by David Dixon of FBR & Co. (edited for conciseness and clarity by Alan J Weissberger)

Summary:

Verizon reported 2Q16 results that fell short of Street expectations. Consolidated revenues declined 5.3% YOY to $30.5B, compared with consensus of $30.8B. Topline weakness was attributable to the shift towards unsubsidized plans and lower postpaid phone activations. However, excluding AOL and divested wireline assets, revenues would have declined 3.5% YOY. Despite continued growth in IoT, retail postpaid net adds of 615,000 were below consensus estimates of 784,000 due to higher tablet churn from the anniversary of the free tablet promotion two years ago.

Management expects the tablet promotion will continue to pressure churn through the remainder of the year, but could be mitigated by growing ARPA, in our view. While the quarter was disappointing, over the longer term, we still view VZ as best-in-class due to

(1) high-quality network,

(2) high-quality subscriber base,

(3) more efficient cost management helping to offset margin impact from shift towards unsubsidized model,

(4) growing media platform with the acquisition of AOL and YHOO, and

(5) consistent dividend growth.

Furthermore, heavy investment in 5G and spectrum refarming should put VZ in the forefront of 5G deployment. VZ is currently conducting technical trials in several markets following the completion of radio specifications.

Key Points:

■ 2Q16 results recap. Consolidated revenue of $30.5B (–5.3% YOY) below our $32.6B estimate and consensus’ $30.8B, driven primarily by a 8.4% YOY decline in wireless revenue and a 2.4% YOY decline in wireline revenue. Adjusted EBITDA of $11.1B (+0.2% YOY) was ahead of the consensus estimate of $11.0B but below our estimate of $11.8B. Postpaid net adds were 615,000, with churn of 0.94% and a prepaid net loss of 30,000. Adjusted EPS of $0.94 were ahead of the consensus estimate of $0.92.

■ Yahoo acquisition to boost digital media presence. Combined with AOL, VZ’s $4.8B complementary acquisition of YHOO will shore up its sagging media business, in our view. We believe original content on AOL/YHOO platforms could help VZ to become a major player in mobile media, offsetting weakness in the traditional wireless business.

■ Cost structure reductions moving forward. VZ continues to make progress in reducing its cost structure through head-count reductions, improved productivity, operational efficiency, and new labor contract benefits to offset weakness in wireless and wireline businesses. Capex spend is anticipated to increase in 2H16 following a downtick in wireline capex in 2Q as VZ focused on maintenance rather than new installations during the work stoppage.

Q &A:

1. Aside from being well positioned on spectrum for the macro network and densification, how to assess the small cell opportunity as an alternative to more macro network spectrum going forward?

A change in the industry network engineering business model is underway. Software-centric small cells on dedicated spectrum provide the opportunity for greater spectrum reuse and will manage more of the heavy lifting associated with data congestion. Verizon demonstrated this shift during the AWS3 auction: It modeled a lower-cost small cell network for Chicago and New York. We expect CEO Lowell McAdam to manage this shift from the top down to mitigate execution risk due to cultural resistance from legacy outdoor RF design engineers, whose roles are at risk as the macro network is de-emphasized. Enablers include LTE and increased spectrum supply across multiple spectrum bands, including licensed, unlicensed (500 MHz of 5 GHz spectrum), and shared frequencies (150 MHz of 3.5 GHz spectrum), amid a fundamental FCC spectrum policy shift from exclusive spectrum rights to usage-based spectrum rights, which should dramatically increase LTE spectrum utilization (similarly to Wifi).

Previously, outdoor small cells co-channeled with the macro network proved challenging. While they can carry substantial loads, they also destroy equivalent capacity on the macro network due to miscoordination and interference, so the macro network carried less traffic but still looked fully loaded. AT&T discovered this in its St. Louis trials that, in part, steered it toward buying $20 billion of AWS3 spectrum. However, the industry trend is toward LTE underlay networks, where small cells are put into other shared or unlicensed spectrum with supervision from (and/or) carrier aggregation with the macro network. It still requires good coordination across all cells for this to work; while Verizon s initial proposals for 5 GHz are downlink only, we think uplink will also be used longer term because uplink needs more spectrum resources for a given throughput. We see higher uplink usage trends in the Asian enterprise segment and from Internet of Things (security cameras).

2. Does Verizon have sufficient spectrum depth to drive revenue growth longer term? Or does it need to aggressively acquire spectrum in future spectrum auctions or in the secondary market (DISH)?

We believe the short answer is yes. Verizon carries 90% of data traffic on 40% of its spectrum portfolio; its combined nationwide CDMA and LTE spectrum depth is 115 MHz, ranging from 88 MHz (Denver) to 127 MHz (NYC). We expect AWS3 capacity spectrum to be deployed in 2017/18. Investors may not be crediting Verizon with potential to source more LTE spectrum from refarming of CDMA to LTE (22 MHz to 25 MHz) used today for CDMA data (22 MHz to 25 MHz). Critically, network performance data show Verizon s network close to the required performance threshold for a VoLTE-only service, suggesting additional refarming potential for the 850 MHz band (25 MHz) used today for CDMA voice and text. This band is likely to be transitioned in 5 MHz x 5 MHz LTE slivers to run parallel with the expected linear (voluntary) ramp, versus exponential (forced) ramp in VoLTE service. More low-band spectrum is key for the surging IoT and M2M segments, which are proving to be more thirsty than “bursty.”

Conclusions:

Verizon is a high-quality company with significant long-term wireless growth opportunities as mobile video and over-the-top Internet app business models evolve.  However, there are risks for VZ:

1.  A possible move may be to spin off the wireless operation. Verizon Wireless composes a material portion of the company’s total revenue and EBITDA. Therefore, while unlikely, any potential spin-off of Verizon Wireless could increase valuation uncertainty.

2. Verizon is exposed to overall economic momentum and is dependent upon economic recovery. Any unexpected downturn would likely result in lower spending in telecommunications and decreased investment in wireless, data, and broadband, as well as enterprise data initiatives.