Vodafone - Ridiculously undervalued?
Today, I take a look at one of my more risky portfolio positions - British telecom company Vodafone (VOD). Vodafone is a stock that has been pressured for years at this point, from a share price of almost $40, to where it is today. The company has, simply put, lost a lot of stock value over the past few years.
I will be arguing that while Vodafone has dropped markedly, most of this drop is actually justified looking at current company valuations and future profit expectations. I will be showing you the metrics for today's valuations, and looking to the future to where I believe you should invest in Vodafone. My article will offer you insight into my own position in the company, and what I expect of them.
I will end with a recommendation to buy VOD at a certain price point, with a further recommendation to purchase more, should the share price deteriorate even more because of materializing risks or further challenges.
(Source: Vodafone Homepage)
Vodafone - Half a billion customers and growing
Today, I will be focusing more on current data than history or where the company comes from, in an effort to cut unnecessary fat from my article.
The company, along with its joint ventures, offers telephone, mobile and broadband services to approximately 550 million customers worldwide.
(Source: Vodafone Annual report FY18)
As can be seen above, Vodafone has operations in a multitude of countries worldwide, 4G coverage notwithstanding (where the company has even more partnerships and greater degrees of coverage).
Vodafone's main markets are Germany, Italy, and the UK, which together account for 53% of its group revenue (Source). The company's plans for this exposure are quite clear - they aim to diversify into further markets in India, Africa, and other nations/continents in order to decrease their dependency on Europe as a market. Vodafone as an entrant into the Indian market has seen some success, and they currently have over 200 million subscribers in India alone. These subscribers will double as a result of Vodafone's merger with Idea Cellular, which was closed during mid-2018.
Before 2014, Vodafone owned a large (45%) stake in US telecommunications giant Verizon (NYSE:VZ). This was sold as a part of the company's restructuring plan. The stake was sold for $130B, and the asset sale that Vodafone has undergone as part of its plans to "cut the cord" in pay-TV and similar ventures is part of what's depreciated the stock's nominal value.
Vodafone's strategy over the past few years has included the M&A of smaller wireless and telecommunications companies and the development of its services into a full-range suite of communication plans for customers worldwide (with a core focus on Europe).
Another core part of Vodafone's strategy is their use of economies of scale, leveraging their massive size and market cap to outspend competitors in home markets in ways that make it impossible for smaller companies to keep up. Vodafone has invested massive amounts (almost €50B) into wireless and fiber infrastructure systems across the world. With Vodafone's investment programs, as well as the ambitious "Project Spring", which they have been engaged in for a number of years at this point, Vodafone has become a major, if not first-place, player in all of their key markets across the world.
Vodafone is, in fact, and measured by consumer NPS benchmarks, in first place in Germany, Italy, the UK, Spain, South Africa, Egypt, and India. They are currently in second place in Turkey (Source). They own Europe's largest broadband network in terms of size and have grown their customers and mobile data traffic for several years straight.
(Source: Vodafone Annual report FY18)
Vodafone's stance on India is that it represents an important driver for future growth (hence the fight for almost a billion customers), and they continue to plan to grow in the country. Vodafone also manages several 5G initiatives across Europe, among other things, in the complete company rollout of the new communication standards across the continent. This is much alike to the plans of AT&T (NYSE:T) and other global/American telecommunications giants, which are all currently facing the CapEx-intensive prospects of expanding already existing 4G networks into 5G.
During mid-2018, it was announced that the company would acquire many eastern European and central European cable assets, in effect transforming the company further in terms of full-service communications infrastructure across Europe, with exposure and products visually presented below for FY18.
(Source: Vodafone Annual report FY18)
The company provides, in this contributor's opinion, an appealing sales and geographic mix, with perhaps still a bit too heavy a weight towards mobile services as opposed to fixed services. Vodafone has changed over the years, from having very little exposure to 4G (they only had 5 million customers with 4G in all of Europe during 2014) to becoming a fully-fledged communications giant offering everything from landlines, cable TV, internet and wireless.
Whether some of these areas are viable for the future is, of course, a topic for debate and for later parts of this article.
(Source: Vodafone Annual report FY18)
The company has ambitious goals with regards to their customer management, tech, and operations departments in a program called the "Digital Vodafone" plan. They intend to use their large customer base and the data gathered therein to provide personalized offers and advertisements - or what they refer to as a 'digital experience', a blend of digital and physical assets.
That's a bit about the company and a presentation of where they are today.
