Yesterday Vodafone ("VOD") released their results for the first half of the fiscal year ending March 31st 2013 ("1H'13").
Following some articles published by the Telegraph titled "Vodafone losses mount as Eurozone woes threaten UK", the Guardian titled "Vodafone slides into the red after southern Europe slumps", and France 24 titled "Vodafone slumps into loss of £1.97 bn on Spain, Italy" I thought it worth some further investigation.
On face value a 7.8% Y/Y decline in top line service revenue during 1H'13 isn't all that great and indeed neither is the -0.4% decline in organic service revenues. Nonetheless, there is a bit of a difference between 7.8 and 0.4 with the difference here being driven mainly by FX movements. Given that company reports in GBP its troubles aren't only the result of stressed southern European states and the subsequent reduced activity in those economies but also the overall impact of a stronger pound relative to the Euro forcing the contribution of even Germany - the company's largest market - into negative Y/Y territory (despite 3.0% organic growth due to pricing). Indeed some articles emphasize weak performance in southern Europe and - for example - the 19.3% Y/Y decline reported Spanish revenues, failing to focus much attention to the difference between a 19.3% reported decline and a 10.2% organic decline. Admittedly both aren't great but let's analyze business performance not FX movements.
Sterling's strength hasn't just been a local phenomenon either, the Rupee and Rand have both depreciated causing 13.5% and 5.4% Y/Y organic revenue growth respectively to become a 3.6% and 6.9% shrinkage when reported. Accounting wise, given that businesses naturally report in nominal terms, strong revenue growth (in local currency) within an inflationary economy can make good top-line performance look great. Just for reference, Indian and South African inflation stand at 9.2% and 5.3% respectively and the customer base in India is reported to have increased by only 5.3%. While I'm in the positive camp on both these markets (despite some headwinds in India in particular) it is easy to get carried away and extrapolate growth beyond reason.
Just one last perhaps geeky point, there's much talk about Verizon Wireless, it's dividend and whether VOD should/could sell its stake in the company. But just for the sake of it suppose VOD consolidated 100% of VWZ (as it does with 65% owned Vodacom) then headlines yesterday might have read "Vodafone increases revenues at 0.9% Y/Y despite European troubles". Alternatively, and probably more realistically with revenue reported on a proportional basis we'd be reading about a 2.3% rather than 7.8% YOY decline in revenue (I'm open to suggestions of what the article title might be).
At the operating level two or three obvious things distort the picture at face value, 1) since VZW is reported as an associate VOD's share of income is reported as one line in the accounts, and 2) due to the on-going difficulties within southern European operations, higher discount rates and lower profitability assumptions lead to a £5.9 non-cash impairment charge during 1H'13. These sorts of factors distort the picture both ways, it's just as important to recognize that at 1.3% (during 1H'13) operating margins aren't unduly depressed or at 24.1% (during fiscal '12) they're not unusually high. A fairer estimate is ~14.2% for fiscal '12 (vs. 13.0% for the industry) and 13.5% for 1H'13 but even these 'guesstimates' are inevitably subject to accounting conventions and estimates.
Then again, some might say profit is opinion cash is fact.
Headline EBITDA declined by 11.7% to £6.6 bn. Again this figure is influenced by FX movements, organic EBITDA declined by 2.9% YOY with declines across the board in Europe being partially offset by improvements in India and Africa. Operating free cash flow fell by 14.2% Y/Y driven predominantly by lower EBITDA which was partially offset by lower CAPEX spending (-10%Y/Y). Less tax and interest charges (still ex-dividends) FCF stood at £1.3 bn having fallen from £1.7 (-22.5%) a year earlier.
On balance, problems in southern Europe, declining margins across the board, regulatory issues don't paint a rosy picture for Vodafone. But the market seems to know these issues fairly well and much of the bad news flow seems to be priced in at this level. The question is: at the current price (~£80bn) is VOD a bargain?
Valuing VOD is a challenge to say the least.
Let's apply a sum of the parts approach and first get an idea of what VZW might be worth:
During 1H'13 VZW earned $15,808 million EBITDA translating to £9,984 million of which 45% or £4,493 million attributable to VOD. VOD disposed of SFR to Vivendi valued at 6.2x EBITDA and applying this multiple to VZW annualised EBITDA values the firm at $186bn less $2bn net debt equals ~$184bn or ~£115bn equity value with VOD's share valued at ~£52bn. This valuation seems a little extreme but I'm open to criticism on this one.
Either way, let's do a thought experiment. The omniscient stock market god appears to you in a dream and convinces you that a £52bn valuation is sound based on VZW's glowing future prospects. The morning comes and you ponder; what is VOD worth then?
Given VOD's ~£80bn market cap, our residual after taking into account VZW's value share stands at £28bn.
For £28bn you're getting ~£44.0 bn of revenues, ~£13bn EBITDA, with ~£28bn net debt (so a valuation of 4.3x EBITDA) and a geographically diversified business which is exposed to some potentially golden nuggets of joy (namely, India and South Africa, etc).
Inevitably with this sort of approach it's important to have a view on margins going forward. I'm working on the basis that there won't be much margin pressure going forwards (and the risk is to the upside) but again I'm open to critique.
As mentioned in the financial report for 1H'13 issued yesterday. Subsequent to the Supreme Court judgment in favor of VOD back in January - that ruled in favor of VOD's interpretation of the Income Tax Act '61. The Shome Committee ( the government commissioned committee of experts) recommended in their first draft report (published 10/10/12) that tax legislation should only be applied prospectively and, if applied retrospectively, only the seller who made the gain should be liable. Though there is no response as yet from the Government of India, the ruling of the Supreme Court, combined with the recommendations of the Shome Committee and prospect of arbitration under the Dutch-Indian Bilateral Investment Treaty resulted in no provision in respect to the enactment of this retrospective legislation.
It's my belief that the Indian government is clutching at straws trying to raise revenues and that it's absurd that VOD should be liable. If anybody should be saddled with this tax it should be Hutchison.
After revoking permits granted back in 2008 to certain carriers, the Indian government on Monday embarked on a process to auction off spectrum licenses again (but with little success). The miniscule amount of enthusiasm reflects the governments lofty expectations and optimistic (to say the least) pricing.
Disclosure: I am long VOD.