Source: Seeking Alpha
Verizon Communications Inc. (NYSE:VZ)
Q2 2014 Earnings Conference Call
July 22, 2014 7:30 AM ET
Executives
Michael Stefanski – SVP, IR
Fran Shammo – EVP and CFO
Analysts
Phil Cusick – JPMorgan
Michael Rollins – Citi Investment Research
Simon Flannery – Morgan Stanley
David Barden – Bank of America
John Hodulik – UBS
Mike McCormack – Jefferies LLC
Kevin Smithen – Macquarie
Jonathan Schildkraut – Evercore Partners
Jennifer Fritzsche – Wells Fargo
Operator
Good morning and welcome to the Verizon Second Quarter 2014 Earnings Conference Call. At this time, all participants have been placed in a listen-only mode and the floor will be opened for questions following the presentation. (Operator instructions) Today’s conference is being recorded. If you have any objections, you may disconnect at this time.
It is now my pleasure to turn the call over to your host, Mr. Michael Stefanski, Senior Vice President, Investor Relations.
Michael Stefanski
Thanks, David. Good morning and welcome to our second quarter earnings conference call. This is Mike Stefanski and I’m here with our Chief Financial Officer, Fran Shammo.
We appreciate you joining us earlier than our usual time this morning. Before we get started, let me remind you that our earnings release, financial and operating information, the investor quarterly and the presentation slides are available on our Investor Relations website. Replays and a transcript of this call will be made available on our website.
I would also like to draw your attention to our Safe Harbor statement. Information in this presentation contains statements about expected future events and financial results that are forward-looking and subject to risks and uncertainties. Discussion of factors that may affect future results is contained in Verizon filings with the SEC, which are also available on our website. This presentation contains certain non-GAAP financial measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are also available on our website.
The quarterly growth rates disclosed in this presentation are on a year-over-year basis, unless otherwise noted as sequential.
Before Fran takes you through the details of our quarterly performance, I would like to cover a special item that is included in our reported results on Slide 3. For the second quarter of 2014, we reported earnings of $1.01 per share on a GAAP basis. These reported results include a pre-tax gain of $707 million related to the sale of 700 megahertz A block spectrum licenses.
On the after tax basis, this gain increased reported net income by $434 million or $0.10 per share. As we’ve done in the past, we’ve accounted for the gain on the sale of these licenses at the corporate level, so it is not part of our Wireless segment results. Excluding the effect of this non-operational item, adjusted earnings per share was $0.91 for the second quarter compared with $0.73 a year ago or growth of 24.7%. On a year-to-date basis, adjusted earnings per share were $1.76 compared with $1.41 last year up 24.8%.
Keep in mind that the $1.76 per share first half result does not reflect full ownership of Verizon Wireless for the entire first quarter since the transaction closed on February 21st.
As discussed on our first quarter call, full ownership for the quarter represents as an additional $0.07 per share of earnings. With that, I will now turn the call over to Fran.
Fran Shammo
Thanks, Mike. Good morning, everyone. We entered 2014 with the great confidence in our ability to grow the business profitably while making the necessary capital investments to position us for the future.
In the first quarter, we closed the Vodafone transaction and delivered strong financial results. On our last earnings call, I indicated that we exited the first quarter with better momentum and expected that to carry forward.
As you can see from our second quarter results, we delivered on what we said, producing very strong customer growth metrics and Wireless and FiOS, in driving excellent top line growth and profitability.
We are competing effectively in all markets and executing our strategy which is focused on providing network reliability and a great customer experience.
Over the past two and a half years, we have delivered consistent high quality earnings results with double-digit year-over-year growth and reported and adjusted earnings per share in nine of the last 10 quarters.
Our adjusted earnings per share of $0.91 represented another quarter of more than 20% growth. This sustained earnings growth demonstrates our ability to execute effectively in all parts of the business in a highly competitive environment.
Our consolidated revenue performance was strong with growth accelerating to 5.7%, our highest growth rate in the past six quarters. In Wireless, we had a great quarter of both growth and profitability. 4G device activations were exceptionally strong resulting in $2.3 million 4G postpaid net adds. Total postpaid net additions top $1.4 million, total operating revenue grew 7.5% with service revenue growth of 5.9% and our EBITDA service margin was 50.3%.
In Wireline, we also had a good quarter with improved growth and margin expansion. Quarterly operating revenue grew 0.3% which is a milestone led by consumer growth of 5.3% as we continue to drive FiOS penetration and customer adoption of our quantum broadbrand and video products.
