Why Verizon and AT&T Are Solid Investments

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

The telecom industry has undergone dramatic changes over the last few years. From the introduction of smartphones and tablets to the aggressive buildup of 4G LTE networks, competition is intense among the oligopolists. It has also brought industry-wide consolidation through various sized acquisitions. After Sprint's stock price more than doubled when many were calling it "dead," investors are right to reevaluate their outlook. Where do we stand now?

Verizon's (NYSE: VZ) Early-Mover Advantage Challenged By Sprint's (NYSE: S) Revival

What attracts me to Verizon is its early-mover advantage. It has a tremendous lead on 4G LTE and offers a strong growth curve. Analysts forecast 9% annual EPS growth over the next half decade. Free cash flow is very strong, and while it has been volatile during the past two years, it is clearly on the upward trajectory. For the twelve trailing months ending 3Q 2012, $18 billion in FCF was generated, or a terrific 15.2% yield against the market capitalization. Research has shown that companies with a FCF yield of more than 10% have substantially outperformed the S&P 500.

I am also optimistic about the company's leverage towards smartphone innovation. Verizon intends on offering a free Windows Phone model, and it has been successful with similar past strategies. But I am even more optimistic about the company's potential in emerging markets. It is looking to increase penetration in Asia, and expansion of the "Share Everything" plan--already successful in the United States--will build sustainable streams of free cash flow. 

Despite Verizon's early-mover advantage, telecom is still a competitive industry. Active consolidation, in particular, has exposed Verizon's vulnerabilities. Sprint still offers the cheapest data plans, and the investment by SoftBank, for example, dramatically boosts the company's supported financial profile. This means that, should Sprint be short on cash, it could always seek assistance from SoftBank, which is now heavily invested on the well-being of the carrier. In addition, the company is just beginning to roll out 4G data plans for tablets So clearly Spring is more of a threat to Verizon than what many analysts had originally expected.

AT&T (NYSE: T): A Defensive Investment With Excellent Growth Prospects

In my view, AT&T is the most undervalued telecom stock. Though it is rated a "hold" on the Street, it has the largest economic moat and an excellent 5.4% dividend yield. Furthermore, the company is aggressive with its takeover strategy, as evidenced by the bid for T-Mobile. With too much anti-trust pressure, the company dropped the bid, but it has made strong organic progress in gaining spectrum.  The company's 4G LTE network is, for example, now available in 23 more markets, and the company will provide LTE coverage to roughly half of the American population by the end of this year. Smaller-sized spectrum purchases have been made to improve the 4G network. And, like Verizon, it is also vulnerable to the $20 billion worth of investments SoftBank is making in Sprint.

As a blue chip stock, the downside is inherently limited. But the real value comes, again, from the company's aggressive growth momentum. Although iPhone sales have cut into margins, the company has showcased its strength against peers by driving higher volumes. And, moreover, research has shown that 94% of AT&T customers that buy a new iPhone stay with the firm and 65% of T-Mobile customers switch to AT&T. Management is also not afraid to make investments. It recently decided to invest $14 billion across three years in building out its wireline and wireless IP broadband networks. In addition to this investment, AT&T will be expanding its U-verse to around 8.5 million more customers.

Analysts forecast 6.7% annual EPS growth over the next 5 years. This is more than enough to keep the multiples elevated as a solid dividend distribution is made to your bank quarterly. With around half the volatility of broader indices, AT&T provides a strong income investment with better-than-recognized growth prospects.


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