Editor's note: Originally published on June 23, 2014
In May last year I argued that the main value of Vodafone (NASDAQ:VOD) lay in its 45% ownership of Verizon Wireless. My model then valued the remainder of Vodafone's business at 67p a share (see here). As Vodafone consolidated its shares in February 2014, issuing 6 new shares for every 11 old shares, this would equal 123p a share today.
Verizon Wireless was a great investment and Vodafone has passed on 51 billion pounds from the sale to shareholders.
Vodafone retained 26 billion pounds (after paying U.S. taxes) of the proceeds of the sale of Wireless. These proceeds amount to 98p a share. Adding 98p to the 123p a share that I valued the company's non-Wireless business in May 2013 would give a notional current valuation of 221p to Vodafone. Vodafone shares currently trade at 192p.
What is the financial state of Vodafone post Wireless?
1. In its 2014 Annual Report, Vodafone provides us with three years of trading results excluding Wireless. It does not make for pretty reading. If one excludes the contribution from Wireless, Vodafone's results for 2012-14 would be as follows:
|Pounds billions to 31 March||2014||2013||2012|
|Profit/(Loss) before tax||(5.3)||(3.5)||4.1|
Revenues are flat and the company is deeply in loss.
2. Net operating cash flows for the three years total 5 billion pounds, which falls far short of the 16.5 billion pounds paid in dividends. The figures by years are:
|Pounds billions to 31 March||2014||2013||2012|
|Net operating cash flow*||(0.5)||1.1||4.4|
|Normal dividends paid||5.1||4.8||6.6|
*Defined as operating cash flow less capital expenditure and interest payments
The 11.2 billion pound shortfall was paid out from the dividends received from associates, nearly all of which came from Wireless. Vodafone is expected to pay a dividend of 11p a share in 2015, costing 2.9 billion pounds. But will the company generate sufficient cash to pay it, or will it have to borrow? It is troubling that management say they will increase the dividend and yet that a huge investment programme will put pressure on cash flow. A dividend paid out of borrowings is not sustainable.
3. The asset side of the balance sheet has taken a turn for the worse. While the 46 billion pound investment in Wireless has disappeared from this account, the company has suddenly added 16.6 billion pounds in deferred tax to non-current assets. €18.3 billion (15 bn. pounds) arises in Luxembourg, where Vodafone has a company that it uses to avoid paying tax in other jurisdictions.
Vodafone expects to generate sufficient profits in Luxembourg to absorb tax losses of €63 billion*. Vodafone will have a great time transferring profits to Luxembourg. The huge losses apparently derive from past impairment charges to goodwill and intangible assets.
*The average tax rate in Luxembourg is assumed to be 29%. Hence the deferred tax asset of 18.3 billion requires 63 billion euros of prior years' losses to be compensated with future earnings. Source: 2014 Annual Report.
Goodwill and intangible assets are valued at 46.7 billion pounds. Given that Vodafone regularly takes impairments for goodwill and intangibles, it is not a wonder that the market discounts Vodafone's net asset value by 27%.
4. With the receipt of cash from its sale of Wireless, Vodafone's debt to equity ratio is quite improved: net debt to equity falls from 44% in 2013 to 27% in 2014. And Moody's maintains the company's A3 credit rating for long-term unsecured debt.
However, there are two caveats.
- The quality of the assets has declined significantly with the loss of Wireless, which paid Vodafone 15 billion pounds in dividends over the last three years.
- Averaging the last three years' net operating cash flow, it would take over 11 years to pay off Vodafone's net debt.
In May 2013 I wrote about truth in financial reporting. I used Vodafone as an example of management presenting its results in such a favourable light that they badly distort the company's true performance. This misreporting is tied to executive remuneration. It is a bad business.
Essentially, management presents results to shareholders that greatly overstates the company's performance, both in terms of profitability and operating cash flow. In particular, management excludes the very large capital costs of maintaining Vodafone's business and the interest cost of financing its operations.
Capital costs include:
- Buying spectrum band width and licenses
- Software development
- Buying and maintaining property, plant and equipment
These three items average 7.6 billion pounds a year over the last six years, equivalent to 20% of Vodafone's revenues.
Vodafone has acknowledged that trading in Europe has been difficult. Adjusted operating profits there fell by half between 2012 and 2014. The decline has been across all major markets - Germany, U.K., Italy and Spain.
Vodacom (OTCPK:VDMCY), which includes South Africa and five other African markets, reported a 10% decline in adjusted operating profits, in part depressed by the fall in the value of the rand.
India - which moved from a loss of 8 million pounds in 2012 to a profit of 326 million in 2014 - and other AMAP [Africa, Middle East and Asia Pacific region] - which improved its profit from 218 million pounds to 393 million - are both moving in the right direction. But these businesses are still quite small.
Vodafone encounters the same difficult market conditions everywhere:
- In most markets there are four or more competitors.
