Verizon stumbles out of the blocks: Merger hangover expected to continue

Verizon Communications last week presented its first-ever earnings report, and it wasn't pretty. The company, created by the Bell Atlantic/GTE merger, announced revenue increases that fell below analysts' expectations and contributed to a significant drop in the company's stock price. Furthermore, the company warned that the merger will continue to affect earnings as the new Verizon takes shape.

Including one-time items, Verizon's net income for the quarter was $4.91 billion, or $1.79 per share, compared with $1.94 billion, or 70cents per share, from the same period last year for GTE and Bell Atlantic.

While those numbers seem like monumental increases, adjustments for one-time items and factoring out Genuity - GTE's Internet backbone and data networking division that was divested as part of the merger - removes much of the gains.

The adjustments bring Verizon's income to $1.97 billion, or 72cents per share, up from $1.87 billion, or 67cents per share, from one year ago. These more modest increases fell significantly below averageanalyst estimates of 80cents earnings per share (EPS).

The source of many of the one-time items is the merger that created Verizon. The $4.91 billion in income includes gains of $4.5 billion, which is partially made up of sales and swaps of wireless assets that overlapped between the merger partners.

Reported results also include charges totaling approximately $1.6 billion after taxes, or 60cents per share, related to the merger and the Bell Atlantic/Vodafone AirTouch wireless combination. Therefore, the net after-tax effects of all gains, charges and pro-forma adjustments in the second quarter was a gain of $2.9 billion, or $1.07 per share.

Verizon expects to feel the influence of the merger far into the future. The company said it would record charges of $2 billion before taxes for the merger's transaction costs, including systems integration, branding, real estate and relocation. These figures will be excluded from future adjusted earnings.

Verizon's business plan calls for the GTE/Bell Atlantic combination to focus on long-term gains by targeting high-growth markets. The new company intends to focus more on emerging services such as DSL - as evidenced by an announced merger with NorthPoint Communications (see story on page 24) - and wireless services.

"There's an extraordinary amount of our business that's being moved into these higher-growth areas," said Ivan Seidenberg, Verizon's president and co-CEO. "More important, though, we're changing our revenue and earnings mix to match that, and you will see over the next couple of years a greater visibility of revenues coming from the new high-tech products and earnings coming from these new technologies."

Linda Meltzer, senior analyst with UBS Warburg, had a similar view of a changing field. "The telecom industry is undergoing a major transformation in several different directions. For the strong players with the asset bases devoted to higher growth, particularly broadband data, we believe the growth opportunities offset the dilutive effects associated with bold positioning needs," she wrote in a report. "We believe [Verizon] will be among a small group of mega-carriers with a strong asset base in wireline/wireless business, with important stakes/affiliation with [Genuity]."

Verizon's quarterly report, combined with the NorthPoint deal and revised earnings forecasts, received a chilly reception from Wall Street. The day the news was released, the company's stock dropped more than 8.5% to $42.25. The fall continued the next day, closing at $40.375.

According to a report from Dan Reingold and Julia Belladonna with Credit Suisse First Boston, these changes were more reactionary than well-considered. A large part of the "drop in [Verizon] shares represents an overreaction" to the company's deal with NorthPoint, whose stock has been faltering over the past few months, they wrote.

However, Verizon has been forced to adjust its financial expectations for the coming years in light of conditions placed on the merger, especially the de-consolidation of Genuity, the formation of Verizon Wireless and the deal with NorthPoint.

As a result of these and other factors, Verizon adjusted its EPS target for the year to between $2.90 to $2.94. EPS growth for 2001 is expected to be between 9.5% to 11.5% and 12%-plus for 2002. If the company can exercise its option to recover Genuity, EPS growth for 2003 and beyond is projected at 15%-plus.

"We are shooting to be a mid-teen EPS growth company with 8% to 10% revenue growth as we go forward. We have some work to do to bring all the pieces back together," Seidenberg said.