Financial Analysis the Company I

Financial Analysis

The company I have chosen for my financial analysis is telecommunications giant Verizon (NYSE: VZ). The competitor I have chosen is at&T (NYSE: T). Both of these firms compete in the landline and wireless telecommunications industries. They each have broad, national customer bases including consumers and both small and large businesses. They are engaged in intensive competition in both industries. Both face similar challenges with respect to their regulatory, economic and technological environments. This paper will analyze both of these firms in the context of their financial ratios and trends, before coming to a conclusion about investing in Verizon.

Liquidity

The liquidity analysis indicates the degree of short-term financial solvency in the firm. The key ratios are the current ratio, the quick ratio, the cash ratio and times interest earned. The current ratio indicates the firm's ability to meet its current liabilities through conversion of all its current assets; the quick ratio includes just cash and receivables and the cash ratio includes just cash. For Verizon, the current ratio for 2008 was 1.0. This is the strongest current ratio in the past five years. In prior years, Verizon's current ratio was significantly weaker, ranging from 0.69 to 0.84. at&T by contrast has a current ratio of 0.53. This figure is significantly poorer than that of Verizon and is in line with at&T's recent performance.

The quick ratio for Verizon in 2008 was 0.84. The represented an improvement over figures from previous years, largely attributable to a substantial increase in cash. Cash improved from $3.3 billion in 2007 to $10.2 billion in 2008. at&T's quick ratio in 2008 was 0.42, which is in line with that firm's performance in previous years.

The cash ratio for Verizon in 2008 was 0.39, representing substantial improvement over 0.13 the previous year, and improvement over each of the previous four years total. at&T's cash ratio is 0.04, roughly in line with its performance in recent years.

Times interest earned reflects the firm's ability to meet its interest obligations. In the statements presented on MSN Moneycentral, neither firm reported an interest expense -- this was included in the broader category of operating expenses. Without a specific interest expense, it is impossible to analyze the times interest earned.

All told, Verizon has healthy liquidity ratios, in particular in comparison to those of at&T. At no point in the past five years did at&T have any ratio better than the comparable ratio from Verizon. Whereas at&T has some alarming short-term liquidity issues, particularly with respect to very low cash ratios, Verizon's figures are fairly strong, given the high amount of capital investment required in its industry.

Profitability

Profitability ratios are indicative of the firm's overall financial performance. These figures are important to investors (the firm's owners) and they also can provide an indication of managerial efficiency. When profitability ratios decline, that is often a symptom of greater problems at the firm.

Return on equity measures the net profit that the company earns for its shareholders -- that is to say from its equity base. Verizon's current ROE is 12.9%, with a five-year average ROE of 13.7%. These figures are slightly above the industry average. at&T has a return on equity of 11.2%, with a five-year average of 10.7%. These figures lag both Verizon and the industry. Both firms have decent returns on their shareholder equity, but lagging the industry indicates that both have room for improvement. Whereas at&T has improved its ROE figures this year, Verizon's number has slipped indicating the perhaps Verizon's performance was not as strong through 2008.

Return on assets measures the net profit gained from the firm's assets. Ultimately, the job of management is to utilize the firm's assets to generate profit, so ROA is a direct measure of managerial efficiency. The 2008 ROA for Verizon was 3.6%, compared with an industry average of 4.4%. The five-year average ROA for Verizon is 3.3%, the industry average again being 4.4%. This indicates that while Verizon trails the industry in efficiency, it has improved in the past year. at&T's return on assets in 2008 was 4.4%, in line with the industry. The firm's five-year average ROA is 4.3%, only slightly weaker than the industry average. Overall, at&T has stronger managerial efficiency with respect to the firm's assets than does Verizon.

Return on investment measures how much profit is earned for every dollar spent to try to make that profit. Again, this is a measure of managerial efficiency. Verizon's 2008 ROI was 5.2%, compared to an industry average of 5.5%. The five-year average is 4.7%, compared to the industry's 5.4%. At at&T, the return on investment for 2008 was 5.2% and the five-year average ROI was 5.0%. These results both lag the industry figures, but are stronger than Verizon's performance.

Overall, at&T outperforms Verizon on these three key measures of managerial efficiency. That company's managers are better able to convert the fiscal and physical resources they have been given into profit.

Debt Ratios

Debt ratios are a measure of long-term solvency at a company. Leverage (the degree of debt a firm has) impacts the firm's financial performance in a number of ways. Leverage increases risk. It allows the firm to capture high returns in good times, but represents an obligation that must be paid even in bad times. Therefore, a firm's financial flexibility is diminished if it is carrying too much debt. The ideal amount of debt that a firm should carry is determined in large part by the nature of the business in which the firm is engaged. The key debt ratios are debt-to-equity and debt-to-assets.

Verizon's debt to equity is 3.85. This is the highest level it has been in the past five years. The best the debt-to-equity ratio has been is 2.69 in 2007. at&T has a debt-to-equity ratio of 1.75. This is in line with the firm's degree of level prior to 2006. For that year and for 2007, at&T had a stronger debt-to-equity ratio following the major acquisition of BellSouth (Crockett & Grow, 2006) that nearly doubled the size of the company.

The debt-to-assets ratio is a similar indicator, highlighting how much of the firm technically belongs to creditors. The debt-to-assets ratio (or simply "debt ratio") for Verizon is 0.79. While this is within its normal range for the past five years, the figure represents a new high end. This can be attributed to a spike in long-term debt, from $28.2 billion to $46.9 billion. at&T's debt ratio is 0.63, which is the same level it was five years ago. The firm has taken on more debt in the wake of its acquisition in 2006 in order to restore its capital structure to pre-merger levels.

