Lots Of Debt On Verizon's Horizon
Verizon is simply a cash cow, and while investments are often high, free cash flow generation is mighty impressive.
Verizon has paid a dividend every year since 1984 and has increased its dividend-per-share payout for the past ~10 consecutive years.
Recently, S&P revised its rating outlook of Verizon to BBB+ from A-, but we think another downgrade may be in the cards, should EBITDA performance disappoint.
Let's take a look at the firm's investment considerations as we attempt to uncover the drivers behind its Dividend Cushion ratio.
Verizon may be an outstanding free cash flow generator but debt service costs, capital investments, and dividend obligations are not minimal by any stretch of the imagination.
--> Verizon (VZ) offers broadband, video and other wireless and wireline services to consumers, businesses, governments and wholesale customers. The firm operates one of America's fastest 4G wireless networks and provides services over one of America's most advanced fiber-optic networks.
--> Verizon's acquisition of the portion of Verizon Wireless owned by Vodafone (VOD) has burdened the firm's balance sheet with more than $100 billion in debt. Though Verizon will have to invest in its network and platforms, a disciplined approach to capital spending will be necessary going forward.
--> Verizon's focus on margin expansion and profitable growth is undeniable. It's hard not to like the firm's ~50% wireless segment EBITDA service margins, and amazingly, about one-third of its customers still don't have smartphones. This offers headroom to capitalize on the migration to tablets and other devices.
--> Verizon is simply a cash cow, and while investments are often high, free cash flow generation is mighty impressive. For example, through the first nine months of 2015, free cash flow totaled ~$16 billion while dividends paid was ~$6.4 billion, suggesting nice dividend coverage with free cash flow.
--> We continue to evaluate Verizon for addition to the portfolio of the Dividend Growth Newsletter, though we note its acquisition of the portion of Verizon Wireless it did not already own has complicated matters (given the outsize debt load it has taken on).
Note: Verizon's dividend yield is above average, offering a ~5% yield at recent price levels. Though we prefer yields above 3% and generally don't include firm's with yields below 2% in our dividend growth portfolio, other factors keep Verizon out of our Dividend Growth Newsletter portfolio. Let's explain why.
Verizon is one of the most well-known telecommunications companies in our coverage universe, arguably delivering the fastest mobile network in the industry. The company has paid a dividend every year since 1984 and has increased its dividend-per-share payout for the past ~10 consecutive years. Verizon recently acquired the remaining portion of Verizon Wireless from Vodafone, a move we like from an operational standpoint. Although the company increased its leverage significantly in the process, it is still a very strong generator of free cash flow. As with many companies in the telecommunications industry, capital expenditures are sizeable, but the magnitude of free cash flow continues to be robust.
The acquisition of the remaining portion of Verizon Wireless it does not already own has significantly expanded Verizon's balance sheet, now with over $100 billion of debt. Recently, S&P revised its rating outlook of Verizon to BBB+ from A-, but we think another downgrade may be in the cards, should EBITDA performance disappoint. Management has prioritized paying down its immense debt load, and a net debt-to-adjusted EBITDA mark of ~2.4x isn't terrible (2015 year-to-date). Verizon may be an outstanding free cash flow generator but debt service costs, capital investments, and dividend obligations are not minimal by any stretch of the imagination.
From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
We think the safety of Verizon's dividend is very poor. Please let us explain. Don't jump to conclusions -- the Dividend Cushion ratio is objective -- it is what it is...
We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion™ ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Verizon, this ratio is -0.2, revealing that on its current path the firm might have difficulty covering its future dividends and growth, with net cash on hand and future free cash flow. All else equal, why not prefer companies with Dividend Cushion ratios well above 1?
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Verizon's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is less than the sum of the next 5 years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend.
Dividend Cushion Ratio Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Verizon's numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of Verizon's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we would characterize its future potential dividend growth as excellent. This is not the case for Verizon's dividend, which we rate as very poor.
Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Verizon's case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low.
Verizon is one of the most impressive free cash flow generators in all of our coverage universe. Its hard not to like the firm's strong wireless EBITDA margins, and material migration opportunity exists due to the fact that approximately one-third of its customers do not have smartphones.
We like the firm's dividend track record, and its yield is nothing short of impressive. However, the company's massive debt load causes us to pause when reviewing its investment considerations. Verizon's free cash flow generating ability, coupled with disciplined capital management, should be enough to handle the more than $100 billion in debt, but the debt load causes us to look elsewhere for safer dividend growth ideas.
Debt averse investors may not like Verizon at all.
Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