Wireline EBITDA increased 4.9% and the EBITDA margin improved to 23.2% up 90 basis points sequentially and 100 basis points year-over-year.
Our cash generation continues to be very strong enabling us to consistently invest in our networks for future growth and innovation. Free cash flow was $3.3 billion in the quarter and totaled $6.3 billion for the first half.
Now, let’s get into our second quarter performance in more detail starting with consolidated results on Slide 5.
Total operating revenue grew 5.7% in the quarter continuing our consistent and improving top line growth trend. Revenue increases were once again driven by Wireless and FiOS. As we indicated last quarter, new revenue streams from machine-to-machine and Telematics while still relatively small are beginning to emerge and make positive contributions with revenue growth of more than 50% in the quarter.
Our continued focus on driving process improvements and cost-efficiencies is also paying off. In the second quarter, adjusted operating income increased 10.4%. To my earlier point about consistent earnings growth, we have also delivered double-digit growth and adjusted operating income in nine of the 10 quarters.
On an adjusted basis, consolidated EBITDA grew 6.4% to $11.1 billion. And our EBITDA margin was up 30 basis points to 35.4%.
Let’s take a look at our cash flow results on Slide 6.
As we previously discussed, it is important to know the lack of comparative ability between the current and prior periods in our statement of cash flows as result of the transaction to require a full ownership of Verizon Wireless.
In 2014, the cash flows from operations line will include higher cash payments for interests and taxes. The cash flows from financing section will have lower cash distributions to Vodafone and higher overall dividend payments to our shareholders due to the increase and shares outstanding.
In the first half of 2014, cash flows from operations worth $14.8 billion which included an incremental $1.2 billion of cash interest payments, $1.5 billion in cash taxes and $800 million of pension funding that we did not have in the first half of 2013. In spite of this additional uses of cash and higher capital spending, free cash flow totaled $6.3 billion year-to-date.
Again, the key point on cash flows is a simple one. The amount of cash available task will be significantly greater this year than some of the former partnership structure, 45% of any excess cash at Wireless would at some point be distributed to Vodafone. So even after a higher interest payment and greater cash taxes, we will have more cash available at the corporate level than prior to the transaction.
I would also point out that we received $2.4 billion in cash flow in the quarter from the transaction to sell wireless licenses to T-Mobile. Capital expenditures for the quarter totaled $4.3 billion and we’re $8.5 billion year-to-date up about $900 million or 11.5%. Wireless capital spending in the second quarter was $2.5 billion. And through the first half totaled $5.3 billion, well ahead of what we spent through the first half of last year.
We are investing to proactively stay ahead of demand. As we’ve said, our capital investments are focused on adding capacity to optimize our 4G LTE network primarily by increasing network density and the point spectrum. We are actively deploying AWS spectrum across our nationwide footprint and currently have more than 350 markets with AWSF or XLTE as we are branding it. The continued deployment of AWS and the addition of small sales distributed in terms of systems and the in building solutions will fortify our network advantage.
In Wireline, capital expenditures totaled $1.3 billion in the quarter and $2.7 billion year-to-date which we’re down $219 million or 7.4%. Our balance sheet remained strong and we continue to have the financial flexibility to grow the business. Gross stat of just under $110 billion was essentially unchanged from the last quarter. Our Net Debt position improved to about $104 billion and the Net Debt to adjusted EBITDA Ratio at the end of the quarter was 2.4 times.
Now let’s move into review with the segments starting with Wireless on Slide 7.
Our consistent investment in Wireless is the foundation of our success and drives our leadership in network quality, reliability and the overall customer experience. Our capital investment strategy is focused on adding capacity to the network to meet increasing 4G device adoption which will drive higher customer usage.
As I highlighted earlier, we have an exceptional quarter of 4G Smartphone and tablet activations with increase in gross addition and upgrades. We also did an excellent job in terms of customer retention. The increase in device volume was driven by a combination of factors starting with the compelling value proposition of our new MORE Everything plans on our high quality 4G LTE network. As you know, we refresh our pricing in framework and value proposition in the first quarter.
Within this plans, we are providing customers a choice between the traditional two years service contracts with subsidize devices of Verizon Edge where customers make monthly installment payments with their devices that receive discounted monthly service pricing. We are also driving 4G device adoption with attractive tablet offers. Our sales strategy in the second quarter dramatically improved customer growth which created strong minimum for us as we entered the second half of the year.
