5G, Less Debt, And A Growing Yield, That’s Verizon – Verizon Communications Inc. (NYSE:VZ)

Looking at Verizon (NYSE: VZ) and AT&T (NYSE: T), investors are being shown two different ways to approach the future. On the one hand, Verizon is essentially sticking to its knitting. The company isn’t involved in any huge deals, claims to not be interested in one, and is laser-focused on building out the promise of 5G. On the other hand, AT&T has transformed itself with purchases of DirecTV and Time Warner over the past many years. Though AT&T has a bigger yield and its diversity may seem appealing, there are three reasons to believe that Verizon should keep moving higher.

Less debt and more focus

One reason Verizon should keep rising is that it plans on paying down debt, while building its 5G capabilities. The company made its dual focus very clear during the last conference call. CEO Hans Vestberg mentioned 5G Mobile, 5G Home, and 5G phones as expected for this year and next. The company’s CFO Matt Ellis talked about Verizon’s plans for debt retirement. He noted that in Q1 2018, the company’s EBITDA was 2.4 times. One year later, Verizon’s EBITDA is down to 2.1, and the goal is 1.75 to 2. Just to put numbers to this metric, in the most recent quarter, the company’s net long-term debt was $111 billion, which was down nearly 4% from last year.

AT&T is on a similar path of debt reduction. The company took on billions in debt to acquire Time Warner. What should surprise investors was a comment made by the company’s CEO, Randall Stephenson, on the last conference call. Of the roughly $40 billion that AT&T took on to acquire Time Warner, he said, “we are on target to retire 75% of that by year-end.”

The big difference between Verizon and AT&T at present is the breakdown of their revenue streams. While Verizon relies very heavily on Verizon Wireless, AT&T’s breakdown is far more diverse. As of last quarter, Mobility was just over 39% of revenue, Entertainment made up 25.2%, WarnerMedia about 19%, and Latin America and Xander made up the remainder.

While some would argue that AT&T’s diversity helps to insulate it from the challenges in its different businesses, this could go the other direction as well. AT&T is the perceived second-place option behind Verizon in the wireless business. The company’s Entertainment business faces massive competition from cable companies and entertainment businesses alike.

WarnerMedia expects to enter the streaming media fray later this year, where new competitors seem to show up daily. Latin America has been troublesome, and Xander is growing but is a relatively tiny piece of the whole. I would suggest Verizon’s focus on 5G could be more beneficial to the company’s overall growth than AT&T’s diversity.

(Source: GSMA Intelligence study)

It’s not that AT&T won’t participate in 5G. The company has plans of rolling out its own nationwide network. However, Verizon’s singular focus on one main division with one main goal should yield bigger and faster results than AT&T’s attention being split between multiple focuses.

Verizon 5G Buildout

(Source: Verizon Wireless 5G)

The 5G market is expected not only to be large but to grow extraordinarily fast. The global 5G Internet of Things (IoT) market is predicted to reach $694 million by 2020, then leap to over $6 billion by 2025. With uses spanning from smart cities to enterprise solutions, connected cars and IoT applications, there are few industries that 5G won’t touch. In addition, companies like Comcast (CMCSA) and Charter Communications (CHTR) know that their broadband business will ultimately be at risk. Tens of millions of customers rely on one of these companies for high-speed Internet with little other choice. Building a 5G network isn’t without risks, namely the cost, but as we’ll see in a moment, Verizon seems ready to take on the challenge.

Big Red produces big green

The second reason that Verizon should keep rising is the company is a cash flow machine. If it is going to go after the massive opportunity that is 5G, the company needs cash flow. The good news is, Verizon has cash flow, and in the billions. In the most recent quarter, its core operating cash flow reached $9.4 billion. By point of comparison, AT&T generated about $11.6 billion in operating cash flow. On the surface, this would seem to suggest that AT&T is in a better position to capitalize on opportunities. However, if we dig a little below the surface, we get a somewhat different picture.

