In a recent edition of Value Investor Insight, Ivory Capital's Curtis Macnguyen (pictured right) - with colleague Neil Chudgar - described why he believes Vodafone (NASDAQ:VOD) is mispriced. Key excerpts follow:
Walk through your specific equity investment case for Vodafone.
CM: Vodafone generates 90% of its revenues from providing wireless services – directly in Europe, Asia-Pacific, Africa and the Middle East and through a 45% ownership of Verizon Wireless (NYSE:VZ) in the U.S. Roughly 60% of its operating profit is generated in Western Europe, 30% comes from Verizon Wireless and the remainder is from emerging markets.
During 2008 and into the first half of 2009, VOD’s stock fell 40% from its highs due to a weakening macro environment, relative underperformance in certain markets, and fears around competition and price cutting in mature European markets. In addition, the Verizon Wireless acquisition of Alltel in early 2009 has caused a delay in the payment of material dividends from the joint venture. As a result of all that, growth-oriented investors have rotated out of the stock.
At today’s price [of around £1.20] the stock trades at only 8.4x fiscal 2010 earnings, 4.6x estimated EBITDA on a enterprise-value basis, and with a free-cashflow yield of around 10%. But if you look closer, it’s even cheaper than that. Including Vodafone’s share of Verizon Wireless’ $12 billion in annual free cash flow, the FCF yield on Vodafone is around 15%. That makes no sense to us.
That kind of yield usually means the company is levered to the risk of bankruptcy, or owns declining assets with big structural problems – neither of which is the case with Vodafone.
What will make the market excited again about Vodafone?
Neil Chudgar: We believe some of the competitive concerns in Europe will prove to be overdone. Vodafone was perceived as a higher-priced carrier in Europe, so the market got spooked as it lowered prices to defend market share.
Now that Vodafone is in the middle or even low end of the pricing spectrum, margin comparisons going forward are likely to be more favorable. On top of that, we think there’s likely to be consolidation in certain of the company’s European markets, which should help rationalize competition. It’s a bit off the radar right now, but Vodafone should also incrementally benefit from competitors’ exclusivity periods ending for Apple’s iPhone in a few key markets in Western Europe. So far Vodafone has only been able to sell the iPhone in Italy.
Concerns over mature markets have overshadowed Vodafone’s emergingmarkets business, where we see significant upside. Developing markets generate more than 20% of the company’s proportionate revenue, but less than 10% of adjusted operating profit. As Vodafone becomes more established in these markets and spends less per incremental revenue dollar to build the businesses, profitability should materially increase.
Another aspect we expect the market to eventually get a handle on is how aggressively the company has been cutting costs. They’ve identified £1 billion in cost savings that should be realized over the next two fiscal years and we see potential for them to increase the costreduction goal with the mid-year earnings release in November. In the U.S., companies’ top lines are mostly horrible, but the market is rewarding them for beating earnings by cutting costs. If Vodafone starts to get similar credit, it will certainly help the valuation.
CM: Finally, and maybe most importantly, as Verizon Wireless repays debt we expect it to pay a significantly higher dividend to its joint owners by 2010 or 2011. By mid-2010, overall leverage at Verizon Wireless will fall below 1x. Even after accounting for spending to build out its 4G network, we don’t see what other uses Verizon Wireless could have for its free cash flow other than a large dividend increase. Given its already leading market position, we doubt current leadership at the Department of Justice or Federal Communications Commission would allow them to make another acquisition in the U.S.
What upside do you see from the current share price?
CM: The easiest way to look at it is on a free-cash-flow-yield basis. Assuming conservatively that this collection of assets deserves a 10x free-cash-flow multiple, just adequately valuing the Verizon wireless stake would result in the FCF yield going from 15% to 10%, generating 50% upside in the stock. At a 12.5x multiple – an 8% FCF yield – there’s 70% upside. And that’s just from the Verizon Wireless catalyst – everything else we consider to be free options.
Is there an argument to be made for their selling the Verizon Wireless stake back to Verizon?
CM: Verizon has said they’d like to control 100% of Verizon Wireless, but the problem for Vodafone is that an outright sale would result in a huge tax bill they don’t want. We actually think a notunlikely outcome is that Verizon one day tries to buy all of Vodafone, which would allow them to expand outside the U.S. in addition to enjoying claim on all of the Verizon Wireless cash flows. We’re not counting on that, but it’s an interesting thing to consider.
Is Vodafone’s balance sheet in good health?
CM: The company’s leverage is in line with peers; total leverage, including the Verizon Wireless stake, is around 2.0x EBITDA.
The biggest risk here is probably the margin pressure that might result from a continued bad economy. We just think that’s more than built into the stock price at these levels, leaving us with several nice catalysts on the upside.