Verizon Communications (VZ, Financial) is a telecommunications services company that now makes a textbook example of a value trap in my opinion. What really makes a value trap in investing? There are many technical definitions of the term "value trap," but in a nutshell, a value trap is a stock that appears to be cheaply priced but may actually deserve the low valuation due to poor fundamentals and a declining outlook. A value trap poses the risk of investing in what seems like a bargain at the risk of ignoring the bigger picture that may hide red flags. Verizon has underperformed in 2023 and appears to be at high risk of financial distress. This is not positive news, and not even the dividend can make up for it.
Valuation hides a trap
Verizon shares have a very attractive dividend yield of 7.12%, a healthy payout ratio of 0.51, a relatively low price-earnings ratio of 7.09, a price-sales ratio of 1.13 and a price-book ratio of 1.65. The GF Value chart fair value estimate is $53.71, but the chart also indicates that the stock is a possible value trap.
On the positive side, Verizon has a Beneish M-Score of -2.75, which implies that the company is unlikely to be a manipulator in its earnings per share. The telecommunications company has seen its operating margin expand from 20.50% for the quarter ending in December 2022 to 23.04% for the quarter ending in March 2023.
Under better circumstances, Verizon shares would seem like a deep value opportunity. Unfortunately for investors, the fundamentals of the company are not just about valuation, they take into consideration financial strength, profitability, growth, outlook, moat, etc. There are severe problems with Verizon's fundamentals that are hard to ignore now, foremost being the risk of financial distress.
Verizon's fundamentals reveal high risk
Verizon has a GF Score of 70 out of 100, which signals poor future performance potential according to a historical study by GuruFocus.
The past performance has been poor too as the stock has lost nearly 26% over the past year and is down about 7.5% so far in 2023. The stock has a moderate GuruFocus rank for profitability and a high rank for value, but at the same time a low rank for financial strength growth, growth and momentum.
Starting with the number one reason of concern in my opinion, Verizon has an Altman Z-score of 1.25, which places it in the distress zone. This implies bankruptcy is possible in the next two years.
Verizon has been issuing new debt at a rapid pace - in fact, over the past three years, it issued $36.8 billion of debt. The debt-to-equity ratio is 1.92, which is quite high, the debt-to-Ebitda ratio is 3.57 and the interest coverage ratio was 6.28 as of March 2023, which seems to be healthy but just barely. I would argue that a deeper look at the interest coverage ratio shows that it has been decreasing severely. The higher the interest coverage ratio, the stronger the company's financial strength. However, Verizon had a peak for its interest coverage ratio back in September 2021 with a figure of 11.12, and ever since the interest coverage dropped for each consecutive quarter. Should investors be worried that the interest coverage of 6.28 for March 2023 is the lowest one for the past one and a half years? I would argue yes, because the company is clearly struggling to maintain liquidity.
Verizon has a current ratio of 0.75 and a quick ratio of 0.70. Both of these are well below the threshold value of 1.0 which indicates neutral liquidity. The higher these ratios are above 1.0, the better it is for a company as it has more current assets than current liabilities and therefore it should not have difficulty meeting its current obligations. Lower than 1.0 means the company needs to continuously raise additional liquidity to keep functioning.
Verizon also has a very low cash ratio of 0.05. The cash ratio is defined as cash, cash equivalents and marketable securities divided by total current liabilities. The low cash ratio signals that Verizon does not have sufficient cash on hand to pay off its short-term debt. This is a reminder that cash is king for any business in any sector, any industry. You need cash to function.
Verizon's low liquidity has likely played a key part in its three-year free cash flow growth rate of -15.4%. A company that is low on cash generates slower free cash flow and may struggle to survive against the possibility of bankruptcy. Verizon also has a three-year revenue growth rate of 0.7%, and Morningstar analysts estimate a three to five year total revenue growth rate of only 0.45%.
My take
Verizon is not growing in the grand scheme of things, at least not from the investor's perspective. It is now in financial distress, and may have to cut its dividend to repay its large amount of debt. In fact, the dividend may be part of the problem, as the company's continuous debt issuance is in part to fund the dividend. This is not sustainable and continuously destroys shareholder value.
