On The Money

Moffett: Verizon Fails Deal Sobriety Test

Analyst says leverage, dividend constraints make M&A difficult 4/24/2017 2:45 PM

MoffettNathanson principal and senior analyst Craig Moffett continued to be among the voices of reason after Verizon CEO Lowell McAdam reignited speculation the telco could be on the hunt for a transformational deal – read: Charter or Comcast – adding in a blog post that the telco simply can’t afford a big transaction.

Speculation has been high for months that Verizon, egged on by AT&T’s pending mega-merger with Time Warner Inc., would counter with a monster deal of its own with either Charter or Comcast. While the stock has settled since January, when reports first surfaced that the telco was eyeing a possible deal with Charter, McAdam told Bloomberg last week that he was open to merger talks with Comcast, Disney, CBS or any other major entertainment company that presented a compelling argument. 

Verizon definitely needs to do something – it is losing Fios TV customers and competition is getting thicker in its wireless business. But shelling out the tens upon tens of billions of dollars needed to fund a merger with Charter, Comcast, or Disney, would not be an easy task.

Now, McAdam didn’t necessarily say what end of the table Verizon would be on in any of those deals – buyer or seller – but most of the speculation has been around it being the buyer. And it also should be noted that McAdam didn’t say he was in talks with any of these companies, just that he would be open to talking with them, which, to be honest, he would have to say no matter what. Saying otherwise would only make them more vulnerable to shareholder suits.

But if investors see Verizon as being a deep-pocketed and free-spending buyer to right its listing ship, Moffett threw an ocean of cold water on the prospect.

In his blog posting, Verizon – A Sobriety Test, Moffett first notes that the telco’s leverage ratio has risen to about 2.6 times cash flow (its highest ever) as its profitability has eroded. While that would appear to provide some room for a deal – its target multiple is 4 times – the telco’s true leverage (which includes capitalizing all its operating leases and adding them to debt) that ratio rises to 3.4 times. Moffett added that Verizon has flirted with higher total leverage (3.5 times) in 2013 when it purchased the remaining interest in Verizon Wireless from Vodafone for $130 billion in cash and stock. But he noted that times were vastly different then – when it closed that deal in February 2014, Verizon’s organic revenue growth rate was 6.2%. In the just-passed first quarter, Verizon’s consolidated growth rate has plummeted to -4.5%.
“To state the obvious, the credit profile of a company growing at 6% is a bit different than that of a company shrinking by an almost like amount,” Moffett wrote.

So that would put a damper on how much cash Verizon could put into a big deal. But what’s that you say? Most companies want equity anyway, for the tax benefits? Verizon stumbles on that front too.

According to Moffett, the biggest wet blanket in an equity deal was, is and always will be Verizon’s stock dividend commitment.

“Ordinarily, limitations to one’s balance sheet require that acquisitions be financed with equity instead,” Moffett wrote. “But for Verizon, issuing equity doesn’t just dilute earnings. It also carried with it a 5% coupon.”

Declining free cash flow has already put pressure on Verizon to cover its dividend. Moffett noted that in the first quarter, Verizon reported a free cash flow loss, which meant it couldn’t cover the dividend. Even using adjusted free cash flow, Moffett wrote that first quarter results suggest that Verizon’s dividends are 70% higher than their normalized free cash flow.

Moffett added that Verizon isn’t precluded from doing any deals, just ones where it has the highest free cash flow yield. It could do a deal similar to AT&T’s 2015 purchase of DirecTV. But Moffett added that the reason AT&T was able to buy DirecTV at a discount to its own valuation was that DirecTV was already priced for what Moffett called “secular decline.”

“Now, two years later it is indeed secularly declining (after adjusting for the forced migration of U-verse subscribers) and AT&T will soon be worse off for having bought it,” he wrote. “With the writing already on the wall, AT&T was forced to go back to the well to buy yet another massive asset, Time Warner, Inc., less than a year after their DirecTV deal closed.”

Buying an asset that is trading at a premium to Verizon – like Charter, Comcast, Dish or Disney – would make the dividend coverage and leverage ratios worse, he wrote. And one much talked about solution – buying a better asset but selling off its existing Fios assets to help finance the deal – only works if they can sell those assets at a higher multiple than the ones they are buying. That wouldn’t be easy.

The difficulty in finding a path to a deal goes both ways. Moffett noted that Charter’s big shareholder John Malone wouldn’t likely be eager to swap Charter (growing at a 7% clip) for equity in a company that is declining 4.5% with a dividend commitment currently more than 100%.

Moffett closed with his reasoning for upgrading Verizon to “buy” in February – the stock was cheap and sentiment was overly bearish.  

“Included in that overly bearish view was (is) the expectation that Verizon will do a badly dilutive acquisition,” Moffett wrote. “Perhaps they still will. But our analysis here suggests they may have less flexibility to do so than most seem to think.”