Wall Street Journal, November 2, 2006 article

Making Calls on Verizon

Wireless and Broadband
Offset Landline Decline;
Yellow Pages Sent Packing

By WORTH CIVILS
November 2, 2006

Shares of Verizon Communications Inc. have been on a tear amid enthusiasm over the company's fast-growing wireless business and expectations for its broadband Internet service. The stock has had plenty of room to grow, starting the year at a 52-week low of $30 and climbing 30% to a recent high of $38.95 on Monday, when Verizon reported third-quarter earnings. Shares pulled back after the report, finishing down 3% Monday on concern over the high cost of rolling out the company's fiber-optic service and customer losses in its traditional phone-line business. The stock lost another 1.7% Tuesday after two analyst downgrades. Some observers worry the spinoff of its yellow-pages business into a new company called Idearc -- shares begin trading Thursday -- is a mistake. But others remain bullish on Verizon, which closed Wednesday at $36.97, and think it will rebound to more than $40 a share in a year. (Ratings and disclosures follow)

The Bull Case

Wireless Power: Strong performance from Verizon's wireless business boosted third-quarter net income by 3%. New subscriptions were strong, and the company's churn rate -- a measure of customer attrition -- is the lowest in the industry. Verizon's 15% subscriber-growth rate was the fastest of all U.S. wireless carriers, adding 1.9 million net new customers to bring its total to 56.7 million. In comparison, rival Cingular Wireless, jointly owned by AT&T Inc. and BellSouth Corp., added 1.4 million customers to boost its base to 58.7 million. "Wireless once again exceeded our estimates," wrote Merrill Lynch analyst David Janazzo. Thomas Seitz at Lehman Brothers had expected Verizon Wireless, which is jointly owned with Vodafone Group PLC, to only add 1.4 million subscribers in the third quarter. He also noted the division's low churn rate of 1.2% -- below his 1.3% estimate -- calling it "comfortably better than any other public wireless company," including Cingular's 1.8%.

Broad Appeal: For the first time in years, subscriptions to Verizon's broadband service outpaced subscriber losses in the traditional fixed-line, or "wireline," telephone business. Verizon added 448,000 net high-speed Internet customers in the quarter -- more than the 419,000 it lost in the wireline business. This was the "most significant development this quarter," wrote Albert Lin at American Technology Research. "Bucking the long-standing fear of [net] customer erosion … may become a trend," he wrote. Mr. Lin expects the company to grow revenue at 3% and earnings per share at 5% in 2007, versus Street estimates of 2% and 4%, respectively. New technology to restrict spam and other unwanted data might make its broadband services more attractive, encouraging customers to pay higher prices, according to Mr. Lin. It could also help alleviate the clogged Internet lines that have forced Verizon to make costly capacity upgrades in the past.

Merger Musings: Verizon's $8.5 billion purchase of long-distance provider MCI earlier this year is beginning to pay dividends. The deal gave Verizon control of a roster of corporate clients second only to AT&T's. These new customers helped Verizon's business unit improve in the third-quarter, with revenue up 1.7% to $5.2 billion from the second quarter. Mr. Seitz said the strong performance shows that "demand for business services is growing and the pricing environment continues to improve," despite broader economic concerns. "In fact, corporate [bids for service] were greater than the existing sales force had ever seen." With the MCI deal closed, David Barden at Bank of America Securities wrote recently that Verizon is now free to "contemplate new ways to benefit stockholders," possibly including a higher dividend and more share buybacks.

The Bear Case

High Speed, High Dollar: The mountain of cash Verizon is spending to implement its new high-speed network will take a larger toll on its bottom line than the company had expected, analysts say. Its fiber-optic service, or FiOS, project involves running cable to millions of homes for Internet and television. It has been closely watched by investors who wonder if Verizon can successfully compete in this market with cable firms. Some analysts see the FiOS project as a long-run winner, but Verizon said when it reported earnings on Monday that it had underestimated the price tag, contributing to a selloff in the company's shares after what was a fairly solid earnings report. "FiOS costs [were] clearly one of the key factors causing the stock to be under some pressure," wrote Christopher King at Stifel Nicolaus. Citigroup's Michael Rollins estimates that the total FiOS investment may approach $26.4 billion -- compared with Verizon's estimate of $22.9 billion -- due to rising marketing, installation and service costs. This could shave about 43 cents per share from earnings in 2007, said Mr. Rollins, compared with company estimates of up to 30 cents.

