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Summary

  • AT&T's $48.5 billion acquisition of DirecTV makes a takeover bid for Vodafone highly unlikely, which means a takeover premium is now unwarranted.
  • Its weakening European business also means Vodafone's fundamentals don't support a valuation premium over its peers.
  • Nevertheless, its huge investment program ongoing and high-dividend yield still makes Vodafone attractive for income investors.

AT&T (NYSE:T) has announced plans to buy DirecTV (NASDAQ:DTV) for $48.5 billion, being the company's largest takeover in eight years. AT&T's growth is modest and the company was looking for targets to boost its growth profile going forward, with Vodafone (NASDAQ:VOD) being the most suggested target. Even though a takeover bid from AT&T was widely expected, this was unlikely as I've analyzed in my previous article. With this large acquisition, AT&T should give up on Vodafone and seek growth in its domestic market instead. For Vodafone shareholders this is bad news because Vodafone's premium valuation to peers may now not be warranted.

Over the past few months, a potential bid from AT&T has been one of the main reasons why Vodafone's share price has performed relatively well despite weak fundamentals. Speculation of a potential bid from AT&T started to emerge when Vodafone agreed to sell its 45% stake in Verizon Wireless (NYSE:VZ). AT&T has made public over the past couple of years its intentions to grow abroad through acquisitions, targeting specifically Europe. However, the company was blocked from buying Telefonica (NYSE:TEF) and was not impressed by Vodafone's strategy of buying cable operators, as AT&T saw better opportunities to grow on mobile through investments in new technology, namely 4G LTE. With the DirecTV acquisition, AT&T is clearly changing its strategy and a large takeover abroad is highly unlikely, at least for now.

Vodafone is one of the largest telecom operators across the world, give that its market capitalization is currently about $96 billion. Therefore, there aren't many potential buyers beyond AT&T and Verizon that are big enough to buy Vodafone. With these two companies tied up with other deals (DirecTV and Verizon Wireless, respectively), Vodafone should be on its own to build out its Internet infrastructure and restore revenue growth. Another potential buyer may be America Movil (NYSE:AMX), which has stakes in European telecom operators KPN (OTCPK:KKPNY) and Telekom Austria (OTCPK:TKAGY), but Vodafone seems to be too much big for it. Without a takeover premium, Vodafone's premium valuation multiples may now be unwarranted given the company's deteriorating European business.

By revenue, Vodafone is heavily exposed to Europe despite being a well diversified company with good exposure to emerging markets. Its largest single market is Germany having a weight of 18% in revenues, followed by the U.K with a 12% weight. In Europe, it has also a large exposure to Spain and Italy. In emerging markets, Vodafone is present throughout Africa through Vodacom (VDCMY) and has a strong position in India.

Historically, Vodafone has posted superior growth compared to other European telecom operators and its growth outlook was above-average. However, in recent years its performance has been much more modest and going forward is not expected to change much. Its revenues are expected to remain flat over the next couple of years and profitability should improve only slightly, an outlook that hardly justifies a valuation premium. Vodafone has invested in network and on its services offering but it looks as past investments delivered limited benefits to Vodafone, which is currently losing market share in most of its European markets. Therefore, the decision to step up capital expenditure [capex] plans by dedicating close to $12 billion to network investments is a good development, but it may be tough to replicate the competitive advantages offered from integrated operators.

Thus, Vodafone's top-line growth should continue to be under pressure over the next couple of years at least, which means that a valuation or takeover premium is now unwarranted. Nevertheless, Vodafone is currently trading at about 10.75x its 2015 estimated earnings and has a forward dividend yield of 5.9%, which is still attractive for long-term investors despite the company's short-term headwinds.

Vodafone's large exposure to European mobile, which has experienced the brunt of the revenue pressure, has magnified the negative impact on its financial performance, contributing to a lower growth in terms of EBITDA compared to most European peers. In its last quarter reported (from October to December 2013), Vodafone's group revenues decreased by 4.8% year-on-year, with Europe contracting by 9.6%. Its revenues declined considerably in countries like Italy (-16.6% yoy), Spain (-14.1%) and Germany (-7.9%). To offset this trend Vodafone is pursuing acquisitions of cable companies, like ONO in Spain and Kabel Deutschland in Germany. This will enable the company to change its profile from a mobile operator to a convergent operator, offering mobile services but also internet and TV-services to customers. This explains Vodafone's recent push on cable, both through its Project Spring program and acquisitions. According to analysts' estimates, Vodafone is expected to report tomorrow $72.5 billion in revenues related to its fiscal year 2014. This is a 3% decline from the previous year and its EBITDA should fall by 3.7% to $21.5 billion.

Historically, Vodafone has posted superior growth compared to other European telecom operators and its growth outlook was above-average. However, in recent years its performance has been much more modest and going forward is not expected to change much. Its revenues are expected to remain flat over the next couple of years and profitability should improve only slightly, an outlook that hardly justifies a valuation premium. Vodafone has invested in network and on its services offering but it looks as past investments delivered limited benefits to Vodafone, which is currently losing market share in most of its European markets. Therefore, the decision to step up capital expenditure [capex] plans by dedicating close to $12 billion to network investments is a good development, but it may be tough to replicate the competitive advantages offered from integrated operators.

Thus, Vodafone's top-line growth should continue to be under pressure over the next couple of years at least, which means that a valuation or takeover premium is now unwarranted. Nevertheless, Vodafone is currently trading at about 10.75x its 2015 estimated earnings and has a forward dividend yield of 5.9%, which is still attractive for long-term investors despite the company's short-term headwinds.

Disclosure: I am long T, VZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Vodafone: Valuation Premium Is Now Unwarranted