by David Dixon and Mike He of FBR & Co.

Summary:

Weaker macroeconomic conditions and an increasingly competitive market chipped away at VZ’s results this quarter. The shift to a lower-priced, unsubsidized device model should continue to weigh on wireless revenues, exacerbated by declining net add growth due to heightened competition. Management vows to protect its highquality subscriber base, but competitive network quality is converging.

VZ still leads the market but may need to use the pricing lever to a greater extent to maintain market share, as all other national competitors are offering unlimited data plans at attractive price points. Strategically, VZ will seek to differentiate through accelerated 5G deployment, relying on 3.5 GHz unlicensed spectrum as its indoor play and spectrum refarming, which should yield cost savings and expedite launch due to a growing ecosystem around 3.5 GHz.

We think AT&T is leading in IoT, but this is a growth segment with network standards finally set.

Editors Note:  We don’t believe IoT network standards are set, particularly for LPWA networks:

A weak macro environment in all verticals is driving lower capex; we see a capacity spectrum supply shock driving less dependency for licensed spectrum for 5G. M&A and weaker expected growth due to capacity challenges at T Mobile are potential 2017 catalysts.

Key Points:

■ Consistent with our previous publications on network topology shifts toward distributed datacenters in the metro network, management affirmed it is in advanced talks to sell its less strategic, centralized data center assets, which could be announced in early 4Q.

■ 5G heavy lifting using unlicensed spectrum. With VZ (and AT&T) barred from the 30 MHz of spectrum set aside in the broadcast incentive auction due to its large cache of existing low band spectrum, we believe the prospect of paying a premium valuation for 600 MHz spectrum may not be as appealing at a time of heightened industry competition and low industry demand. The 3.5 GHz ecosystem is moving ahead faster than expected and could be leveraged by VZ to do more of the heavy lifting for 5G, which would also suggest less dependence on new licensed spectrum.

■ Lower capex across the industry. Our industry checks indicate a weak capex environment across the industry, which drove VZ’s lower-than-expected 3Q capex spending of $4.1B, versus Street expectations of $4.8B. We believe this is driven by a combination of network architecture shifts and macro economic conditions across all sectors.

Q & A:

Aside from being well positioned on spectrum for the macro network and densification, how should investors 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 under way. 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 $20B 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 (e.g. security cameras).

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)?

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 surging IoT and M2M segments, which are proving to be more thirsty than bursty.

Conclusions:

Verizon is a high-quality defensive name and significant long-term wireless growth opportunities as mobile video and over-the-top Internet app business models evolve.

Editor’s Note:  

We’re surprised that Mr Dixon didn’t discuss VZ’s acquisition of content companies like aol, Huffington Post and most recently Yahoo’s Internet portal.  Will the Yahoo hack or their cooperation with the feds on reading incoming emails effect Verizon’s price for Yahoo or even cause the deal to be cancelled?