Losing Lines: Verizon hopes FiOS can help make up for its fading traditional phone line, or wireline, business, but Chris Watts of Atlantic Equities wrote recently that Verizon's wireless growth is not sufficient to make up for its wireline losses. And some analysts expect Verizon's wireline growth to slow at a faster rate than its wireless business grows. In the latest quarter, wireline revenue declined 4.7% to $12.8 billion as Verizon's subscriber base fell 7.5% from a year ago to 46 million. Analysts were disappointed by the wireline unit's narrowing profitability, as well. Mr. Watts wrote that, while FiOS is gaining traction, its high costs coupled with the loss of wireline customers "will continue to put near-term pressure on [Verizon's] bottom line."

Directories Divestiture: Reaction has been mixed to Verizon's decision to spin off its yellow-pages business. While the move will shed roughly $7 billion in debt, it will also remove some $3.5 billion in annual revenue, or about 5% of Verizon's total. This caused Deutsche Bank's Greg Miller cut his 2007 earnings-per-share estimate by 18 cents to $2.35. Richard Klugman at Prudential adds that the Idearc spinoff will also increase Verizon's price-to-earnings multiple by one point, to 15 times estimated 2007 earnings, making Verizon shares just a little more expensive. Mr. Rollins said he disagrees with the Idearc spinoff, "as it reduces the strategic flexibility and cash flow at a time when Verizon requires it the most." And while some had hoped increased share buybacks would follow the spinoff, the company hasn't indicated any additional return to shareholders. Morgan Stanley's Raina Smyth still thinks another buyback program of $2 billion is likely, "but this is far less than the $5-6 billion that some might have hoped for."

--Annelena Lobb and Chris Bain contributed to this article

Write to Worth Civils at worth.civils@wsj.com¹

Analyst Ratings

Brokerage Firm	Stock Rating	52-Week Price Target	Last Update
Davenport Equity Research	Buy	$45	Oct. 30
Buckingham Research Group	Accumulate	$42	Oct. 30
Deutsche Bank	Buy	$42	Oct. 30
Lehman Brothers	Overweight	$41	Oct. 31
Merrill Lynch	Buy	$40	Oct. 30
Banc of America Securities	Buy	$39	Oct. 30
Morgan Stanley	Equal-weight	$36	Oct. 30
American Technology Research	Buy	n/a	Oct. 30
CIBC World Markets	Sector Performer	n/a	Oct. 31
Atlantic Equities	Neutral	n/a	Oct. 30
Prudential Equity Group	Underweight	$34	Oct. 31
Citigroup	Sell	$31	Oct. 30

Disclosures:

• Merrill Lynch acts as a market maker for the securities of Verizon, of which it beneficially owns one percent or more. The firm has received compensation for investment banking services from the company within the past 12 months, and expects to receive or intends to seek further compensation for such services within the next three months.

• Lehman Brothers trades regularly in the shares of Verizon, of which it beneficially owns 1% or more . The firm has managed or co-managed a public offering of securities for the company in the past 12 months, during which time it has received compensation for investment banking services; it expects to receive or intends to seek further compensation for such services in the next three months.

• American Technology Research listed no specific disclosures for Verizon.

• Banc of America Securities beneficially owns 1% or more of a class of common equity securities of Verizon. The firm has led or co-managed an offering of securities for Verizon in the previous 12 months, during which time the it performed investment banking services for the company and has received compensation for those services; it expects to receive, or intends to seek, further compensation during the next three months.

• Stifel Nicolaus expects to receive or intends to seek compensation for investment banking services from Verizon in the next three months.

• Citigroup is a market maker in the publicly traded equity securities of Verizon. The firm has received compensation for investment banking services provided within the past 12 months from the company, and expects to receive or intends to seek more within the next three months.

• Prudential Equity Group listed no specific disclosures related to Verizon.

• Atlantic Equities listed no specific disclosures related to Verizon.

• Morgan Stanley beneficially owns 1% or more of a class of common equity securities of Verizon. The firm managed or co-managed a public offering of securities for the company within the past 12 months, during which time it received compensation for investment banking services; it expects to receive or intends to seek further compensation for such services in the next three months. An employee or director of Morgan Stanley is a director at Verizon.

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