Verizon: Fiber is Fine, But Watch the Balance Sheet

By William Trent, CFA of Stock Market Beat

A while back our friend Doug McIntyre said Verizon’s (VZ) fiber to the home strategy was unpopular with investors and hurting the company’s price/sales ratio. We pointed out that the price/sales differential was easily explained by the fact that Verizon and AT&T (T) use different accounting methods when reporting the results of their wireless divisions. Still, the nay-sayers continue to pour vitriol on Verizon’s strategy, the latest bears being the folks at Computerworld:

Verizon is alone among the major telcos in building an extremely expensive fiber to the home (FTTH) network rather than less-expensive fiber to the node (FTTN). This extra cost could end up killing the company.In Verizon’s FTTH network (also called fiber to the premises, or FTTP), fiber is laid all the way to people’s home. With FTTN, by way of contrast, fiber goes to a neighborhood node, and existing copper lines carry the signal to the home. FTTN is far less expensive than FTTH.

Verizon argues that it’s worth the cost, because it will be able to deliver higher-quality services, and get increased revenue because of that. But that doesn’t appear to be the case. Other telcos say that they can deliver the same services, but at far lower cost.

Verizon is in essence betting the company on FTTH, because it’s enormously expensive to deploy it, far more expensive than FTTH. The Mercury News, back in September, noted that AT&T’s FTT project will cost about $5.1 billion to wire up 19 million homes. The newspaper added, “That’s less than a quarter of the capital commitment Verizon is making to completely rewire markets serving 18 million homes.”

As any first-year business student can tell you, industry forces shape the competitive environment for any company. In order to compete effectively, a company generally must either have the lowest cost structure or be able to differentiate itself. Video content has to be purchased, and costs essentially the same for either telco or cable providers. So unless there is some other way to achieve a lower cost structure differentiation is the way to go. While one may argue whether Verizon will actually achieve a differentiated position (note to naysayers: look what they have been able to do in wireless) to say they shouldn’t pursue the strategy is another thing. To say they shouldn’t pursue the strategy simply because their competitors aren’t borders on absurdity, as no differentiation is possible when imitating competitors.

And there are signs that the differentiation is indeed working – or at least that the strategy is gaining momentum. Verizon has announced price increases for its video services, beginning in January.
So stop picking on Verizon for its FTTH strategy. If you must criticize the company, there is lower-hanging fruit in its former directory business, which took with it $9 billion in debt (and possibly an unknown amount of retiree benefit obligations as well). Why is this significant?
Because new accounting rules are in place that require Verizon to recognize its full liability for expected retiree benefits beginning this year. Previously companies were able to keep a large part of these liabilities off-balance sheet. As of December 31, 2005 Verizon had unfunded liabilities totaling $20 billion due to its retiree health plans (unfunded liability of $23.5 billion) and pension plans (which are $3.5 billion over-funded). Of that amount, only $2.5 billion of net liabilities were being recognized on the balance sheet.

The idea that Verizon would sell or spin out its directory business has been bandied about for years but never done. Does anyone else think it more than coincidental that it finally happens, partially cleaning up the balance sheet in the very same quarter that Verizon will have its off-balance sheet liabilities recognized?

The author may hold a position in the securities discussed. The author’s current holdings are as follows: Long: Intuit (INTU) put options; Nasdaq 100 (QQQQ) put options; Bookham (BKHM; Ballard Power (BLDP); Syntax Brillian (BRLC); CMGI (CMGI); Genentech (DNA); Ion Media Networks (ION); Lion’s Gate (LGF); Three Five Systems (TFS); Adobe Systems (ADBE) call options; IShares Japan (EWJ); StreetTracks Gold (GLD); Starbucks (SBUX); U.S. Oil Fund (USO); Plantronics (PLT) call options; Short: Lion’s Gate (LGF) call options; Dell (DELL) put options; Plantronics (PLT) put options.

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