First, operating cash flow isn’t the same as free cash flow. The best way to compare free cash flow across companies is to look at free cash flow generated per $1 of revenue. In the most recent quarter, AT&T’s free cash flow per $1 of revenue equaled $0.14. Verizon, on the other hand, managed to generate $0.16 of free cash flow. By this measure, Verizon has relatively more to spend from each dollar of revenue.

In addition, AT&T and Verizon’s dividend obligations have a lot to do with why the latter seems to be better-positioned. In the last quarter, AT&T’s core payout ratio was just under 58%, whereas Verizon managed a ratio of under 49%. Even though AT&T generated more free cash flow on an absolute basis, the actual money each company had after dividends was almost the same.

Where AT&T is concerned, the cost to build out and try to gain customers in streaming video will be on ongoing challenge. Customers who are using DirecTV or its high-speed Internet services will face a choice between 5G home broadband, 5G mobile, or their existing service. The company’s wireless business may make up for some of these challenges but won’t offset the risk completely.

While Verizon’s 5G buildout will take years, at some point, just as in 4G, the massive investments will dissipate. The company can focus on providing the backbone for the shift to 5G and little else. With more relative free cash flow being generated from each revenue dollar, and a lower payout ratio than AT&T, investors should have confidence in Verizon’s 5G future.

Which is more important? Dividend yield or dividend growth?

One of the bigger challenges comparing Verizon to AT&T is the latter’s larger dividend yield. Investors looking for income can’t ignore a 6.3% yield from Ma Bell. However, as with most things, there is more to the story than just one number. Given each company’s reliance on wireless revenue, it shouldn’t be too surprising that analysts expect earnings growth over the next five years to be very similar. Verizon and AT&T are expected to report 2.5% annual EPS growth.

There are two questions investors need to answer before they simply accept analysts’ expectations for the companies. As in most industries, earnings growth normally starts with revenue growth, expense control, or a combination of both. On the expense side, both AT&T and Verizon are attempting to cut expenses. On the revenue side, analysts seem to see a different path for the two companies.

For 2019, AT&T’s revenue is expected to grow by 7.4%, mainly based on the Time Warner acquisition. Verizon is expected to show much slower revenue growth this year of about 0.8%. Where things begin to diverge a bit is starting in 2020. While AT&T’s revenue growth is expected to increase by just 0.4%, Verizon’s 2020 revenue growth is pegged at 1.3%. These numbers don’t sound that different, but it’s the direction of future revenue that should interest investors. In this matter, Verizon’s trajectory seems more favorable.

Speaking of trajectory, a third reason Verizon should keep rising is its dividend growth. At present, AT&T’s yield is larger, but Verizon’s yield of 4.2% is no slouch either. We can see over the last several years, Verizon’s dividend growth has ranged between 2% and more than 3%. Though the last several years have seen a decrease, the company has been investing in its 5G network and digesting a slowdown in smartphone upgrades.

Verizon Dividend Growth

(Source: Verizon dividend history)

Where AT&T is concerned, the path is straight down. The company has been sticking to a policy of a $0.04 annual increase for many years. The problem for investors, of course, is as the dividend amount gets larger, this $0.04 represents a smaller and smaller increase.

AT&T Dividend Growth

(Source: AT&T historical dividends)

While Verizon is increasing its dividend based on cash needs and what it feels comfortable with, AT&T is sticking to a set amount. With AT&T’s current process, each year investors are going to get a smaller percentage increase. Once Verizon makes its significant 5G investments and this technology becomes more commonplace, the company should have significantly more cash to plow into dividends. For long-term investors, Verizon’s path of what could be bigger dividend increases should be appealing.

In the end, investors are faced with two very differently positioned companies. AT&T is more diversified, but theoretically, that could be both a blessing and a curse. While new technology like 5G should be a massive opportunity for Verizon, it threatens over 25% of AT&T’s revenue from the Entertainment business. We already know that Verizon squeezes more core free cash flow from each dollar of revenue, and theoretically, this should improve as its 5G investments dissipate.

As Verizon cuts expenses and reduces its debt load, the cash flow should improve further. With a solid yield, good long-term growth prospects, and the potential for better dividend growth in the future, investors should look forward to the stock rising in the future.

Disclosure: I am/we are long VZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.