Recommendation No. 2: Verizon Communications (NYSE: VZ)

“Sell to Open” Verizon Communications May $38 Call

Option Symbol: VZ120519C38

Limit Order Price: $1.05 or more

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Income

• Income generated: $105 per options contract (representing 100 shares of stock)
• 92-day rate of return at current stock price of $37.83: 2.8 percent (11.0 percent annualized)
• Tell your broker:

I want to sell a covered call against 100 shares of my Verizon Communications (VZ) stock. Specifically, I want to “sell to open” one May $38 call for a credit of $1.05 per share or more.

• Remember: You should only sell one call option per 100 shares of stock purchased. The trade can only be done in 100-share increments (100, 200, 300, 400, 500, etc.).

Alternative Trade for Those Who Don’t Already Own Verizon Communications:

Buy/Write on Verizon Communications (NYSE: VZ): Buy the Stock and Simultaneously “Sell to Open” the May $38 Call

Option Symbol: VZ120519C38

Limit Order Price: $36.78 or less (stock is at $37.83 and May $38 call is at $1.05)

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Income

• Net cost of buy/write: $3,678 per 100 shares
• 92-day return if stock does not move: 2.8 percent (11.0 percent annualized)
• Brokers vary as to whether they call this trade a “buy/write” or a “covered stock” trade.
• Do the trade simultaneously at a single limit price, if possible. For example, if you wanted to buy 100 shares of stock, tell your broker:

I want to do a buy/write trade. Specifically, I want to buy 100 shares of Verizon Communications (VZ) and “sell to open” one May $38 call for a net debit of $36.78 per share or less.

• Some brokers require that you buy the stock and sell the call in separate trades. If your broker is one of these, always buy the stock first and sell the call against it second. Tell your broker:

Trade No. 1:

I want to buy 100 shares of Verizon Communications (VZ) for $37.83 per share or less.

Trade No. 2:

I want to sell a covered call against 100 shares of my Verizon Communications (VZ) stock. Specifically, I want to “sell to open” one May $38 call for a credit of $1.05 per share or more.

• Ex-Dividend Date: The stock’s next ex-dividend date is around April 6th. If the May $38 call is in the money at that time, there is a chance that the call owner will opt to exercise the option early in order to capture the dividend. In such a case, an early roll of the covered call may be warranted.
• Why the May $38 Strike?: With Verizon Communications going ex-dividend in April, I wanted to avoid selling a covered call in that month. The following month of May is still in my 45-to-90 day “sweet spot” for selling covered calls. Personal Finance associate editor Roger Conrad likes Verizon Communications as a long-term holding, but investors are still digesting the company’s less-than-stellar fourth-quarter earnings that were impacted by a worker’s strike, an October snowstorm, and a pension charge. Consequently, the stock may not go much higher in the short term.

Price Adjustments Regarding This Trade

Stock prices are currently fluctuating and option prices fluctuate with them. Consequently, the limit prices recommended in this trade alert may no longer be immediately fillable by the time the alert has been published. The alerts are valid for seven trading days, so please be patient and place your limit orders as “good ‘til cancelled” for seven trading days.

Investment Rationale for Underlying Stock:

Analysts were divided about the release of Apple’s (NSDQ: AAPL) iPhone on Personal Finance Income Portfolio stalwart Verizon Communications’ (NYSE: VZ) network in early 2011. The iPhone boosters said that the popular smartphone–which was previously offered exclusively by AT&T (NYSE: T)–would draw millions of users to the US’ second-largest telecom company. Doubters argued that the high subsidies Verizon would have to pay to iPhone consumers would narrow the carrier’s margins. 

With the release of a new iPhone model in mid-October, the iPhone 4S, and price reductions for older iPhones, Verizon booked sales of 4.2 million iPhones during the fourth quarter, beating management’s earlier forecast of sales ranging from 3.8 million to 4 million. In fact, iPhone sales comprised 54.5 percent of the 7.7 million smartphones sold during the quarter.

These gangbuster sales come at a cost; Verizon’s estimated average subsidy on every iPhone is $350 compared to $150 to $200 for a smartphone running on Google’s (NSDQ: GOOG) Android operating system. That relatively high subsidy caused the Wireless segment’s cost of sales to rise 25.2 percent to $24.1 billion in 2011 versus the prior year, which led to a 310 basis point drop in operating margin to 26.4 percent. By contrast, archrival AT&T’s operating margin for its wireless division was 24.2 percent during that same period. 

Nevertheless, iPhone sales contributed to a 68.1 percent jump in new additions to postpaid plans, with nearly 4.3 million net adds during 2011 versus just over 2.5 million in 2010. Since 62.6 percent of these new customers are smartphone users, that should drive higher-margin revenue from data usage.

Indeed, smartphone users are notorious data hogs and data usage is the smartphone endgame for mobile network operators such as Verizon. In fact, wireless data is one of the company’s fastest growing sources of revenue, posting 19.2 percent year-over-year sales growth in the fourth quarter to $6.3 billion. It’s estimated that every iPhone user consumes approximately 800MB of data per month, straining third-generation (3G) networks (Apple has yet to release a 4G iPhone).

To break the looming data bottleneck, Verizon’s wireless division in early December paid $3.6 billion for a block of coveted wireless spectrum from SpectrumCo, a joint venture between Comcast Corp (NSDQ: CMCSA), Time Warner Cable (NYSE: TWC), and Bright House Networks. Fitch Ratings lauded the move as “a long-term positive” that would put the company in a “strong position within the industry” for the foreseeable future.

The company’s consolidated revenue rose 5.4 percent year over year to $28.4 billion in the fourth quarter. However, a previously announced pension obligation forced Verizon to adjust its earnings downward by $1.20 per share for a loss of 71 cents per share during the quarter, compared with a profit of 93 cents per share in the prior-year period.

Despite this disappointing short-term performance, management expects the company to increase its earnings by 10 percent to 16 percent from a base of $2.20 per share (excluding pension costs and other one-time items).

In September, Verizon announced a quarterly dividend increase of 2.6 percent, which increases the annual dividend by $0.05 to $2.00 per share.

Over the long haul, Verizon’s dominance of the US wireless market and ongoing capital investments in its network, marketing and emerging technologies should enable the firm to grow and sustain its dividend. Verizon Communications is rated as a buy under 40 in the Personal Finance Income Portfolio.