High Margins at Verizon Wireless Unlikely to Last

High Margins at Verizon Wireless Unlikely to Last

For the fourth quarter of 2013, Verizon Communications reported a surge in operating margins in the wireless sector due to lower subsidies for new accounts. The question is whether the wireless provider can continue generating these higher margins with Sprint Nextel and T-Mobile in customer-acquisition mode.

While Verizon is generating solid gains in FiOS Internet and video segments, the company is increasingly dominated by its wireless division. In total, fourth-quarter revenue only gained 3.4%, but the company was able to hold expenses down. The combination sent operating margins surging, but the lack of spending to attract new customers could hurt growth in 2014 and beyond.

Subscriber additions decline
Verizon added 1.7 million net additions for the fourth quarter to reach 102.8 million total retail wireless connections. Net additions were actually a 26% drop from the 2.2 million additions acquired during the same period in 2012. Is this a sign that competition from Sprint and T-Mobile is heating up?

T-Mobile had total net customer additions of 1.65 million, compared to a loss in the year-ago period. While a lot of the additions were in the wholesale segment, branded postpaid added 869,000 subscribers.

Sprint hasn't released fourth-quarter customer additions yet, but the increase in the build out of the 4G LTE network during 2014 should lead to a major competitive shift. The company spent most of the last two years transitioning customers off the old Nextel network. Unfortunately, that move pushed millions of customers off Sprint-controlled networks to the likes of Verizon Wireless.

Are the surging margins sustainable?
The increase in retail service revenue by 7.5%, and the nearly $800 million reduction in costs of services, led to a surging operating margin of 29.5%, up from 24% in the year-ago period. The combination also led to free cash flow of $22.2 billion for the year. With the completed deployment of the 4G LTE network, the company will no longer grow by covering additional populations. On one hand, this will help keep capital expenditures in check, with investment expected to be nearly flat in 2014 at around $16.75 billion. On the other hand, the maxed-out network means that competitors like Sprint and T-Mobile will catch up and whittle away at the competitive advantage.

In the case of T-Mobile, the "un-carrier" concept appears to be gaining steam. The bold moves to un-bundle smartphone costs from wireless service contracts is, naturally, attracting lower-end revenue customers.

For Sprint, additional spectrum from Clearwire and the build out of 4G LTE service will leave the wireless provider in a substantially more competitive position at the end of 2014. At that point, the company should have roughly 200 million people covered by the 4G network. With a larger spectrum position than both AT&T and Verizon, analysts expect Sprint to have a compelling network advantage over the two larger rivals, with more capacity and faster Internet speeds. While a technological possibility, the company will have to execute in order to actually attract and retain customers.

Bottom line
With real competitive threats from Sprint and T-Mobile, it will be difficult for Verizon to remain a leader without offering better deals. The wireless leader might find itself losing subscribers this year if it doesn't offer a less-profitable pricing solution. T-Mobile has already matched Verizon's customer additions during the fourth quarter, and Sprint is finally becoming competitive with a 4G network. The drastic reduction in network and pricing advantages during the year will undoubtedly place a strain on the customer additions. Investors shouldn't expect margins to remain this elevated into 2015, with price quickly becoming the differentiating factor in wireless provider decisions.

With Verizon trading at only 12 times forward earnings, the stock trades at a reasonable valuation, but one that provides limited upside if margins are pressured going forward.

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