizon Wireless in a joint venture with European telecom giant Vodafone (NYSE: VOD). But Verizon management knew that strategically, the company needed to take full control of its wireless unit, since it was growing at a far greater rate than traditional wireline.
Sure enough, this decision was right on the money. Verizon Wireless is a cash machine. According to Verizon, it’s the most profitable wireless carrier in the United States. The reason is that its parent company invested heavily in the Verizon Wireless network.
Last year alone, Verizon invested more than $17 billion in its business infrastructure. Over the past three years, Verizon spent more than $50 billion on its network. As a result, Verizon holds the highest-quality (and highest-margin) wireless business.
This dynamic proved itself once again in the first-quarter Verizon earnings report. Wireless revenue grew 6.9% year-over-year. This was significantly better performance than wireline, which posted 4% revenue growth. Verizon Wireless reaped a 44% EBITDA (earnings before interest, taxes, depreciation and amortization) margin on total wireless revenue last quarter.
Verizon grew adjusted earnings per share by 21% last quarter, from $0.84 per share to $1.02 per share year-over-year. This is fantastic growth for a $208 billion telecommunications company.
Compare Verizon’s results to AT&T (NYSE: T), its fiercest competitor in the telecommunications space. AT&T grew wireless revenue by just 1.8% last quarter. Wireless EBITDA margin stood at just 35%, a full nine percentage points below Verizon’s wireless margin. And AT&T’s wireless margin actually contracted by nearly four percentage points from the same quarter last year.
Essentially, Verizon’s strategy is to focus on higher-margin, higher-income customers. The company spent a lot of money on its network for a reason. With the strongest network quality, Verizon can charge premium prices. This keeps margins fat and profits increasing.
A side benefit to the strategy is that it insulates the company from a competitor undercutting it on price. Recall that Sprint (NYSE: S) launched a highly-touted price war strategy, in which it would cut customers’ bills in half for switching carriers. This brought in customers, but it has had a disastrous effect on Sprint’s profitability.
Sprint added nearly 1 million connections last quarter, which sounds impressive. But to do so, the company made significant price concessions. As a result, Sprint booked a $2.5 billion operating loss last quarter.
Verizon’s customers want quality, and as a result, price alone isn’t a big motivator. That’s why, although Verizon does see some customer churn from quarter to quarter, its margins and profitability remain intact – even when competitors swoop in with discounts to try to steal its customers.
Verizon’s high-margin strategy results in prodigious free cash flow. It generated $4.2 billion of free cash flow last quarter, up 40% year-over-year. This allows the company plenty of financial room to pay a generous 4.5% dividend.
The company spent $2.1 billion on dividends last quarter, which equates to a very comfortable 50% payout ratio. By contrast, AT&T’s dividend constitutes approximately 90% of its free cash flow.
Verizon isn’t likely to change strategies any time soon, because the company knows that price wars, such as the one Sprint launched, can’t last forever. Sprint’s experiment got a lot of attention in the financial media, but even Sprint understands this is a short-term scheme. Sooner or later, Sprint’s widening losses will compel the company to end the price war. As the old saying goes, a company cannot make up losses on volume.
As a result, while Verizon’s dividend is slightly below AT&T’s, it makes up for this with much stronger revenue and earnings growth. In terms of total return, Verizon shareholders have done much better. Verizon stock is up 85% in the past five years, while AT&T shares have increased 31%. That means Verizon outperformed AT&T by more than 50 percentage points in that time frame.
With wireless set to remain the growth engine of the future, expect Verizon’s outperformance to continue.
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