- It is difficult to distinguish one company's offering from another, except by price.
- Prices are under constant pressure, from both competition and the regulators.
- 'Bundling', by expanding into new technologies and products, increases costs and competition. Fixed line and cable operators are moving into each other's markets and Vodafone's mobile market.
- In 2014, the company lost market share in 10 of its markets (including all the large European markets) and gained market share in seven (including India, South Africa and Turkey).
- Companies must invest large amounts in spectrum, software and plant just to stay competitive.
Meanwhile, the growth in the global market for telecoms, in real terms, has come to a halt:
Mobile (bright red), fixed voice (light red) and fixed broadband (pink), courtesy Vodafone's 2014 AR.
Vodafone has often paid a full price for its acquisitions. The trend continues.
In September 2013, the company bought Kabel Deutschland, in a bidding war with Liberty Global, the U.S. based cable company, for €7.7 billion. Applying a standard 33% tax rate to Kabel's pre-tax earnings means that Vodafone paid a whopping 50 times earnings. Kabel is the largest cable company in Germany. It gives Vodafone a big lift in its German market. And Vodafone promises big cost savings and revenue synergies.
Also in September 2013, Vodafone paid Verizon $3.5 billion for its 23% stake in their Italian venture. Applying an Italian federal tax rate of 27.5% to adjusted operating profits suggests that Vodafone paid 26 times earnings for the remaining stake in the joint venture.
In March 2014, Vodafone bought ONO, Spain's second largest cable company, from a private equity group for €7.2 billion. Given that ONO made a profit of just €52 million the previous year, the company paid around 130 times earnings and close to five times sales. Vodafone promises revenue synergies of €1 billion.
Vittorio Colao has been Vodafone's CEO since 2008. He has launched a new strategy with the hopeful title of Project Spring. The main elements are:
- Total investments of around 19 billion pounds in the next two years.
- Aim to reach 91% of the population in Europe with 4G.
- Lay fibre-optic cable "deep into residential areas across Europe" and into selected emerging market urban areas.
- Developing products for enterprises (commercial) and extending machine-to-machine wireless transmission to 75 countries.
- Modernising 8,000 stores.
There is no mention of the expected return on investment or the possible implications for earnings per share.
The CEO's outlook, from the 2014 Annual Report, is for short-term pain followed by medium-term gain:
"In the short term, we continue to face competitive, macroeconomic and regulatory pressures, particularly in Europe, and still need to secure our recovery in some key markets. . . We anticipate that our investments will begin to translate into clearly improved network performance and customer satisfaction in the coming year.
"In the medium term, this will become more evident in key operational metrics such as churn and average revenue per user ('ARPU'); and subsequently into revenue, profitability and cash flow. I am confident about the future of the business given the growth prospects in data, emerging markets, enterprise and unified communications. . . While cash flow will be depressed during this investment phase, our intention to continue to grow dividends per share annually demonstrates our confidence in strong future cash flow generation."
The company has already warned that its margins will be lower and its cash outflow higher in 2015 than this year. The promise is that heavy capital spending will bring about an improvement in profitability in the medium term.
At the current price of 192p Vodafone is yielding 5.7%. But it is not making profits nor is it generating sufficient cash to pay that dividend. Under these circumstances, my standard valuation model is of no use in valuing the company's shares.
Vodafone's share price has been steadily falling since the date that shareholders no longer had the right to the payout from the sale of Wireless (this is marked on the graph with a small black triangle in late February 2014).
Graph courtesy Yahoo, Vodafone share price in blue compared to FTSE 100 in green, click to enlarge
Given the parlous state of Vodafone's future as a stand-alone concern, the only factor supporting the shares is a possible bid. Vodafone has break-up value. A bid could come from AT&T (NYSE:T), although it has said it is currently not interested in Vodafone, or another, very large telecommunications company. Or it could come from a well-endowed private equity firm. In either case, a potential bidder can afford to wait until Vodafone's shares fall to a more attractive level.
Investors in Vodafone should consider:
1. The attractive dividend yield is not, in the present trading conditions, sustainable.
2. Without the share of Wirelesses net income Vodafone is no longer profitable.
3. Like-for-like revenues have declined by 6% in the past two years. Vodafone has spent 14 billion pounds in the last 12 months on acquisitions, which should help to reverse this decline in revenues. But the company continues to pay a high price that, on prior experience, may not prove to be justified.
4. The CEO's plan is short on concrete objectives that will benefit the shareholder.
5. The company will increase its debt, as it is both committed to a dividend payout that exceeds its capacity to generate cash and by the 19 billion pound capital spend set out in Project Spring.
6. The share price is likely to fluctuate in relation to bid rumours rather than trading results. The share price is inherently unstable.
Disclosure: I do not hold any long or short positions in Vodafone and I will not do so for at least 15 days from today.