1 Number That Sums Up Verizon's Disappointing 4th Quarter

By Adam Levy Markets Fool.com

Fierce competition caught up with Verizon (NYSE: VZ) in the fourth quarter. All four major U.S. wireless service providers offered huge incentives to sign up for new services or upgrade existing plans. For example, at one point last quarter every carrier offered a free iPhone 7 to customers trading in their old iPhones.

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Those promotions were designed to take advantage of the holiday season, when many people consider upgrading their phones or switching carriers. Unfortunately for Verizon, it didn't add too many new subscribers. The company's postpaid net additions for the fourth quarter totaled just 591,000, 167,000 of which were phone subscribers. Last year, Verizon managed to attract 1,519,000 net new postpaid customers and 449,000 phone subscribers in the fourth quarter.

Verizon's shortfall is most evident in a singular metric: its wireless segment's operating margin.

Image source: Verizon.

Where did all the profits go?

Despite declining service revenue -- revenue collected strictly for high-margin wireless service and not including lower-margin device payments -- Verizon managed to increase its wireless segment's operating margin in each of the first three quarters of 2016. In the fourth quarter, however, operating margin for the segment fell 160 basis points year over year to 27%.

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The biggest factor was that Verizon's service revenue declined 4.9%, but cost of services increased 3.1%. Cost of services accounted for 12.6% of services revenue last quarter compared with just 11.6% the year before. Considering services revenue accounts for more than two-thirds of the segment's total sales, that 1% margin can have a significant impact.

Verizon made some changes to its wireless service plans earlier this year, but mostly worked to increase pricing. But as customers come off high-priced two year contracts (which subsidized the cost of devices), they're switching to lower cost unsubsidized service plans. The percentage of postpaid phone subscribers on non-subsidy plans climbed from 40% to 67% over the last year. The result is continued pressure on service revenue. Management says it doesn't expect service revenue to return to growth until 2018.

Additionally, Verizon took a slightly wider loss on equipment sales. In 2015, Verizon's equipment cost totaled 126.7% of what it collected in equipment revenue. That grew to 128.3% last quarter. The widening may be the result of device promotions like the free iPhone trade-in mentioned above. Equipment costs are the largest contributing factor to Verizon's wireless operating costs, so even a slight bump can have a major impact on its margins.

Will margins return to normal?

For the immediate future, investors may well see continue declines in operating margin in line with the declines in service revenue. "I would expect us to continue to have very strong margins in the Wireless business, but it's going to be off of that service revenue trajectory continuing to be slightly negative, though in an improving direction," Verizon CFO Matt Ellis told investors during the company's earnings call.

Ellis wouldn't directly answer the question about whether he expects margins to at least remain flat. "We now see the point at which we get back to year-over-year positive [wireless service revenue growth] pushing out into 2018," he said, indicating that Verizon will continue to struggle with customers switching to lower-cost plans for some time still, resulting in further pressure on margins.

As service revenue returns to growth, however, there's hope that Verizon's wireless margins will improve along with it. It's shown an ability to raise rates with minimal impact on churn, which is a good sign that there's room for margin expansion down the road when nearly all of its subscribers have switched over from phone subsidy plans. The company should still take a hit every fourth quarter as it finances new devices and runs promotions to attract customers, but the overall trend should start moving in the right direction in a couple of years.

Investors will have to remain patient.

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Adam Levy owns shares of Verizon Communications. The Motley Fool recommends Verizon Communications. The Motley Fool has a disclosure policy.