Published on June 23rd, 2018 by Bob Ciura
The U.S. wireless industry is a gold mine. Consumers love their smartphones and other mobile devices, and their mobile applications, web browsing, and text messaging requires data. Plus, as so many of us are extremely reluctant to go without our devices, wireless service providers hold pricing power and are resistant to economic downturns.
This means the major wireless service providers are highly profitable. The top two operators, Verizon Communications (VZ) and AT&T (T) rule the roost, while the two smaller providers—T-Mobile US (TMUS) and Sprint Corporation (S)—are trying to catch up.
Meanwhile, Sprint and T-Mobile have agreed to a merger, which if successful, could give them the resources necessary to compete more effectively with AT&T and Verizon.
This article will discuss the top 4 wireless service providers in the U.S., based on the Sure Analysis Research Database, which ranks stocks based upon the combination of their dividend yield, earnings-per-share growth potential and valuation multiple change to compute total returns.
Wireless Provider #4: Sprint Corporation (S)
- Expected Annual Returns: -5%
Sprint Corporation came together with the merger of Sprint and Nextel in 2005. Since then, the company has taken many twists and turns. After multiple acquisitions and spin-offs, SoftBank acquired 70% of Sprint Nextel in 2012, and the company name was changed to Sprint Corporation. Today, Sprint is the #4 wireless carrier in the U.S., with roughly 55 million customer connections. Its various brands include Sprint, Virgin Mobile USA, Boost Mobile and Assurance Wireless.
On 5/2/18 Sprint released fourth-quarter and full-year 2017 financial results. The company had postpaid phone customer additions of 606,000 for the full year. The company generated net income of $7.4 billion, although $7.1 billion of the net income was due to favorable tax changes. Adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) were $11.1 billion in 2017. The company expects adjusted EBITDA to grow 2%-6% in fiscal 2018, to $11.3 billion-$11.8 billion.
We do not expect Sprint to generate positive returns over the next five years, as the company’s financial condition is highly challenged. Sprint has consistently reported losses over the past 10 years. It has a high level of indebtedness, and the company needs to reinvest billions of cash flow in its network, to keep up with AT&T and Verizon.
And, with the U.S. wireless market heavily saturated at this point, Sprint’s wireless service revenue is not growing.
Source: Investor Update, page 11
Going forward, the best chance for Sprint to turn itself around would be the definitive merger agreement with close competitor T-Mobile. This would bring together the #4 and #3 wireless providers. Their combined financial resources and scale would allow them to more heavily invest in next-generation technology, such as 5G rollout, and streamline operations to generate efficiency gains. However, the deal faces a tough path toward regulatory approval, meaning it is not a certainty.
Sprint’s financial condition is a concern, particularly if interest rates rise. The company has a credit rating of ‘B’ from Standard & Poor’s and ‘B2’ from Moody’s. These are considered below investment-grade, meaning Sprint already incurs higher debt costs than higher-quality borrowers. In addition, the company has significant debt maturities coming up—including $12.2 billion of debt maturities through 2020.
From a valuation perspective, Sprint is difficult to analyze. The company has not reported positive earnings-per-share since 2008, which makes it impossible to generate a price-to-earnings ratio. Sprint is expected to be barely profitable in 2018. Even with 10% assumed earnings growth each year, Sprint is likely to generate poor returns for shareholders. The stock is not likely to be rewarded with an extremely high price-to-earnings ratio, based on its weak balance sheet, limited growth opportunities, and lack of a dividend.
Our fair value estimate is a price-to-earnings ratio of 25 over the next five years, which would be a reasonable estimate if the company can become profitable. The valuation contraction will be a headwind for the stock, which we estimate in the -15% range each year.
Sprint is not a suitable holding for investors with a low tolerance for risk. The company does not generate steady profits, nor does it pay a dividend to shareholders. If the merger with T-Mobile does not go through, we expect Sprint to generate negative total returns over the next five years.
Wireless Provider #3: T-Mobile US (TMUS)
- Expected Annual Returns: 9%-10%
T-Mobile US Inc. was formed through the combination of T-Mobile USA and MetroPCS in 2013. Its parent company is Germany-based telecommunications giant Deutsche Telekom (DTEGY). Today, it is the third-largest wireless service provider in the U.S., behind AT&T and Verizon. It provides nationwide 4G LTE network services to approximately 74 million customers.