Total Wireless revenues grew to $21.5 billion up 7.5%. Our service revenues grew 5.9% to $18.1 billion. This was the first full quarter of discounted service pricing for customers on Verizon Edge. A portion of the sequential decline in the rate of growth was due to the tradeoff between the lower service revenue and higher monthly equipment billings. The percentage of phone activations by customers choosing Edge increased to about 18% in the quarter up from about 13% in the first quarter.
In terms of profitability, we generated $9.1 billion of EBITDA in the quarter, an increase of 6.8%. As I highlighted earlier, our service EBITDA margin was 50.3%, 50 basis point higher than a year ago. The estimated benefit to EBITDA in the quarter from Edge was not significantly different than in the first quarter due to the cumulative impact of service price discounts in the program.
Let’s now turn to a more detailed look at Wireless revenue per account beginning on Slide 8.
Our service revenue growth was once again driven by 4G smartphone and tablet adoption as well as increased data usage. Retailed postpaid revenue per account or ARPA moved 4.7% which was down from 6.3% in the first quarter. Again, more than half of the decline in the rate of growth resulted from this being the first full quarter of discounted monthly service pricing from Edge.
Since ARPA is calculated using service revenue, it does not capture the monthly equipment billings from customers on the Edge program. In the second quarter, monthly equipment billings totaled about $180 million which was significantly higher than the first quarter. We continued to see good additional device adoption within our customer accounts. We ended the second quarter with an average of 2.8 retail connections per account, an increase of 3.7%. About 55% of our 35.2 million postpaid accounts have subscribed to MORE Everything shared data plans. Increased usage per device and per account continues to drive step ups to higher data tiers.
Let’s take a closer look at connections growth on Slide 9.
We ended the quarter with $104.6 million total retail connections. Our industry leading postpaid connection space reached $98.6 million and prepaid totaled just over $6 million. Postpaid gross additions in the quarter were significantly higher both sequentially and year-over-year. Our 4.2 million postpaid gross add were 18.1% higher than a year ago in terms of the gross add mix, more than half for smartphones at about 40% more internet devices primarily tablets.
Our retail postpaid term rate of that 9.4% was much improved from the first quarter and only one basis point higher than the second quarter of last year. As we previously said, postpaid net additions were very strong and totaled 1.441 million up 900,000 sequentially at about 500,000 from last year.
As I highlighted earlier, our postpaid net additions included 2.3 million new 4G devices. Within that total more than 1 million were 4G smartphones and 1.2 million were 4G tablets. Postpaid phone net adds totaled a positive 304,000 as the 1 million new 4G smartphones were partially offset by net declines in basic and 3G smartphones.
For the third straight quarter, we had company record setting tablet net adds. While 4G smartphones provide the highest value, tablets provide a very good incremental value through increased data consumption and lower churn at the account level. Tablets also have a lower cost subsidy than smartphones. We see tablet as the highly profitable growth opportunity with significant headroom in terms of further penetration. Our postpaid tablet base is only 5.4 million. So we have a great opportunity with these devices to generate growth in 2014 and beyond.
Turning now to customer upgrades. Our postpaid upgrade rate increased sequentially to 7.1% for the quarter. Once again, these were high quality upgrades. About 90% of all upgrades in the quarter were smartphones. Consistent with our plan to drive 4G smartphone penetration about 1.4 million or 23% of our smartphone upgrades were from basic phones. About half of the remaining smartphone upgrades were 3G to 4G which we monetized through higher data usage and lower cost to serve.
Next, let’s turn to Slide 10 and take a look at device activations and our continued progress in terms of 4G adoption and usage. Postpaid device activations which we include both gross adds and upgrades increased both sequentially and year-over-year. Second quarter activations totaled 11.1 million up 10.2%. Smartphone activations totaled 8.3 million, 92% of which were 4G.
Our smartphone penetration increased to nearly 75% of our total phones. We ended the quarter with 63.5 million smartphones and about 69% of those were 4G. So we still have about 20 million 3G smartphones and almost 22 million basic phones in our base which provides us with a good upgrade opportunity. Our overall 4G device penetration continues to steadily increase. At the end of the second quarter nearly 55% of our retail postpaid connections were 4G, up from 33% a year ago.
Data and video usage on our network continues to rise. Currently about 76% of total data traffic is carried on the 4G LTE network. We carry more traffic on our Wireless network than any of our competitors. This network advantage continues to be acknowledged by national surveys from widely recognized third party organizations. More importantly, our own stringent drive testing shows that we are continuing to improve our network performance.
