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By Jeremy Glaser and Josh Peters, CFA | 09-05-2013 12:00 PM

Verizon Deal No Reason to Hang Up on Telecom Dividends

Verizon's wireless buyout could shake up things for Vodafone shareholders, but the telecom industry is positioned to remain profitable and have good dividend yields, says DividendInvestor editor Josh Peters.

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. What impact will Verizon Communications’ purchase of the remaining stake of Verizon Wireless and Vodafone have on dividend investors? I’m here today with Josh Peters, the editor of Morningstar DividendInvestor, and also the director of equity income strategy at Morningstar, to take a closer look.

Josh, thanks for joining me today.

Josh Peters: Good to be here.

Glaser: Let’s take a look at the nuts and bolts of this deal first. Why is Verizon finally ponying up this money to fully control Verizon Wireless?

Peters: Verizon Wireless has long been Verizon Communications’ most valuable asset. But under the structure of this joint venture, which dates back more than 10 years, Vodafone had to get $0.45 on the dollar of any cash that was paid out, and Verizon Communications would get the other $0.55. So this created a situation where Verizon can’t help but share a lot of the cash that this business is generating with a partner that wasn’t really controlling or helping operate the business at all. Now they are going to be in a position to continue to manage the business, but as well as collect 100% of the cash that it generates going forward.

Glaser: How is this deal going to be structured, and what could that mean for shareholders who are expecting dividends from both Verizon and Vodafone?

Peters: You’re not looking at a significant difference for Verizon Communications. The company did announce a dividend increase little under 3%, which they were probably going to do anyway, so really just the status quo there. The stock yield is in the mid-4% range. It’s a pretty mediocre type of total return when you consider that relatively low dividend-growth rate. But it’s not bad. We think the stock is moderately overvalued, but there is not a big effect here going on. Other than that, the company will certainly be looking to devote most of the rest of its cash flow to debt reduction to help pay down the debt involved in the cash portion of the deal.

For Vodafone, this is whole new company now after the close of this transaction. For each Vodafone ADR--I’ve done the back-of-the-envelope math--it looks like you get $5 of cash, as well as about 0.26 Verizon shares, which right now would be worth about $12. Then you’ll also get that remaining stub that represents the rest of Vodafone’s businesses around the world, and they’re actually going to do a reverse stock split after the transaction. They call it a consolidation; it seems to be a British custom if there is a large distribution like this. But basically you get cash, Verizon stock, and then the post-deal Vodafone [shares].

Now, one of the drawbacks here is, for me, as somebody who has owned Vodafone in our Harvest portfolio for more than a year, I don’t actually want to own Verizon. There are lot of investors, especially in Europe, that might not want to own Verizon and might not even be able to because of ownership rules within their portfolio mandates. That could put some downward pressure on that valuation.

Another thing you have to be aware of is the potential tax implications. The distribution of cash, and maybe the distribution of stock--we don’t know yet for certain--might be a taxable event. If you own Vodafone shares in a taxable account, this could mean a big tax bill even though you’re only getting a certain amount of cash, $5 per ADR in cash.

The post-deal Vodafone, post-sale Vodafone, that looks a little bit more attractive to me, but I also want to see what kind of valuation that’s going to carry. What’s implied right now in the market price between the two different stocks and the cash piece is about a 10 times free cash flow multiple for the rest of Vodafone. That seems reasonable but not screamingly cheap, and it fits neatly with the fair value estimate we actually had before the deal was announced, which was $33 an ADR.

In all, this a lot of sound and fury without necessarily a whole lot of direct benefit. You’re always waiting, as a Vodafone shareholder, for this value to be unlocked, and now here is the key, here is the lock, you hear it click, and there is nothing more in there than you thought.

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