Telecom July 28, 2008, 4:45PM EST

Verizon Suffers from Wall Street's Woes

The telecom giant reports strong profits, but concerns over the economy and landline subscriber losses hurt its stock

This is what it's come to.

On July 28, Verizon Communications (VZ) topped estimates with its second-quarter profit, and reaffirmed its financial goals for the second half of the year. "We feel very comfortable with our business plan despite the concerns about the economy," said Verizon President and COO Dennis Strigl on a conference call following the announcement.

The result? Wall Street punishment. Verizon's stock closed the day down 2.3%, to 33.65, while the Dow Jones industrial average closed down 239 points, or 2.1%, as continuing anxiety about the credit crunch led investors to dump financial stocks. In an interview with BusinessWeek, Strigl expressed surprise at the negative reaction. "I don't know what all the hubbub is about," he said. "You can get all hung up on these numbers. We're not a one-day, one-week story. We don't get frustrated at a couple of cracks that people make."

As the second-largest U.S. telecom company, Verizon's size and diversity have helped it to weather the growing economic storm. Strong performance in its wireless arm, stability in its corporate business, and growth in new products such as high-speed fiber-optic Internet and TV connections continue to offset losses in its legacy landline phone operation. Cost-cutting also juiced the company's bottom line. "It showed a surprising level of resilience," says David Barden, analyst with Bank of America (BAC). "The trends that have gotten the business to this point are intact."

The communications giant posted net income of $1.88 billion, or 66¢ a share, up 13.7% from $1.68 billion, or 58¢ a share, in the year-ago quarter. Adjusted for one-time items, Verizon reported a profit of 67¢ a share, 2¢ better than the Thomson Reuters (TRI) average estimate. Sales rose 3.7% from a year ago to $24.12 billion, though that figure was just shy of Wall Street's expectations of $24.17 billion.

Landline Losses

Still, fear rules on Wall Street these days. One development at Verizon that sparked particular concern is the acceleration of losses from its traditional landline telephone business. The company saw the number of residential subscribers slide 11.4% to 22.45 million, from 25.35 million on June 30 last year. The rate of such losses rose from 10.6% last year and 10.9% in the first quarter. "Verizon continues to hemorrhage lines at a stunning rate," wrote Craig Moffett, a senior analyst with Sanford Bernstein who has been bearish on telecom, in a research note. He added that the losses are "significantly worse than the rate at AT&T (T) and the worst rate in Verizon history."

In addition, Moffett pointed out that the growth rate of its FiOS video and Internet service slowed in the quarter, and that Verizon saw a loss of 133,000 subscribers who use an Internet technology called digital subscriber line (DSL). While admitting the second quarter tends to be weak, Moffett wrote that "the fact that Verizon's DSL—which continues to represent their sole broadband offering on two-thirds of their footprint—is now shrinking, is a remarkable turn of events."

On a conference call, Verizon executives admitted the losses were "higher than we had been geared for," due to stiff competition from the cable industry and consumers trading in their landlines for cell phones. However, Strigl said he doesn't expect line losses "will spike further."

"The Right Direction"

Verizon hopes to stem the tide of losses by offering consumers a one-stop shop of phone, video, and Internet broadband services. On that note, the company announced July 28 that it has officially launched its long-awaited FiOS TV service in New York City. The Big Apple franchise covers more than 3 million households. Bank of America analyst Barden says before the New York launch, Verizon's TV footprint only covered about 7 million households. "The opportunity is monstrous compared to what they've built at this time," he says. "Based on my experience with Time Warner, I cannot wait to try it out."

Wireless, though, is still the company's growth engine. The division grew its revenues 11.8% to $12.1 billion, while reporting operating income margins of 28.6%, its highest ever. In the quarter, the company added 1.5 million customers—the highest tally in the U.S. industry. Verizon also scored another first by reporting that its churn rate, or the percent of customers that cancel their service, had dropped to 1.12%, a record low for the company that already boasts the industry's most loyal customer base.

"We do think there is more stability in these businesses than the stock market is giving them credit for," says Todd Rosenbluth, an analyst with Standard & Poor's (MHP). "There's pressure but there's more positive offsets." Currently, Verizon trades at a price-earnings multiple of around 11 times next year's earnings. But Rosenbluth and other bullish analysts believe Verizon deserves a price-earnings multiple of around 13 to 14 based on its stability and growth potential.

To keep its wireless engine churning, Verizon is counting on a combination of investments and mergers and acquisitions. On June 5, Verizon Communications agreed to buy Alltel for about $28.1 billion, including the assumption of debt. The deal would allow Verizon to surpass AT&T as the largest U.S. cellular telephone operator. If the deal is approved by the end of this year, as Verizon hopes, it will give Verizon ample opportunities for revenue growth and cost-cutting. Further down the road in 2010, Verizon hopes to keep its industry lead by building a fourth-generation wireless network with the spectrum it purchased in a government auction earlier this year.

"We feel good about where we are," said Strigl. "We believe we are positioned to continue to move in the right direction."

Ante is the computers department editor for BusinessWeek.