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Amidst today’s economic gloom and the European sovereign crisis, I have been selectively adding stocks that I view as more defensive in nature. Recently I purchased Vodafone (NASDAQ:VOD), a global wireless carrier, as in my view, it ranks up there with utilities and food stocks for its ability to weather difficult times. Even the unemployed often keep their cell phones; it has become a consumer staple and for that reason cell phone usage will continue to grow, perhaps even in a recession, at a steady clip.

With Vodafone, I also find the dividend to be quite healthy. Over the past 5 years, VOD has paid dividends that have grown annually by over 11% (in dollar terms). At the same time Vodafone has maintained an approximate 55% payout ratio. To be fair, I have included the $10BB Verizon Wireless special distribution in this calculation which is a big boost to Vodafone's dividend this fiscal year.

But the point of this piece is to argue why Verizon Wireless will not only continue paying this level of distributions next year, but also likely to grow it in future years. That means that Vodafone's dividends likely will remain at its current elevated levels going forward.

Background on Verizon Wireless

Verizon (NYSE:VZ) and Vodafone have co-owned the Verizon Wireless business in the US since 2000, with VZ owning 55% and VOD 45%. Control has rested in Verizon’s hands however, and speculation of VZ buying out VOD’s stake has been ongoing for years. Verizon Wireless (VZW) hasn’t paid a dividend since 2005, however, and instead of dividends to the parent companies, it has continued to buy spectrum, acquire other wireless carriers, and build out an advanced 4G LTE network.

In fact, in 2008, just as VZW appeared able to pay a dividend to its parent companies, they instead purchased Alltel for a hefty $28BB, of which Verizon Wireless assumed $22BB in debt.

Fast forwarding to today, VZW has paid down almost all of the debt incurred from the Alltel deal. Not only that, but there just aren’t any more wireless carriers that are worth buying of any size. US Cellular is the biggest remaining CDMA carrier, but only has a market cap of $3.5BB. Leap and MetroPCS (often rumored to merge) together have another $3.5BB of market cap but aren’t likely to be purchased by VZW. Their models are different and geared toward the lower end pre-paid customer in select markets. (I seriously doubt regulators would let VZW buy Sprint, the other CDMA carrier).

And finally, the build out of their 4G LTE network is complete, meaning capex should decline at wireless going forward.

Below is the gross and net debt at VZW since the Alltel deal. I also forecasted what gross and net debt would look like through September 2012. (the maturity schedule from VZW is incorporated).

Sep-09

Sep-10

Sep-11

Mar-12

Sep-12

VZW Gross Debt

$29.4

$16.5

$12.5

$10.9

$10.0

Cash

$0.8

$2.2

$9.4

$4.4

$10.1

Net Debt (Cash)

$28.6

$14.3

$3.1

$6.5

($0.1)

So VZW finally agreed in July to pay a special distribution of $10BB to their owners, $5.5BB obviously to Verizon, and $4.5BB to Vodafone. By next September VZW will have generated an additional $3BB in cash, give or take, even after paying out this $10BB in cash! The company becomes virtually debt free in a year.

Here is my estimate of Verizon Wireless FCF, simply using runrate Q3 2011 numbers.

Runrate Q3

Verizon Parent Total EBITDA

$35,200

Verizon Wireless Q3 EBITDA annualized

$28,756

Capex VZW (equals D&A)

$8,000

EBIT

$20,756

Interest

$500

Pretax

$20,256

Taxes (35%)

$7,090

FCF after tax/capex

$13,166

FCF / month generated at VZW

$1,097

While it has been widely reported that VZW generates around $1BB per month in FCF, that number today actually looks more like $1.1BB. If the company grows revenue next year by another 6% (its current growth rate), then VZW will throw off close to $14BB in FCF next year. Vodafone’s 45% share of this would be approximately $6.3BB. With $14BB in FCF in all, I wouldn’t be surprised if VZW announced at least another $10BB special distribution in mid 2012.

Why Verizon Needs This Distribution

Verizon the parent will pay around $5.5BB in dividends in 2011. Next year, I would guess that number will be around $5.7BB. What is interesting is that in 2009, Verizon Wireless paid down an intercompany loan due to Verizon the parent, in the amount of $9BB. In 2010, Verizon sold $5.5BB of assets to help fund the $5.4BB in dividends, and also collected another $2.5BB in intercompany loans from VZW.

But the well has run dry as the intercompany notes have all been paid off, most access lines at VZ have been sold that can be sold, and without Verizon Wireless’ cash flow upstreamed to the parent, there is no way that the parent can continue paying out their dividends. Unless they borrow money to do so.

Here is Verizon’s FCF excluding Wireless.

