On news that Verizon (VZ) is close to acquiring the 45% of Verizon Wireless it doesn't own from Vodafone (VOD) for $130 billion, both stocks soared. I believe that Vodafone presents a very strong buying opportunity at its current price. Depending on the exact structure of the deal, Vodafone's tax bill will vary. For instance, Verizon has a stake in its Italian subsidiary worth roughly $5 billion. They could do a share swap with that stake, so less cash changes hand, limiting Vodafone's tax bill. While there will be some minor variations, the fact is that Vodafone will owe a significant amount in taxes because its Verizon Wireless stake has grown in value so tremendously.
This tax bill is the result of what was a tremendous business decision: entering the nascent U.S. mobile market 15 years ago. In my analysis, I generally prefer to be conservative and pleasantly surprised to the upside than vice versa, so I will assume the worst case that Vodafone will pay a 20% tax on the entire value of the deal, or $26 billion, meaning it will see a net inflow of $104 billion.
Prior to this transaction, Vodafone had 13 billion pounds in cash and 41 billion pounds in debt. At the current exchange rate, Vodafone has net debt of $43 billion. After this new cash infusion, the company will have a net cash position of $61 billion or 40% of its current $150 billion market cap. Further prior to this deal, Vodafone had $110 billion in shareholder's equity. Its long term investments total $39 billion, mostly reflecting its Verizon Wireless stake, so with an after-tax gain of $65 billion, its shareholder's equity jumps to $175 billion. After adjusting for the merger, Vodafone we bill trading at a 14% discount to book value, unheard of a for a profitable telecom firm. Verizon trades 4x book value while AT&T (T) is valued at 2.25x book. Clearly, Vodafone is seriously undervalued at current levels.
Analysts currently estimate Vodafone will earn $2.50 and $2.60 on its remaining businesses in the next two years. That translates to a profit of $12.25 and $12.5 billion respectively. Taking out its net cash position, Vodafone's remaining businesses are valued at $90 billion. In other words, ex-cash, the company has a P/E of 7.4, suggesting substantial upside. Further with the European economy finally finding its footing, Vodafone is poised to substantially grow its earnings in the next 3-5 years. Its cash position also leaves Vodafone will the ability to buy back a significant number of shares below book value to boost EPS in a very accretive fashion. It can also substantively raise its juicy 5% dividend yield or acquire many cheap wireless and cable businesses throughout Europe to grow its earnings power.
Trading below book value and 7.3x earnings with a 5% dividend yield suggests that Vodafone has little downside because it is already dirt cheap. As the market appreciates its value and the profitability of its core businesses, Vodafone could more towards a normalized ex-cash P/E of 15x, representing 60% upside from its current price. It is leveraged to a European recovery, which appears increasingly likely. Given its current valuation, it is a low-risk high reward play on the survival of the European economy. I would strongly recommend buying Vodafone on today's news of an impending deal for Verizon Wireless.