In its post-merger form, T-Mobile has spent heavily to build its network to compete with the established industry giants, AT&T and Verizon. It has also offered promotions to lure subscribers, such as switching incentives and cheaper unlimited data plans. These efforts have worked, as T-Mobile successfully captured market share against the two larger rivals with outsized customer growth.
Source: Investor Presentation, page 5
According to T-Mobile, it has captured over 90% of the industry postpaid phone growth, and 80% of the prepaid growth, in the last five years. Going forward, the company plans to continue this growth, both through capturing additional market share, and expanding its service offerings.
This has led to strong financial performance in the past few years. On 5/1/18 T-Mobile reported another great quarter. It racked up 1.4 million net customer additions, including 617,000 postpaid phone additions. Service revenue rose 6.5% last quarter, which led to total revenue growth of 8.8%. For 2018, T-Mobile expects postpaid net customer additions of 2.6-3.3 million, and adjusted EBITDA in a range of $11.4-$11.8 billion.T-Mobile has invested significantly to prepare for the near-term industry growth catalysts outside of wireless, such as entertainment, 5G, and the Internet of Things (IoT).
Source: Investor Presentation, page 14
Another growth catalyst is the planned merger with Sprint, announced on 4/29/18. The merger would create a company with an enterprise value of $146 billion. The combined company would be named T-Mobile. However, the merger faces a tough path to regulatory approval.
Share repurchase will also boost earnings growth. T-Mobile does not currently pay a dividend, but it still rewards shareholders with cash returns, through buybacks. On 4/27/18, T-Mobile increased its stock repurchase program to $9.0 billion, consisting of the $1.5 billion in repurchases previously completed, and for an additional $7.5 billion of repurchases through 2020. We expect 10% annual earnings growth for T-Mobile over the next five years, which may be a conservative estimate.
T-Mobile shareholders have enjoyed returns of over 170% in the past five years. But after such a massive rally, the valuation is likely to come down as the company matures. By 2023, we estimate fair value to be a price-to-earnings ratio of 18.0, which is a reasonable valuation due to the company’s earnings growth in the context of a saturated wireless market.
T-Mobile does not pay a dividend, which could make it unappealing for income investors. Value and growth investors, on the other hand, might view the stock more favorably, due to its growth and cash returns. We expect 9.3% annual returns for T-Mobile stock over the next five years.
Wireless Provider #2: Verizon Communications (VZ)
- Expected Annual Returns: 14%-15%
Verizon is a giant telecommunications company. It provides a wide range of services, including cable, broadband, and wireless. It has a market capitalization of $199 billion. Business conditions have become more challenged for Verizon over the past year. Wireless competition has intensified from lower-priced carriers such as T-Mobile. Verizon has responded with comparable offerings to retain its customer base, which has negatively impacted its bottom line.
However, Verizon’s promotions have helped grow revenue. On 4/24/18, Verizon reported strong first-quarter earnings that beat on both the top and bottom lines. Revenue of $31.77 billion rose 6.6% from the same quarter a year ago, and beat expectations by $550 million. Earnings-per-share of $1.17 beat estimates by $0.06 per share.
Source: Earnings Presentation, page 8
Verizon’s impressive beat was largely the result of strong performance of its unlimited wireless plans. Wireless segment revenue increased 4.9% last quarter, which more than offset a 1.6% decline in wireline revenue. Postpaid smartphone net adds were 220,000 for the quarter.
For 2018, Verizon expects full-year revenue growth in the low-single digits. Adjusted earnings-per-share growth is expected to grow at a similar rate. Verizon has positive long-term growth potential as well, because it has among the strongest networks in the wireless industry. The company spent $17.2 billion on capital investments in 2017 alone. New technologies will help Verizon retain its competitive advantages.
Two emerging technologies that will fuel Verizon’s growth are 5G deployment and the Internet of Things. According to the company’s 2017 annual report, 5G “will allow 10 to 100 times better throughput, 10 times longer battery life and 1,000 times larger data volumes than anything offered today”. The company is conducting 5G trials, and nationwide deployment isn’t too far off.
