Editor’s Note: Welcome to our weekly Reality Check column. We’ve gathered a group of visionaries and veterans in the mobile industry to give their insights into the marketplace.
On Thursday, Verizon Communications kicks off the telecommunications earnings season with their release expected before Wall Street opens (Google, another closely followed company, announces after the bell). There’s more to Verizon than a large LTE build, as this Reality Check will show.
Verizon in the past five years has brilliantly executed several deals, including the acquisition of Alltel Wireless and the divestiture of access lines to Frontier (which did not result in a bankruptcy, unlike the divestiture of New England access lines to Fairpoint or the resulting bankruptcy of Carlyle Group’s Hawaii Telecom). On top of this, they have integrated MCI (which six years ago was in disarray) into their business operations; bought one of the leading providers of collocation in North America (Terremark); and strengthened their position in the machine-to-machine segment through acquiring the remaining stakes in their NPhase joint venture and acquiring Hughes Telematics for $680 million in June.
The most impressive element of Verizon’s growth, however, has been growth from the core retail (and until the iPad, postpaid) wireless business. Sure, they continue to have a relationship with Wal-Mart as one of many providers for their Straight Talk service (and, as a result, re-launched their own prepaid retail offering to mixed results).
As the chart above shows, Verizon’s maniacal focus on post-paid ARPU and churn has paid off. Unlike other attempts throughout the telecom history to acquire market share at marginal value levels, Verizon has grown approximately 20 million net customers on an organic basis, while raising cash flow margins and keeping retail postpaid churn steady. And they’ve accomplished this despite AT&T Mobility’s iPhone exclusivity and the rise of Leap Wireless and MetroPCS.
How did they do this? Sprint Nextel’s 2011 10-K provides our first clue:
Hard to believe, but during the same period Verizon Wireless was growing 20 million non-acquired customers, Sprint Nextel was losing nearly half that amount (9.8 million). Assuming that 40% of Sprint Nextel’s losses went to Verizon Wireless (which is likely conservative), at least 4 million or 20% of Verizon Wireless’ postpaid organic growth came through transfers from Sprint Nextel. However, at $55 ARPU, that only translates into $660 million in quarterly service revenue growth or just more than 10% of the total shown in the table above.
To get the remaining organic revenue and profitability growth, Verizon Wireless pulled two separate levers. First, to preserve profitability for the increasingly smarter phone base, it began to require all new 3G multimedia customers to purchase at least a $10 data plan per month in January 2010. By doing this, it eliminated the possibility that customers could buy a device with a heavier subsidy (which included a full 3G radio) and not generate at corresponding data revenue. This plan, which charged a whopping 40 cents per megabyte, started the process of tying network speeds (and their corresponding devices) to pricing plans. It also resulted in increased earnings before interest, taxes, depreciation and amorziation and operating margins (which topped 30% in Q4 2010 prior to the introduction of the iPhone last year).
Second, it bet big on Android, which created leverage in their forthcoming negotiations with Apple (note: while it may have seemed to some loyal Verizon Wireless customers like an eternity, it was actually less than 18 months from the introduction of the first Droid in October 2009 and the introduction of the iPhone 4 on Verizon Wireless’ network in February 2011). It created a franchise, Droid, around a single operating system, regardless of network speed. In the process, it probably saved Motorola from bankruptcy and quickly moved Google’s Android operating system into the smartphone mainstream.
One interesting note – in 2010, Verizon Wireless’ smartphones as a percentage of their total postpaid base increased from 15% to 26%. As of Q1 2012, it was at 47%. Clearly, introducing the iPhone helped smartphone adoption throughout 2011, but the Android momentum had already started in 2010.
Verizon faces a new set of challenges as it finishes out 2012 and enters 2013. As we discussed with AT&T, the wireline unit continues to struggle with lower earnings. Overall, the wireline unit generates about $600 million per quarter in free cash flow, of which $500 million comes from lower ongoing capital expenditures than depreciation and amortization. This is barely enough to cover the estimated $590 million in interest expense attributable to debt carried by the wireline unit (using Q1 net debt of $6.4 billion for the wireless unit that was communicated on the Q1 conference call). Simply put, FiOS’ promise is being overshadowed by significant value declines in the rest of the wireline business. As we have said many times before in this column, the wireline unit would have a fundamentally different value without the current support from their wireless counterparts.
Verizon is continuing to invest in the wireline business, as discussed earlier with cloud and M2M. What is greatly surprising, however, is their inability to turn their business and enterprise brand (and effective duopoly with AT&T in the global marketplace) into a profit engine. The global profit picture will likely continue to be under pressure as Europe struggles, but it might also create opportunities to strengthen their footprint abroad.
Also needed is a quick path to LTE-centric (and, in some cases LTE-only) devices. With LTE adoption varying worldwide (and with most countries lacking the growth seen in the United States), Verizon Wireless is placed at a competitive disadvantage versus a global LTE standard. Also, while Qualcomm continues to heavily influence the LTE standards, alternatives to Qualcomm’s 3G dominance exist with many LTE chipsets. Faster LTE increases sourcing flexibility, profitability and global competitiveness.
Verizon Wireless also seems to have become a victim of its own success, with their recent offer to purchase 1.7/2.1 GHz spectrum from several cable companies being put on ice by the Department of Justice. While it is likely that the joint marketing arrangement will be amended to exclude and/or restrict certain Verizon FiOS jurisdictions, it’s the beginning of a more systematic evaluation of each Verizon acquisition against their market position.
Few, including me, would ever have predicted that any company could survive let alone thrive against the execution hurdles Verizon has faced. From the combination and integration of six separate regional wireless companies (Bell Atlantic Mobile, GTE, PCS PrimeCo, Western Wireless, Rural Cellular and then Alltel Wireless), to the acquisition of MCI, to managing an ever-growing JV with Vodafone, to countering AT&T’s exclusivity with Apple in 2007 with the launch of the Droid franchise in 2009, the road to success has not been easy for Verizon over the past decade. There was no leadership heritage within Verizon to draw upon – it had to be built from within. But Verizon will continue to flourish because of its willingness to make smart bets, whether network/operating system supplier choices, technology selection, partnerships or acquisitions. The rewards should be apparent in this Thursday’s earnings and in their 2012/2013 outlook.