Earnings Preview: Verizon

Verizon Communications (VZ), the second largest U.S. phone company, is slated to release its fourth quarter and fiscal 21010 earnings results on January 25, 2011, before the opening bell. The current Zacks Consensus Estimate for the fourth quarter is 55 cents, representing a 1.58% annualized growth.

Verzion had an average of 1.82% positive earnings surprise in the last four quarters. Hence, we will not be surprised if the carrier beats expectations in the fourth quarter on continuous broadband network investment, strong wireless and FiOS services, and increasing smartphones penetration.

On its third quarter conference call, Verizon has not released any financial forecast for the fourth quarter. For 2010, the company targets capital expenditure in the range of $16.8 billion to $17.2 billion.

Yesterday, Verizon announced that it will incur a non-cash pre-tax charge of $600 million in fiscal 2010 related to a change in pension accounting. This charge will reduce earnings per share by a penny in each quarter of 2010, including fourth quarter earnings. This move is similar to that of its largest rival AT&T Inc. (T) announced last week.

Despite these charges, Verizon stated that the company can achieve the upper end of its earnings per share expectation of $1.05 to $1.10 for the second half of 2010. The $600 million charge stems from the reduction in the pension discount rate to 5.75% from 6.25%, partially offset by higher-than-expected return on assets, favorable health care trends and other costs.

Verizon has changed its method of recognizing actual gains and losses for pension and other post-retirement benefits in order to improve transparency in its financial reporting. According to the company, these gains and losses will now be recognized in the year in which they are incurred, instead of amortizing them over several years.

Third Quarter Flashback

Verizon reported third quarter adjusted earnings per share of 56 cents surpassing the Zacks Consensus Estimate by 2 cents and the year-ago quarter’s earnings of 41 cents, driven by continued strength in Wireless, FiOs and strategic business services.

Revenues improved slightly driven by Wireless revenue on lower churn (customer switch) and higher data revenues. However, Verizon’s subscriber growth plunged as it struggled to compete with AT&T in the smartphone market.

Wireline revenue remained under pressure due to persistent erosion of access lines. FiOS services remain strong across all markets with the penetration rate of both FiOS Internet and FiOS TV reaching approximately 31% and 27.2%, respectively.

During the first nine months of 2010, Verizon’s cash and cash equivalents increased to $5.4 billion from $1.2 billion in the year-ago period. Debt-to-equity ratio declined to 58.4% from 59.3% in the year-ago period.

Agreement of Analysts

Analysts covering Verizon have not made any revisions to their earnings estimate either in the last seven days or last 30 days for the fourth quarter. For fiscal 2010, one analyst out of 26 revised the estimate downward indicating its concern regarding persistent erosion in access lines and the slowdown in post-paid subscriber growth.

Though Verizon Wireless is the largest U.S. wireless carrier with 93.2 million subscribers at the end of September 2010, it has been losing market share to AT&T’s iPhone exclusivity.

Verizon will start selling Apple Inc.’s (AAPL) iPhone from February 10, which will mark the end of exclusivity that AT&T iPhone has been enjoying since 2007. The company also started deploying its high-speed fourth generation Long-Term Evolution (4G LTE) network at the end of 2010 with average download speed more than five-times faster than the company’s third generation (3G) network.

In addition, Verzion is expected to offer new handsets and devices that support 4G network in 2011. These offerings will strengthen Verizon’s position with respect to Sprint Nextel Corp. (S), the first to launch handsets on its nationwide 4G service in 2010.

With respect to the Wireline division, Verizon focuses on gaining market share through the deployment of service offerings (FiOS Internet and FiOS TV), including expansion of voice-over-Internet protocol (VoIP) and international Ethernet capabilities, the introduction of video and Web-based conferencing capabilities and enhancements to the virtual private network portfolio.

Magnitude – Consensus Estimate Trend

The magnitude of revisions for the fourth quarter and fiscal 2010 has been static at 55 cents and $2.24, respectively, over the last 7 days as well as 30 days. The Zacks Consensus Estimate for 2010 reflects a decline of 6.68% year over year.

Although Verizon continues to expand its 3G wireless and wireline FiOS network footprint, returns from investments in these businesses are highly uncertain. Further, persistent erosion in access lines continues to hurt wireline revenues and margins. High promotional and restructuring expenses may also drag earnings and margins going forward.

Our Analysis

We expect Verzion’s growth prospects to be strong driven by new customers, higher smartphone adoption, 4G LTE network and the sale of iPhones and mobile broadband services, which will lead to improved revenue growth.

A healthy balance sheet and strong commitment to shareholder return make the stock more attractive for income-oriented investors. However, persistent erosion in access lines, high promotional and restructuring expenses, and intense competition from cable companies and other alternative services providers may be the downside.

We are currently recommending our long-term Neutral rating on Verizon supported by the Zacks # 3 Rank (Hold).

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