Verizon estimates the total market opportunity for 5G at $12.3 trillion, by 2035. Verizon’s $3.1 billion acquisition of Straight Path Communications, which closed on 2/28/18, helped Verizon gain more valuable spectrum, and further its lead in 5G. Verizon is prepared for 5G rollout in the second half of 2018.
Source: Sell Side Analyst Presentation, page 21
The nationwide rollout of 5G will also help Verizon in another area, which is the Internet of Things. Verizon has made significant acquisitions to boost its presence in IoT, including the $2.5 billion acquisition of Fleetmatics, and the $900 million acquisition of Telogis. Verizon exceeded $1 billion in IoT revenue in 2016, and it has continued to grow since then. Total IoT revenue increased 13% last quarter.
Verizon has a significant amount of debt on the balance sheet, including $112.7 billion of long-term debt at the end of last quarter. Verizon’s debt is largely the result of acquiring the remaining interest of Verizon Wireless it didn’t already own, for $130 billion in 2014. Fortunately, the company generates more than enough cash flow to service its debt. Its net-debt-to-adjusted EBITDA is 2.6, which is manageable.
Verizon has a 4.9% dividend yield, and a secure dividend payout. Verizon had a dividend payout ratio of 62% last year. This leaves plenty of cushion for the dividend. To help further boost its dividend coverage, Verizon is planning a massive cost-cutting program. The company is targeting $10 billion in cost reductions through 2021, which will help the company fund its dividend and pay down debt. Verizon’s dividend safety is analyzed in detail in the video below.
We expect Verizon to generate earnings-per-share of $4.35 in 2018, and the company to grow earnings-per-share by 5% per year going forward. With a price-to-earnings ratio of 11.1, we view Verizon as undervalued, and our fair value estimate is a price-to-earnings ratio of 14. Valuation changes could add 4.8% to Verizon’s annual returns. In addition to the 4.9% current dividend yield and 5% annual earnings growth, Verizon stock could generate annual returns of 14.7% per year over the next five years.
Wireless Provider #1: AT&T Inc. (T)
- Expected Annual Returns: 18%-19%
AT&T takes the top position in this list, in part because of its excellent dividend growth history. AT&T has increased its dividend each year for 34 years in a row, which makes it one of 53 Dividend Aristocrats.
AT&T offers a variety of telecom services, including wireless and cable TV, as well as satellite TV through its subsidiary DirecTV. AT&T reported disappointing first-quarter financial results. Revenue of $38.04 billion and earnings-per-share of $0.85 both came up short of expectations, missing analyst estimates by $1.27 billion and $0.02 per share, respectively. Revenue declined 2.3% from the same quarter a year ago. AT&T saw sales growth of wireless equipment and strategic business services, but this was more than offset by declines in legacy wireline services, domestic video, and wireless service revenues.
Source: Earnings Presentation, page 3
AT&T is focusing outside of wireless for growth. For example, the company acquired satellite television provider DirecTV in 2015, for $48.5 billion. The biggest growth catalyst going forward is the recently-completed $85 billion acquisition of content giant Time Warner. Time Warner has a number of strong media properties, including TBS, TNT, HBO, and the Warner Bros. movie studio. AT&T expects the deal to be accretive to earnings-per-share a year after closing.
In wireless, AT&T expects wireless service revenue to return to growth on a comparable basis this year; and expects to be the first to release standards-based mobile 5G in 2018.
In terms of safety, AT&T has a highly secure dividend payout. Based on 2018 earnings guidance, the company is on pace for a dividend payout ratio of approximately 58%.
One potential risk factor for AT&T is rising interest rates, as the company is highly leveraged, and will incur even more debt if and when the Time Warner deal gets approved. After the integration of Time Warner, AT&T will have $180.4 billion in net debt. To help mitigate the risk of rising interest rates, AT&T has an investment-grade credit rating of BBB+ from Standard & Poor’s, which will help keep its cost of capital manageable.>/p>
We expect AT&T to generate adjusted earnings-per-share of $3.45 in 2018. Based on this, AT&T stock currently trades for a price-to-earnings ratio of just 9.3, compared with an average of 13.4 over the past 10 years. Therefore, we believe the stock is significantly undervalued. The combination of valuation changes and earnings growth should provide annual returns of approximately 12% for AT&T stock through 2023. Adding in the 6.3% dividend yield means annual returns could exceed 18% for AT&T shareholders over the next five years.