3 Reasons Verizon May Not Be as Safe as You Think

For many investors Verizon is the epitome of a safe and secure investment. In November of last year, the company carried a forward dividend yield of about 4.1%. One of the biggest worries was a price war among Verizon and its peers. Today, the company's yield is roughly 4.5% and COVID-19 is weighing on investors' minds. While some will blame Verizon's current performance on the pandemic, there are a few issues that could be longer-term challenges. Investors who assume the stock is rock-solid may be surprised that Verizon may not be as safe as they think.

Serving up less growth

Investors looking for income are likely going to compare Verizon and AT&T as dividend stalwarts. In the last quarter, the majority of Verizon's service revenue was connected to its wireless division. On the other hand, AT&T generated roughly 40% of its total revenue from mobility. If we look at overall subscriber counts, there seems to be a clear divergence among the two heavyweights.

Verizon's wireless business is broken into consumer and business. The consumer side witnessed a slight decline in wireless postpaid connections, while the business side increased these connections by 8.4%. The difference is Verizon's business wireless postpaid connections sit at just under 26 million, whereas its consumer business is nearly 90 million strong. With its consumer business lagging, overall postpaid connections increased by 2% year over year.

Source: Getty Images.

AT&T Wireless also reported total postpaid subscribers down slightly versus last year. However, the company had two silver bullets that allowed its overall subscriber count to best Verizon. First, AT&T's prepaid business reached 17.8 million subscribers for annual growth of nearly 5%. Second, AT&T reports connected devices as a separate category, and connecting customers' vehicles, watches, and other devices, is a fast-growing business. Connected devices reached almost 70 million devices, which was up nearly 28% annually.

Not surprisingly, AT&T's overall subscribers reached 169.2 million, which was up 9.4% year over year. The bottom line here is Verizon is heavily reliant on its wireless business and it isn't keeping up with AT&T from a growth perspective.

Generally a problem

One item that often gets overlooked on a company's income statement is selling, general, and administrative expenses (SG&A). These are the costs to keep the company running: rents, benefits, and more. Theoretically, the company with a lower SG&A as a percentage of revenue is a more efficient operator.

Data sources: AT&T and Verizon.

As we can see, not only was Verizon less efficient in both periods, but its SG&A expenses increased, while AT&T's went down. Verizon mentioned a loss of $1.2 billion from the Federal Communications Commission's (FCC's) Auction 103 that hurt its results. However, if we back this amount out, Verizon still ends up at $7.4 billion or 23.4% of total revenue for Q1 2020. No matter how you slice it, it appears Verizon is less efficient than AT&T in this area. In addition, Verizon seems to be underperforming in the cash flow department as well.

What's the bottom line?

Cash flow statements can have multiple adjustments counted as affecting operating cash flow even if it's a noncash event. For this reason, I use net income plus depreciation minus capital expenditures to even the playing field. I normally adjust for true one-time items like a big tax benefit or a significant write-off. If we look at how Verizon performed last quarter compared with AT&T, the results are somewhat worrisome.

Data sources: AT&T and Verizon. *Verizon net income adjusted $1.2 billion for FCC Auction 103 event.

One troubling factor is that Verizon's management said the jump in capital expenditures was to support "unprecedented traffic" and for the deployment of 5G. By contrast, AT&T said its capital expenditures were to support 5G, broadband, and HBO Max. Considering each company pays a generous dividend, we know that free cash flow is a significant consideration.

Verizon paid $2.5 billion in quarterly dividends; using our core free cash flow calculation, this equates to a 57% payout ratio. AT&T paid $3.7 billion in quarterly dividends, giving us a 51% payout ratio. Given that AT&T's yield is approaching 7%, whereas Verizon is at about 4.5% -- Houston, we have a problem.

Verizon wireless business is growing at a slower rate, the company is spending more on SG&A, and its core free cash flow last quarter was almost 40% lower than AT&T's. At some point Verizon's promise of 5G may be a competitive advantage, but that day is not today. If Verizon cannot improve its wireless growth, or cash flow situation, the stock may not be as safe as many assume. In any case, AT&T seems like the much better option at this time.