Vodafone's Eggs Are All In One Basket

Aug.14.06 | About: Vodafone Group (VOD)

Investopedia Advisor submits: It was bound to happen sooner or later. After years of double digit growth, the European cellular market has finally flattened out. Pretty much everybody that has ever wanted a cell phone has got one now. Chasing new subscribers is no longer the name of the game. In what is now a very mature market, hanging on to existing market share and harvesting more revenue per user by coaxing them to pay for additional services beyond voice is the primary business strategy.

One key component to bringing up average user revenues was supposed to be 3G. Unfortunately, the boost in revenues resulting from increased usage of 3G services like video messaging has failed to offset the drop in revenues resulting from declining trend in user voice time.

The culprit in this situation has to be the relatively expensive talk-time that Europeans are charged for wireless service, which averages about US $0.23/minute vs US $0.08/minute in the US. To European telecom regulators, all this smacks of a cozy oligopolistic arrangement, and they’ve been aggressively reviewing rates and enforcing price roll-backs.

Now, events are unfolding that suggest that the industry's pricing structure is about to get a lot more competitive.

Recently Deutsche Telecom (DT) fired the first shot in what could quickly become a continent-wide price war by announcing new highly competitive price bundles which will bring the average rate down to about US$0.13/minute.

The news came in tandem with a second quarter earnings announcement, which saw net income drop 14%. The combined effect of these negative announcements caused DT’s share price to plunge close to 7% on the day.

Since the impact of this radical shift on pricing will affect other European cellular markets, other European telecoms also took a hit on the announcement. Shares in France Telecomm (FTE), Telefonica (NYSE:TEF) and British Telecom (NYSE:BT) all slipped materially.

Perhaps the one industry player with the most to lose, now that the rules have changed on the European cellular playing field, is Vodafone (NASDAQ:VOD) - a wireless pure play with broad exposure across a variety of European markets.

As the world’s largest cellular operator, Vodafone was a major player during the high growth years of the industry, building or buying capacity from the U.S. to Japan at a frenetic pace. Its services are now available in 59 countries, but its major customer base is in the U.K., Germany and the U.S.

Lately, the company has had to bear the consequences of its overly aggressive growth during this period. In May 2006, the company announced the largest corporate loss in British business history when it wrote down the equivalent of US $53 billion in connection with earlier, obviously ill-timed, acquisitions in Germany and Japan.

Lately, there has been considerable Street speculation regarding whether Vodafone will sell-off the 44% interest it holds in Verizon Wireless - the second largest cellular operator in America. Majority partner Verizon (NYSE:VZ) has publicly announced its interest in buying out Vodafone, however Vodafone has so far shown no interest in selling – at least publicly.

While Vodafone has made money on its investment in the joint venture, the deal has never made a great deal of strategic business sense. It lacks technology synergy, since Vodafone operates on the incompatible GSM system, it can’t use its brand name and it has no control over dividend policy in the arrangement. Selling out would be a smart move – but only at the right price. Pundits are looking for a price somewhere between US $40 to $50 billion.

If a sale of Verizon Wireless were to materialize, Vodafone would have the enviable position of having to decide how to dispose of all that cash. Since investment returns in the European wireless market now look like they’re about to move permanently lower as a result of the emerging move to a more competitive pricing regime, it wouldn’t make sense for Vodafone to be adding to its existing investments there.

The only sensible thing to do with the cash would be to pay down debt (the company has about US $35 billion on the books) and return some of it to shareholders, possibly in the form of a special dividend. While this might provide investors with a one-time windfall, it wouldn’t be sufficient to offset the fundamental deterioration now taking place in its core business.

With a P/E of about 10.5x and a yield of 5.5%, the shares are already trading at a cash-cow valuation. However the amount of ongoing cash this “cow” pays out to investors now looks to be at risk of declining in the years ahead.

VOD 1-year chart:

By Eugene Bukoveczky, Contributor - Investopedia Advisor

At the time of release Eugene Bukoveczky did not own any shares in any of the companies mentioned in this article.