Overall, Verizon is a more highly levered company than is at&T. Their debt level is not unexpected given the massive investment the firm is presently undertaking to roll out the next generation Long-Term Evolution (LTE) network (Chen, 2009). at&T is slightly ahead of the investment curve with respect to this network, the result of which is that it has not needed to take on the added debt. The company has merely taken on debt to restore the capital structure it had before the BellSouth merger.

Profitability Ratios

The profitability ratios measure a firm's ability to convert revenues into profits. There are two major components to these measures. The first is the firm's ability to increase its revenues; the second is its ability to control costs. Doing both of these simultaneously will result in improvements to the profitability ratios. The key profitability ratios are the gross margin and the net margin.

The gross margin for Verizon is 59.9% and has held steady at that level for the past three years. Prior to that, the gross margins were higher, in the mid 60s. The shrinking of the profit margin indicates increased competition in Verizon's core businesses, but the steadiness of the numbers indicates that Verizon has strong control over its pricing structure. at&T's gross margin is 49.5%. This represents a slight decline from the previous year, but an improvement over the prior three years. at&T's gross margin hit bottom following the BellSouth acquisition, where it was at 42.8%, so the company has done well to bring that figure up higher. However, at&T is not able to extract the same margins as Verizon, and this may reflect their greater dependence on landline revenues.

The net margin for Verizon is 6.6%. This is the highest figure in the past three years. Prior to this, net margins were in the high 8s. This confirms what was indicated in the gross margin, that Verizon's competition level has increased, forcing the company to adjust its prices downward. The firm has not been able to cut its costs to restore the figures of the mid 00s. at&T has a net margin of 10.3%. This is at the low end of its historic range. at&T did not suffer as strong a drop in its net margins three years ago as it did in its gross margins.

Overall, at&T is the more profitable of the two companies. That Verizon has the stronger gross margins and at&T the stronger net margins indicates that at&T does a better job of controlling its cost structure than does Verizon.

The Industry

The telecommunications industry is highly competitive in both the landline and wireless segments. By 2006, wireless spending had match wireline spending. While this presents significant opportunities for telecommunications, much of that spending comes in the form of cannibalizing, as wireline revenues have been decreasing steady over the past decade, matching the steady increases in wireless spending.

There are four major wireless operators in the U.S. And over 170 regional players (Megna, 2009). Competition is based on coverage area (capital investment), price and customer service. Both firms can be considered industry leaders. As of 2007, at&T had a subscriber base of 65.7 million and wireless revenues of $10.9 billion. Verizon had a subscriber base of 63.7 million and wireless revenues of $11.3 billion. The followers in the industry are Sprint (54 million and $8.7 billion) and T-Mobile (27.7 million and $4.89 billion) (Herperger, 2008). The remaining firms are regional or relatively minor players, although some have experienced strong growth and may one day be more important to the industry dynamic.

With at&T and Verizon running a close one-two at the top of the industry, they are essentially co-leading the industry. Both firms have taken on lead roles in negotiations with the FCC for example, and both strong nationwide coverage. The industry is still growing rapidly, and is subject to a rapid pace of technological change. While the FCC seems determined to keep the industry open, the economies of scale that the large firms have built up will continue to give them a stronger competitive advantage over small firms. There is the possibility of bandwidth restrictions, as there is currently insufficient bandwidth to support demand from consumers. This makes having an established network and large installed base all the more important.

Raising Funds

If Verizon needed to raise funds, it should consider tapping the equity markets. In the wake of taking on a significant amount of new debt last year, Verizon no longer has much capacity for more debt. The firm's debt ratio of 0.79 is high, indicating that the firm is already taking a high risk-high reward strategy. To take on any more debt, however, would be irresponsible.

Tapping the capital markets, however, is fraught with its own challenges. Three of the most important are dilution, the cost of capital, and the state of the capital markets. The former is important because equity issues do not create equity so much as they sell it off. This results in dilution to the existing shareholders. The best way to ameliorate the effects of dilution would be to offer a rights offering. Cost of capital is a concern because equity is typically the most expensive form of capital to be raised. Verizon would find that raising debt costs the company less than raising equity, making equity a less likely or palatable option. Another concern with raising equity is that the capital markets may not be able to provide this funding. The markets are recovering this year after feeling the impacts of the subprime crisis and corresponding recession, but the market for large new equity deals is still not great.

Although debt financing is a relatively unpalatable option for a number of reasons, it is the option I would recommend to Verizon if it needed to raise additional capital at this point in time. The company is unlikely to raise the required funds on the equity markets, would suffer dilution on an already suppressed stock price and the move would increase the company's cost of capital. Debt financing would be relatively easy to obtain -- albeit likely with strict covenants as a result of the firm's already high debt load -- and would cost less than an equity issue.

Lending to/Investing in Verizon

I would lend to Verizon. The company is in a relatively strong financial position. The firm has just taken on additional debt, and that has boosted its liquidity ratios for the time being. However, the fundamentals of the firm's business are strong.

In terms of financial situation, Verizon's is relatively strong. The company earns strong profits and its primary industries are growing. As an industry leader, Verizon is building economies of scale that allow it to control costs. It has demonstrated the ability to control prices. The firm is directly involved at the regulatory level to work with the FCC for a more favorable operating environment. This demonstrates that the firm's capabilities to manage its operating environment, an important factor for a lender.

Verizon has traditionally had strong liquidity as well, and earns decent returns on equity, investment and assets. As a result, there is little concern over Verizon's financial situation or its fundamentals. As a lender at this point, I would likely wish to restrict the ability of Verizon to borrow further by placing restrictive covenants limiting the firm's debt ratio, and perhaps covenants with respect to solvency as well. These steps would merely be enacted to help protect my bank's investment in Verizon.