Crushing It Big Red Style

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I know that the big news recently has been Softbank's investment in Sprint (NYSE: S). While this does change the company's financial position, what it does not change is the huge outperformance in the industry by Verizon (NYSE: VZ). In truth, I think most investors would be hard pressed to make much of an argument to suggest this isn't the best domestic telecom. company. Verizon not only reported good earnings growth, but the company's free cash flow growth is second to none.

In Verizon's most recent quarter, it was hard to find something that the company didn't do well. Overall revenue increased 3.9%, and EPS was up an impressive 14.29%. Normally the big weakness in companies like Verizon and AT&T (NYSE: T) is their wireline operations. It seems a near certainty that at some point having a wireline phone will be akin to finding a payphone. While in years past payphones dotted the landscape, once cell phones became more affordable and commonplace, they have slowly disappeared. This is what's happening with landline phones. However, Verizon and AT&T both have found that they can help offset the runoff in landline service by offering high-speed internet and video offerings.

Verizon's wireline business showed a 2.3% decrease in revenues, but there were multiple positives out of the unit during the quarter. First, the company's average revenue per user increased over 10%. Second, the company added 136,000 FIOS internet subscribers, and 119,000 video subscribers. Both of these net additions represent at least 14% growth in their respective services. The company is not done yet either, with 37% internet penetration, and 32.9% video penetration, Verizon can continue to sell these services and help their customers. As you can see, a small decline in revenue actually hides quite a few positive surprises. Where Verizon's real strength lies as most people know is their wireless service.

Verizon wireless is the second largest domestic wireless provider and is co-owned by Verizon and Vodafone (NASDAQ: VOD). Vodafone holds 45% of the venture and benefitted tremendously by a multi-billion dollar payment from Verizon. While this payment might not be consistently repeated, Vodafone investors can likely expect a fairly consistent return of profits based on Verizon Wireless' results. The growth in this huge service with over 95 million subscribers is simply amazing. In the last quarter, this divisions' revenue increased 7.3%, and this was just the start of the unit's amazing numbers. Verizon Wireless added 1.8 million retail net additions, and 1.5 million of these were postpaid subscribers. This new subscriber growth equated to 4.8% growth in postpaid, and 22.3% growth in prepaid customers. Equally impressive is the company's average revenue per user increased 6.5%, and churn was a very low 0.91%. Not surprisingly, 53% of the company's subscribers are using smartphones, and 78.8% of postpaid phones sold were smartphones. I've written about this before, and hopefully looking at the company's financials, we can put to bed the theory that wireless carriers are having their margins crushed by the subsidies they have to pay for smartphones.

Verizon's overall operating margin was 18.90% in the most recent quarter. By comparison, competitors like AT&T had an operating margin of 19.17%, while Sprint showed a negative margin. Even looking at Vodaphone, their operating margin was 24.10%. It might be true that smartphones are putting a bit of a squeeze on margins, but this is an industry-wide phenomenon. In addition, looking more specifically at just Verizon Wireless' operating margin it would be hard for the company to convince anyone that they are struggling. In fact, over the last year Verizon Wireless' operating margin increased from 29% last year to 31.8% in the last year. Since this time frame includes both the introduction of the iPhone 4S, iPhone 5, Samsung Galaxy SIII, Motorola Razr MAXX and other high-margin smartphones, this information seems to argue against smartphones being a problem as many have suggested. If there is any doubt that Verizon is doing well despite the smartphone revolution, consider that free cash flow in the last nine months has jumped almost 50%. During this same timeframe, Verizon's generated $13.443 billion in free cash flow and paid $3.887 billion in dividends, which gives the company a free cash flow payout ratio of just 28.91%. With this type of free cash flow generation, there are two major winners and two potential losers.

The two companies that should look at these results and shake in their proverbial boots are AT&T and Sprint. AT&T already is consistently rated lower in wireless network quality than Verizon. When you consider that analysts are calling for just over 7% growth at AT&T versus about 11% at Verizon, you can see the difference between the two companies is going to grow. While Softbank's investment in Sprint puts the company on most stable ground, it does not change the fact that Verizon has nearly twice the wireless subscribers, and is already much financially stronger. Consider this for a minute; Verizon generated enough free cash flow in the first nine months of 2012 to pay off the majority of what Sprint owes in long-term debt. Sprint appears set to compete on price and that is a losing position in the wireless industry. Even if you make the argument that Sprint will be a more effective competitor, it's highly unlikely that they will overtake the 95 million wireless subscribers at Verizon and over 100 million at AT&T. If price were the defining factor in wireless, then other companies like MetroPCS or T-Mobile's, less expensive plans would have won out long ago. The two big winners from Verizon Wireless' success are of course Verizon and Vodaphone. Verizon's huge free cash flow generation allows the company to return significant profits to Vodaphone. This cash flow also allows Verizon to continue to repurchase shares and raise the company's strong dividend. Though Verizon's stock sells for a premium to their competition, you can clearly see the company has been crushing it Big Red style.


MHenage owns shares of Verizon Communications. The Motley Fool owns shares of AT&T.; Motley Fool newsletter services recommend AT&T;, Vodafone Group Plc (ADR), and Vodafone Group Plc (ADR). Try any of our Foolish newsletter services free for 30 days. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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