Let’s move next to our Wireline segment starting with the review of our consumer and mass markets revenue performance on Slide 11.
In the Consumer business, we continue to see positive revenue trends driven by FiOS. In the second quarter, Consumer revenue growth was 5.3% making it eight consecutive quarters of growth in excess of 4%. Mass markets which includes small business grew 4.2%.
FiOS now represents 75% of consumer revenue and we are sustaining strong double-digit revenue growth. In the second quarter, FiOS consumer revenue grew 13.4% driven by customer additions, pricing actions and Quantum penetration. We continue to see strong adoption of Quantum as 55% of our FiOS Internet customers subscribe to the higher speeds ranging from 50 to 500 megabits per second.
We continue to enrich the customer value proposition and drive investment returns by creating new and innovative services on our FiOS platform. We recently introduced FiOS Quantum TV with enhanced features and functionality in terms of storage, recording capabilities and control of content. While still in the early stages, we are pleased with the initial adoption of this differentiated TV viewing experience by existing and new customers.
In our FiOS markets, we continue to focus on adding quality customers and generating profitable growth in a very competitive market environment. In Broadband, we added 139,000 new FiOS Internet customers in the second quarter and now have 6.3 million subscribers representing 40% penetration.
Overall, net broadband subscribers in the quarter were a positive 46,000. In FiOS video, we added 100,000 new subscribers in the quarter. So we now have 5.4 million subscribers representing 35% penetration.
During the quarter, we also converted about 70,000 customers from copper to fiber. This network initiative continues to be important as we systematically upgrade our network and provide higher quality of service.
Aside from maintenance savings and improvements in customer satisfaction, conversions to fiber also provide a long-term opportunity for customers to purchase FiOS services which result in additional recurring revenue.
Let’s turn to Slide 12 and review our overall Wireline segment revenue and profitability. In the Enterprise space, we continue to work through secular and economic challenges. In the second quarter, Global Enterprise revenue declined $70 million or 1.9%. Revenue declined in Legacy Transport Services and CPE continue to outweigh growth in newer and more strategic applications which are smaller in scale.
Strategic Services which include Private IP, Ethernet, Datacenter, Cloud, Security and Managed Services, grew 3%. In our Global Wholesale business, quarterly revenues declined $92 million or 5.5%.
While we continue to see healthy demand for Ethernet services, positive growth continues to be more than offset by price compression, technology migration and other secular challenges.
As I highlighted earlier, total Wireline growth turned positive this quarter. Looking ahead, we expect to continue to see some fluctuation in year-over-year growth rates. We are making progress but are not satisfied, we have much more to do here. We are focused on continuous improvements particularly in driving operating efficiencies.
Wireline EBITDA increased 4.9% and the EBITDA margin expanded 100 basis points in the quarter to 23.2%. We continue to target increased Wireline EBITDA and margin expansion in 2014. As Lowell and I have both stated we continually look for opportunities to streamline the business and monetize non-strategic assets. To that end, on July 1st, we closed the transaction for the sale of the unit within our public sector business with revenues of about $600 million in 2013. A majority of which was equipment.
Let’s move next to our summary slide. As always, the foundation of our success is the steady and consistent investment in networks and platforms. These networks and platforms form the building blocks for the innovative products and services that will fuel our growth and improve the customer experience.
Our Wireless and Wireline networks continue to be the hallmark of our brand and provide the fundamental strength upon which we build our competitive advantage. We had a strong first half of 2014, with consolidated revenue growth of 5.2% and 36% adjusted EBITDA margin representing 90 basis points of margin expansion.
We continue to deliver high-quality double-digit earnings growth and we have a much stronger cash position with the full access to Wireless cash flows. We have great confidence heading into the second half of the year and we remain on track to achieve our revenue growth, margin expansion and capital spending targets for the year.
We have strong momentum in Wireless and expect to build on that strength driving further penetration of 4G smartphones and tablets while extending our network leadership position in 4G LTE. In FiOS, we expect to drive higher penetration in existing markets, and continue to differentiate ourselves with the superior Quantum broadband and video products.
In the Enterprise space, we will continue to aggressively market key platforms, demonstrating that we have a unique set of capabilities to provide for customer solutions. As always, we will remain extremely focused on profitable revenue growth and will continue to drive network and cost structure improvements, utilizing our Verizon Lean Six-Sigma principles.
With that, I will turn the call back to Mike, so we can get to your questions.
Michael Stefanski
Thank you, Fran. David, we’re now ready for questions.
Question-and-Answer Session