Wachovia analysts: Do not be tempted by Verizon just yet

By Ronda Fears

Nashville, Tenn., July 26 - Do not be tempted by Verizon just yet, said Wachovia Securities, Inc. convertible analysts Jeanine Oburchay and Brian Park in a report Friday.

"As of this writing, Verizon equity was trading at a 5.5% yield, which, for an investment-grade company, 5.5%, up 0%, sounds pretty tempting," the analysts said in the report.

"But we still need to remain somewhat cautious on the name, as there are some catalysts that could continue to take the name down or, at the least, keep the pressure on Verizon. There will come a time when this name is absolutely irresistible, but we are not convinced now is the time, just yet."

Verizon shares ended up $1.18 to $28.78 Friday.

Even after Verizon resolved the Genuity issue by saying it would not reintegrate Genuity into the company, thereby removing a significant overhang, the analysts said, "there are still a few issues out there that we would like to see resolved before we get involved."

First, the analysts pointed to unbundled network elements (UNE) pricing and access line growth, noting that BellSouth and SBC Communications pointed to UNE pricing as a reason for lower numbers.

"Of course, this may be posturing to get more favorable treatment from the courts and the FCC on UNE pricing, and more power to them if it is and it works, but in the near term, we believe pressure on numbers leads to pressure on valuation," the analysts said.

"The same goes for weak access line growth."

Then, there's the WorldCom resale.

"AT&T Wireless attributed its entire shortfall in net adds this quarter on WorldCom exiting the resale business. Cingular petitioned the bankruptcy court to allow it to move its WorldCom customers onto its own system," the analysts noted.

"We believe Verizon Wireless's exposure may be minimal but enough to cause the company to miss net add numbers when it reports on July 31."

Also, there is the uncertainty surrounding Qwest.

"We think whatever happens to Qwest will not be good for Verizon," the analysts said.

"There is a faction of the world that believes Noteabaert wants to take Qwest into bankruptcy and emerge, regional Bell operating company (RBOC) assets intact, with minimal debt and stronger than ever. We are not totally convinced this is the case yet but, if that happens, we believe the ripple effect would hit Verizon, a la WorldCom."

If that did not happen and Qwest instead chose to sell off assets or split the company back up into classic Qwest and US West, the analysts said whatever valuation that would be done likely would be below average market valuations for the RBOCs and therefore would also put pressure on Verizon.

Then, there is the Vodafone put.

Next year, Vodafone can put $10 billion worth of Verizon Wireless to Verizon in cash or stock. The two companies would each work up their own valuations of Verizon Wireless, and if they are within 5% of one another, they will split the difference. If not, they will hire a third party to do a fair market valuation.

Considering where market values currently are, and that Vodafone owns 45% of Verizon Wireless, $10 billion could be more than half of Vodafone's entire position, which we estimate at roughly $17 billion, and could be nearly enough to take out all of Vodafone's ownership, the analysts said.

The second put option requires Verizon to repurchase up to $20 billion, provided Verizon Wireless is worth that much, less any amount paid in relation to its initial put option, of its interest in July 2005, July 2006 and/or July 2007. Vodafone can require up to $7.5 billion of this payment to be in cash.

"Verizon points out that Vodafone CEO Chris Gent is on record saying he has no intention of exercising the put. We heard him say the same thing at a recent Vodafone analyst meeting but, of course, these things can change," the analysts said.

Perhaps the most important issue that would prevent Vodafone from exercising its put next year, aside from the significant loss of value since it invested, is the fact that the way the put is currently structured, Vodafone would have to pay taxes on it, the analysts said, adding they are not totally convinced Vodafone would realize a gain on the sale.

Also, Vodafone also still has a non-compete pact with Verizon, whereby if it owns more than 20% of Verizon Wireless it cannot compete in the U.S.

"We believe there is probably a 25% chance Vodafone exercises its puts next year," the analysts said.

If it does, the analysts expect, based on current numbers, Verizon to issue shares before it would issue more debt, based on the fact that Verizon is the most levered of the RBOCs, and that the deal would be minimally dilutive from a share base standpoint and possibly accretive from a valuation standpoint.

"Nonetheless, from the rating agencies' standpoint, we would expect the put to remain an overhang and possibly contribute to a downgrade at some point," the analysts said.

"However, we remain confident in Verizon's investment-grade status and think the company will work to keep that."

That brings up the analysts' final issue - fundamentals.

"Verizon is an established RBOC, servicing the local, long-distance and wireless consumer and business customer," the analysts said.

"It is not going away. We are not going back to tin cans and string."

Nonetheless, the analysts noted, relative to other RBOCs, Verizon is the most levered. Thus, it should have the highest yield at 5.50% versus 4.18% for SBC and 3.47% for BellSouth.

Currently, Verizon is levered at 2.20 times versus 1.55 times for both SBC and BellSouth, the analysts said.

And Verizon's valuation is not significantly lower than its peers. At 9 times the estimated EPS for 2002, Verizon trades only slightly below SBC at 10.95 times, and BellSouth at 10.09 times.

On an EBITDA multiple basis, the company trades at 5 times, versus SBC at 5.09 times and BellSouth at 4.56 times.

"The bottom line, we believe, is that this is a solid company with a great customer base and the potential to not only be around a long time but to be a strong credit for a long time," Oburchay and Park said.

"We would like to see a few of these issues get ironed out before we would be aggressive on the name."

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