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Summary

  • Vodafone is an interesting case with a lot of moving parts.
  • Vodafone's robust free cash flow will be dented by upcoming activities which could pay off.
  • What kind of growth is Mr. Market pricing into the stock price?.

Background

Every week or two, I run a screen looking for undervalued securities to see what rises to the surface. I initially disregarded Vodafone (NASDAQ:VOD) when it showed up. This was probably initially due to my lack of familiarity with the company - I saw it as just operating in a crowded European market (not really true) - and also due to my general disregard for the state of the telecom industry everywhere. I don't like it when you have to spend boatloads of cash on capex just to stay in the game. All the same, I decided to take a deeper look to see if there was anything worth noting.

Lo and behold, for a while there I thought I did find something.

  1. Vodafone was well compensated for Verizon Wireless - albeit with much of that money going directly to existing shareholders and to pay down debt.
  2. Vodafone is trying to turbocharge its business through Project Spring (see here and here for a little information). This ambitious project has Vodafone greatly increasing capital expenditures in order to win greater share in existing markets.
  3. Vodafone has experienced and continues to experience a lot of short term regulatory pain as individual countries decrease MTR rates that had benefited Vodafone in the past. (read more here)
  4. Vodafone has managed to offset some of the losses it has seen in Europe with aggressive increases in the developing world and looks to be well positioned in a number of countries.
  5. The deals for Kabel Deutschland and Grupo Corporativo Ono, S.A. seem to have been conducted at reasonable valuations, even if there is no huge upside.

In short, there are quite a few moving parts with Vodafone which makes it difficult to parse out exactly where the company will be in a few years. With that in mind, I decided to take a look at exactly how much growth is currently priced into the stock using a discounted free cash flow approach.

The facts:

VOD

Current Price

$35.04

Market Cap

$92.6B

Yield*

5.2%*

Data Source: Yahoo! Finance

*Adjusted to remove special dividend

Free Cash flow scenarios

The approach that I take when discovering the intrinsic value of a company is to develop three separate free cash flow scenarios and conduct a discounted cash flow estimate. The first is typically a negative view of the company essentially assuming that performance will either stay flat or deteriorate. In the case of Vodafone, scenario 1 involves all of the capital expenditure of Project Spring - ₤7B ($11.7B) with an additional ₤1B ($1.7B) thrown in for good measure. Despite the added capacity and quality of service, the European business continues to weaken and is only partially offset by success in emerging markets. This is combined with the fact that Vodafone has provided guidance stating that they will be free cash flow positive this year (before any M&A). For the purposes of my analysis, I'm assuming ₤0 free cash flow in the first year.

2014-20152015-20162016-20172017-20182018-2019Disposal @ 8x FCFDisposal @ 10x FCF
Free Cash Flow£0.00£0.46£1.71£1.64£1.57£12.56£15.70Final Value Range£11.32-£13.22
$0.00$0.77$2.86$2.74$2.62$20.98$26.22$18.90-$22.08
Discounted£0.00£0.38£1.27£1.10£0.95£7.62£9.53
$0.00$0.63$2.12$1.84$1.59$12.73$15.91

In the second scenario I assumed that once Project Spring was completed (at the planned cost) that growth would start again, albeit at a relatively low rate. I think this is the most likely situation due to the fact that Europe will still be a fairly price sensitive and crowded market to operate in.

2014-20152015-20162016-20172017-20182018-2019Disposal @ 8x FCFDisposal @ 10x FCF
Free Cash Flow£0.08£1.01£1.99£1.97£1.94£15.52£19.40Final Value Range£14.29-£16.64
$0.13$1.69$3.32$3.29$3.24$25.92$32.40$23.86-$27.79
Discounted£0.07£0.83£1.47£1.32£1.18£9.42£11.77
$0.12$1.38$2.46$2.21$1.97$15.73$19.66

In the final scenario, I made the same assumptions as above only that growth is fairly robust representing success in Europe and continued success in emerging markets.

2014-20152015-20162016-20172017-20182018-2019Disposal @ 8x FCFDisposal @ 10x FCF
Free Cash Flow£0.29£1.46£2.50£2.74£2.99£23.92£29.90Final Value Range£21.47-£25.10
$0.48$2.44$4.18$4.58$4.99$39.95$49.93$35.86-$41.92
Discounted£0.26£1.20£1.85£1.84£1.81£14.51£18.14
$0.44$2.00$3.09$3.07$3.03$24.24$30.30

Conclusion

Looking at the value ranges above, it seems that the market is pricing in fairly robust growth into the stock. The model in scenario 3 assumes both a 6% growth rate, which will be difficult to achieve and sustain, and a reduction in shares outstanding of about 2% per year, which is somewhat likely to occur based on past activities. At the same time, I do believe that the first scenario laid out is a fairly low probability set of events. Vodafone's strategy is based on a set of assumptions that (1) data usage will increase at a healthy rate for the foreseeable future, (2) a sizable customer base will pay a slight premium for a differentiated level of service that allows for high levels of data usage and (3) Project Spring will deliver a differentiated level of service. Only time will tell how valid these assumptions are, but from where we stand today, they have merit. Therefore, Vodafone should see improved customer patterns - at least to some degree.

So where does that leave me? I won't be investing in Vodafone today, but will keep an eye on it. These value ranges have to be taken with a grain of salt. If the price of Vodafone was below the average of these options - say in the $25 range, I would be potentially interested. As it is, I'll keep watching for operational improvement, waiting for a drop in the price of the stock, and looking for other opportunities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: I am not a professional investment advisor nor a financial analyst. I am writing this article because I feel that investing is not a zero sum game for the individual investor and because I believe that the process of writing and receiving feedback improves my own performance.

Source: Vodafone: Where's The Value?