Verizon Wireline (ex VZW)

Runrate Q3

Verizon Wireline EBITDA

$8,688

Capex VZ (equals D&A)

$8,476

EBIT

$212

Interest

$2,300

Pre-tax

($2,088)

Taxes (35%)

$0

FCF after tax/capex

($2,088)

Verizon holdco needs the Wireless cash distributions because its Wireline businesses are losing signficant FCF, to the tune of $2BB per year. That is a problem. You cannot pay out $5.7BB in dividends, when your Wireline business is losing $1-2BB, and without upstreaming cash from the Wireless subsidiary. Not without further asset sales or raising a lot of debt. Which by the way, Verizon investor relations has indicated they don't want to do.

As a side note, I wonder if investors realize that when they are looking at consolidated Verizon numbers, that they include 100% of wireless assets. Here is what their 2010 10K states: “For controlled subsidiaries that are not wholly owned, the noncontrolling interest is included in Net income and Total equity.” That is, the noncontrolling interest (ie VOD 45% stake) IS included in Net income.

At least VZ reports Net Income, and also breaks out Net attributable to VOD and Net attributable to VZ. So while EPS numbers are roughly correct when reported, the EBITDA numbers, the CF statement, and the balance sheet consolidate the 45% VOD stake, as if it was wholly owned. Very confusing.

On the opposite side, Vodafone does not include its stake in VZW in its consolidated financial statements. Their Verizon Wireless stake is reported on one line on the balance sheet, called Investments in Associates. The carrying value of this asset is $38BB, and isn’t revalued upward. It can suffer write downs or can grow based on attributable Net Income, but it is not marked to market by any stretch. In fact, given that their stake is probably worth $75BB, I would say that the Vodafone balance sheet is way understated. As is the CF statement, which doesn’t reflect the economic interest in VZW cash flow.

Dividend Conclusion

Verizon likely will see continued negative cash flow next year from its Wireline business. Growth in FIOS, their digital TV segment, is just offsetting declines on the wireline phone side I suspect. Wireless, however, will grow 5-8%, and will generate quite a bit of FCF. For VZ to keep paying dividends to its shareholders, without asset sales or intercompany notes left to pay down, it HAS to upstream cash from Verizon Wireless via dividends. Either that, or it needs to borrow substantial capital at the parent company level.

But raising debt financing at the parent with subsidiary guarantees probably requires approval from Vodafone, which I am not sure they would give. Verizon can raise unsecured parent level debt likely, but I think they want to use real CF from operations. And I don’t think the debt capital markets would be excited about lending to just the parent company given the use of proceeds would be to fund shareholder dividends. Shareholders also prefer dividends to be paid out of cash flow. In total, Verizon’s payout ratio with the VZW payments is close to 100%. Barring raising $7-8BB of parent company debt next year, I think the Verizon Wireless dividend has to continue.

Dividend Yield on Vodafone with VZW Distributions

Vodafone’s management is committed to providing a 7% growth in their dividends over the next few years. Compared to Verizon which essentially pays out all of its FCF to dividends, VOD will pay out £4.7BB in dividends this year, while generating FCF of £6-£6.5BB. Lots of cushion.

Including the £3BB of cash from VZW, Vodafone will generate around £9.3BB in FCF, of which it will pay out £6.7BB in dividends. That leaves lots of room for stock buybacks too, which management is also currently engaged in. You have to like Vodafone management for being extremely shareholder friendly.

Now, if the ordinary dividend at VOD grows next year by 5%, that would take it from 9.1 pence to 9.55 pence. If VZW pays another $10BB to its shareholders, then at least another 4 pence can be added to the total dividend for VOD shareholders. 13.55 pence in div’s would equate to $2.17 in div’s per Vodafone ADS. At a stock price of $26.50, that is a very nice yield of 8.2%.

Simply normalizing the dividend to VZ’s and AT&T’s (NYSE:T) dividend yields in the 6% range, means that next year VOD can easily trade at $36 per share, or 37% higher than today. Now of course all of this assumes that the Verizon Wireless payments continue. If they don’t then the upside gets more capped. But I honestly don’t think the market is pricing in any further distributions from the Wireless sub. So, if VZW does not pay next year, there won’t be a mad rush for the exits. But if they do pay, the stock should see significant appreciation.

In part II, I will look at the comps in more detail, and show why, adjusted for the CF from Verizon Wireless, VOD looks far cheaper than either T or VZ. I will also do a sum of the parts on VOD to show what the stock is worth in my opinion.

Disclosure: I am long VOD.

Source: Vodafone: Great Defensive Stock With A Big Dividend Yield - Part I