Blog Post

photo credit: lucasreddinger

This article is a reprint of my February 22, 2008 RealMoney column

Forget the debate over whether telecom is a buy or sell. Make money being indifferent.

The decisions by Verizon (VZ - Annual Report) and AT&T (T - Annual Report) to offer unlimited wireless plans for $100 has launched a furious debate at RealMoney over whether the move is the right thing or the wrong thing to do. I see both sides of the story, and if anything lean toward the side of the bulls. But while the bulls and bears hash things out, I think investors can make money by being neutral.

To sum up the arguments, on the bearish side Tero Kuittinnen notes that “The AT&T and Verizon growth stories rest largely on their mobile service, and the mobile service growth hinges on mobile data, not voice. Investors are going to be deeply disappointed if Verizon’s mobile data growth keeps cooling down from the still-torrid 53% pace of the fourth quarter of 2007. For Verizon, mobile data revenue still generates just $11 a month out of the overall $51 average revenue per user. The data growth has to continue to run hot, or the overall ARPU will start declining.”

Jim Cramer counters that “the stock can trade back up toward the high $30’s over the coming quarters as the market comes to realize that these wireless price cuts are a savvy move to take market share from Sprint Nextel (S - Annual Report), which appears to be in serious trouble.”

In the short term, I’m making absolutely no forecast about the effects of the wireless pricing cut, the effects of a potential recession, or the stock price. But there are a few facts to consider that explain my lean toward the bull side.

First, this isn’t the first time in recent memory that there has been a competitive telecom environment. Since the 1996 telecom act, everybody from CLECs to independent wireless operators to cable and long distance companies has taken their shots at the big integrated telecom firms. Several of those categories of competitors no longer exist in any meaningful fashion. So, while it’s true that the pricing power in telecom may not remain at the high levels enjoyed of late, a competitive environment is nothing these companies haven’t seen before.

Second, Verizon is going to continue churning out massive amounts of cash. Its operating cash flows have been roughly $20 billion or more each year this century, and even the dual wireless/FIOS buildouts have required no more than $17.5 billion in capital expenditures. The $5.8 billion in free cash flow generated over the last 12 months leaves more than enough to pay the handsome 5.1% dividend yield that has attracted Cramer’s attention.

Finally, Verizon is getting close to massive technical support at $30. The only time this stock has traded with a $2-handle is for a couple of months in 2002 around the trough of the telecom bust.

Still, I promised that investors could make money in this name without being bullish, and those who know me probably realize I am talking about writing options. I just wrote March $32.50 put options for $0.95. If the stock stays above that level, I collect a 2.9% yield in the next month. Given that Treasuries pay less than that for one year, getting it in one month simply by being willing to buy a utility-like cash flow stream seems like easy money to me.

If the stock continues to slide, I’ll get an effective purchase price of $31.55, from which my dividend yield will be 5.5%, taxed at a more efficient rate than the smaller Treasury yield. Alternatively, I could turn right around and write covered calls to reduce my exposure still further. Those who currently own the stock could also consider covered call writing to enhance their yield.

Yet another useful option strategy here relates to Cramer’s plan to scale into Verizon over time, potentially bringing his initial 1,000 shares up to 4,000 or 5,000. Why not write some puts with staggered dates to accomplish that? Again, using the $32.50 puts, the following table shows how this could work.

Scaling Into Verizon by Writing Puts

Shares

Cost

Effective Price

Sources: Option quotes obtained from Fidelity Investments at time of writing

Assuming all the options get exercised against him, Cramer would achieve an average purchase price of $31.11 per share, scaling in over time at progressively lower effective entry prices. If the stock stays right where it is, or goes up, he collects a total of $8.35 in option premiums for the shares he never buys.

To me, that sounds like a winning strategy.

Disclosures: William Trent has written put options against the shares of Verizon (VZ - Annual Report)