Vodafone's risk - debt
There's a lot of buzzwords and ambitious wording in the annual report - moreso in fact than in other reports and quarterlies than I've read in a while. Let's instead, without spending further time presenting a type of company which most of you have already read about quite a bit, focus on Vodafone and the problems they're currently having.
Well, they are a telecommunications firm active in the potential 5G rollout. As we learned from other telecommunications firms, they're incredibly CapEx-intensive businesses. This is both good and bad.
It's good because it prevents the easy impact from new entrants into a market that's effectively closed due to the CapEx requirements associated with it - it's bad because of the massive bills associated with keeping a modern-age telecommunications network up and running - and more, upgrading existing systems. Now, Vodafone has already spent a lot of money on CapEx - but this is likely to only continue as demands for new technology not only in Europe and North America but in the rest of the world grows.
Vodafone has spent €48B on existing infrastructure CapEx over the past five years (Source), partially as a deterrent for new players to gain entry into the market or provide too much of a competition. What the cost will be to upgrade the entire company's infrastructure is anyone's guess - I was unable to find numbers or guesses as to this.
The company, as of 2018, has taken on an ever-increasing pile of debt.
(Source: Vodafone Annual report FY18)
It's almost €31.5B as of FY18, and one of the risks associated with Vodafone is obviously this mountain of owed cash. Vodafone has considered selling assets in Europe to deleverage their sheet (Source), and is also planning to cut customer support jobs across northern Africa, India, and Eastern Europe during the coming years. Whether these measures will be successful is anyone's guess, but one thing that's certain is that the company's debt is a risk to consider when investing - especially considering the company's massive yield of nearly 10%.
The debt risk is magnified further with the upcoming Liberty deal. Should it pass, the sale price of ~$21B will further stress Vodafone's balance sheet, increasing leverage to 3.0x. The company's positive credit rating would then be in danger, and Moody's has already placed the company's Baa1 up for review.
Vodafone's risk - Geographic diversity
Vodafone is active in numerous markets across the globe, including markets that can be described as having a high degree of currency volatility. The company deals with euros, pounds, rupees, and several smaller markets with niche currencies that experience more fluctuation than your typical American dollars. Apart from the associated growth headwinds which greatly affect an already slow-growing business, there are the more serious (albeit rare) risks of these smaller currencies being devalued greatly towards the euro and US dollar.
This risk also applies to the dividend and the stability thereof. It's hard to be certain what to expect, when your dividend is paid out semi-annually in pounds sterling. As such, the dividend history is a bit iffy (though not entirely due to FX concerns, of course).
Apart from currency, Vodafone's geographic diversity also exposes them to numerous regulatory frameworks. With the EU as their home market, Vodafone is fairly experienced at handling the legal issues associated with operating over here. However, the same is not true in say Africa, India, or other nations that are outside of EU jurisdiction, and as such, regulation. The challenges of growing in these countries have already been faced and failed by numerous European telecommunications companies such as Telia (OTCPK:TLSNY) and Telenor (OTCPK:TELNY).
Germany's regulatory institutions have already three times in the past blocked Vodafone's attempts to buy major competitors. This is due to the fact that the EU, and the member states, want a fractured market in terms of competition. Should Vodafone desire to grow further, any major M&A within the EU is more than likely to be blocked by the regulatory bodies. In fact, even their deal with Liberty is highly encouraged to be blocked for this very reason (Source). While Vodafone expects EU approval for it, and certain things speak in favor of such approval being forthcoming, it's in no way a guarantee.
Vodafone's risk - they have stumbled many times before
Looking at Vodafone's history, the company has a downright horrible track record with M&As, specifically overpaying of them. Now, we're no strangers to overpaying during M&As. In fact, it seems like the rule rather than the exception - regardless of geography. Vodafone, however, brings this to a new low. Since 2006, the company has written off almost €90B in losses related to acquisitions alone. Given the company's awful track record in these things, it seems safest to take Vodafone's plans for India with a shaker of salt - it seems likely that things aren't going to turn out as rosy as the company expects them to.
The fact is, Vodafone has a history of managing shareholder - our - capital, and that's not something you want to see in a company you invest in.
Vodafone's risk - Problems in their home markets
Vodafone's troubles in Spain and Italy are nothing to sneeze away. While markets such as Egypt and Turkey are seeing double-digit Q1 revenue growth in terms of percentages, Spain and especially Italy are seeing drops in revenue due to an increasingly competitive landscape with new players on the board. Should these troubles intensify and put more stress on an already financially stressed corporation (which intends to overleverage itself to the degree of lowering their own credit rating), it could be the first kick in a series of kicks that causes Vodafone to fall over - in that it would likely require a dividend cut to increase their balance sheet safety and positive credit rating over the long, if not the short, run.
