Verizon's Big Bet Starts to Pay Off

Fourth-quarter results vindicate CEO Seidenberg's efforts to transform the telco into a multichannel delivery service

Under Chief Executive Ivan Seidenberg, Verizon Communications (VZ) is trying to reposition itself as a provider of premium communications services—depending less on the meat-and-potatoes phone company fare of decades past. To that end, Seidenberg is pushing ahead with a plan to spend $18 billion to build a network capable of delivering not just telephony but also Internet access and a gamut of TV and video. Bigger rival AT&T (T) is upgrading its network too, but spending far less—$4.6 billion—to get it done.

Comparisons like that have scared some of the sharpest minds on Wall Street, causing many analysts and investors to question whether Verizon's outsize investments will produce an equally outsize payoff.

But on Jan. 29, Verizon's earnings announcement provided some fresh evidence that Seidenberg's bold strategy is beginning to gel. Although the company's fourth-quarter revenue fell due to taxes on the sale of assets and costs related to a spin-off, Verizon's results surpassed Wall Street estimates in several key areas. Its wireless arm continues to propel the company, its enterprise business is showing signs of a turnaround, and new markets in video and broadband are also gaining momentum. "It was a solid quarter," says Todd Rosenbluth, an analyst with Standard & Poor's, which like is owned by the McGraw-Hill Cos. (MHP). Verizon's stock edged higher on the announcement, gaining 20¢, to $38.03, but that may be because some of the improved outlook is already reflected in the stock price, which has risen more than 12% since late November.

Wireless Steals the Show

In the fourth quarter of 2006, Verizon earned $1.03 billion, or 35¢ a share, down from $1.66 billion, or 59¢ per share, a year earlier. Net income was reduced primarily by a $541 million after-tax charge related to the sale of the company's telecom assets in the Dominican Republic and $101 million in costs stemming from the spin-off of Verizon's directory business. On the sales side, fourth-quarter revenue totaled $22.6 billion, a 26.1% increase from a year earlier, though a big chunk of the gain came from the acquisition of the MCI long-distance business in early 2006. Without the benefit of MCI, Verizon grew sales 3.9% over the year-ago quarter.

As it has for years, Verizon Wireless, a joint venture with Vodafone (VOD), stole the spotlight from Verizon's other businesses. It added 2.3 million new customers in the fourth quarter, ending the year with 59.1 million customers. Analysts at Bank of America (BAC) expected just under 2 million subscribers. AT&T's mobile-phone business, formerly known as Cingular Wireless, added 2.4 million customers in the same quarter, ending the year with 61 million customers.

Though Verizon's gain was smaller, analysts believe the company is attracting a higher-quality customer, measured by revenue and loyalty. As proof, they point to the fact that a higher percentage—88%, or 2.1 million—of Verizon Wireless subscribers are "post-paid" customers that sign up in retail stores for two-year contracts. By contrast, only 67%, or 1.6 million of AT&T's 2.4 million customers, came from retail stores. The remaining customers, who typically pay in advance to use a phone for a short amount of time, tend to be either under 18 years old or don't have the wherewithal for a regular calling plan. As a result, Verizon's average revenue per user grew 2.9%, to $50.78, beating analyst estimates of $49.71. "Verizon's customers are going to be more loyal and generate more profitability for the parent company than AT&T's customers," says S&P's Rosenbluth.

Broadband on the March

Verizon Wireless is also outpacing its bigger competitor when it comes to growth. Verizon Wireless sales grew 16.3%, to a market-leading $10.1 billion, from $8.69 billion a year earlier. And the so-called churn rate, measuring the average percentage of subscribers who defect each month, came in lower than many forecasts, averaging an industry-leading 1.14%, compared with 1.8% for AT&T.

Verizon's phone business continued to shrink, but the revenue decline was offset by growth in other areas—digital subscriber line, or DSL, Internet access; the new, higher-speed broadband and TV network; and the former MCI operations that cater to corporations. Revenue for all wireline operations fell 3.5%, to $12.73 billion, compared to a 4.7% decline in the third quarter. "Wireline financials were slightly better than expected," wrote Bank of America analyst David Barden.

The improvement was driven mostly by new broadband customers. In the fourth quarter, Verizon added 409,000 new fast Internet connections, including 165,000 for its new fiber-based FiOS broadband service. The company now claims 687,000 FiOS Internet subscribers, representing a 14% penetration of the homes to which it's available. "The market penetration is exceeding some earlier expectations," says Rosenbluth. "The product is resonating with customers."

TV Taking Off

Perhaps the biggest surprise of the quarter came from Verizon's new effort to sell TV service and turn up the heat on cable providers such as Comcast (CMCSA) and Cablevision (CVC). Verizon has connected 6 million homes with fiber optics and cable broadcast technology—twice as many homes as AT&T.

Thanks to a strong fourth quarter, the company also handily surpassed analyst expectations on the TV front. For the year, Verizon signed up 207,000 TV customers, compared with 181,000 expected by analysts at UBS (UBS). By contrast, AT&T has signed up only about 15,000 TV customers for its comparable U-verse service. "We chose a proven technology that allowed us to get to market quicker," says Marilyn O'Connell, Verizon's senior vice-president for video solutions. "I feel so much better going into this year. We've got some momentum."

But Verizon is also taking a much bigger financial risk. Verizon's network will cost more than three times as much as AT&T's because it requires digging up trees and tulips to put fiber into every house. AT&T is only laying fiber into neighborhoods and using already laid copper lines to carry video the last mile to living rooms.

Despite the higher price tag, UBS expects Verizon to produce a return on its investment by 2011. The reason? It believes the higher bandwidth of Verizon's network will attract more video, Internet, and phone customers—at higher prices—and thus generate about four times as much revenue as AT&T's network.

Although the market for corporate customers has been declining the last few years, Verizon's enterprise business appears to be stabilizing. Revenue totaled $5.3 billion in the fourth quarter, up 2.7% over the year-ago quarter. Most analysts expected a small decline in sales. The company said it is seeing stronger demand for consulting services and broadband connections. Verizon also boosted its estimate of 2007 cost-saving targets from the MCI merger to $900 million, up from $825 million. "We believe this is a meaningful turnaround in the business," says Verizon Chief Financial Officer Doreen Tobin. "Verizon Business continues to have lots of opportunities to grow market share and increase efficiency."

To keep the momentum going, Verizon must continue to post strong results in its wireless arm as AT&T steps up the competition. One key test will be to see how the company's new mobile TV service performs when it is introduced over the next few months. Just as important, Verizon must continue to report gains in newer markets such as broadband and TV against aggressive rivals in the cable industry. Otherwise, investors will again raise questions about the wisdom of Seidenberg's plan.

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