Vodafone's risk - picking up failing technologies
Well, perhaps not so much failing as technologies that have been proven to be poor M&As by AT&T when they acquired DirecTV in 2014. While streaming services aren't as popularized in countries with different cultures and traditions (many of our eastern-European countries dub their media, and attracting customers here is harder for streaming services than in say, Sweden, England or Norway), the young generation may still lean towards streaming services such as Netflix (NASDAQ:NFLX) instead of traditional TV. If trends are similar to countries like Germany, older generations will stick to their traditional television. Regardless of the outcome of this investment, the risk Vodafone is taking in partially investing in old technology and expecting excessive cost synergies/cross-selling, is that these things may not materialize. Vodafone argues that the amount of traditional television in this M&A is limited, but one is still reminded of the DirecTV debacle.
Hold your horses. It's Vodafone - half a billion subscribers and counting
As usual, I write a lot of negativity and challenges about the stock I review in an attempt to balance the scales somewhat. Let's move to the opposite side - valuation and positives.
(Source: F.A.S.T. Graphs)
Different from how I usually look, I'm going to look at Vodafone from a 10-year historical perspective so as not to skew the graphs too far. Due to company developments and divestments, the stock price has hit a major downward spiral as a result of FY15/FY16 EPS drops. These negative trends somewhat bounced in FY17 and FY18, but analysts are still expecting a negative FY19 for the company, in no small part related to the above-mentioned risks, planned M&As and the challenges the company faces.
As a result, the stock is, as of today, not clearly undervalued or fairly valued. It's almost there, and my own position initiated at ~$18 could be considered to be too expensive by many dividend investors. However, I consider the company valuation to be excessively in the negative, and I consider a -30% to be excessive in relation to what Vodafone could achieve.
There's simply a lot of unknowns in the company's future. A lot of potential risks, and a lot of potential upsides. As usual, when this is the case, I prefer looking at current numbers and facts. So, here are the facts.
Vodafone is BBB+/Baa1-graded with a current 2.1x leverage, making it if not conservative, acceptable with a nice credit rating. The company has paid uninterrupted dividends for 15 consecutive years (Source), and it's unlikely that the new CEO, having started the job in October of 2018, wants to start his career with a dividend cut or axing, unless absolutely forced to do so.
The fact remains that while the company's stock is under tremendous pressure, on the level of some current pharmacy stocks, it's trading at a current blended P/E of 17.7, as opposed to its historical valuation of 22.6. Now, the historical premium valuation is, I believe, no longer valid given the company's future growth prospects. Instead, I believe we should use a more fairly valued blended P/E of 15-18. We must not forget that Vodafone, while under pressure, and excluding Vodafone Idea (their India operations), they are ranked as the 4th-largest mobile operator in the world in terms of customer base. They are bigger than AT&T. They are bigger than Verizon, Sprint (NYSE:S) and T-Mobile (NASDAQ:TMUS). In fact, Vodafone is, in terms of subscribers, bigger than Verizon and AT&T combined. And that's excluding Vodafone Idea.
While there's one map showing certain company operations, I want to show you a different map as well. Check it out.
This is Vodafone's global footprint. Or perhaps a better way to say it, bootprint. This company is massive. Their customers, on the enterprise division, include equally massive companies such as Linde, Volkswagen, Unilever, and Deutsche Post. Economics of scale for such a company is nothing to discount, regardless of debt leverage or current future risks.
Vodafone - they are profitable, and you're likely to make a profit
(Source: Vodafone Annual report FY18)
For one thing, I want to clearly point out that Vodafone is a profitable company. Their adjusted EBITDA is growing for FY18, and while this doesn't offset coming risks in terms of M&As or regulatory risks, I probably wouldn't be investing in the company if they didn't show numbers going towards the positive despite the pressure on the shares and all the current negativity on the company. The company made significant progress during FY18 with a solid EBITDA increase. Their service growth revenue was at a measly ~2%, but considering the company size and industry headwinds, I count this as an acceptable result.
In short, despite all the negativity and future concerns, current fundamentals and historical data show a company that's profitable - not one mired in financial troubles and fundamental challenges. Other fundamentals such as historical FCF and historical FCF margins support this thesis.
(Source: F.A.S.T. Graphs)
Should the company return to standard valuations, meaning lower than they are currently valued, you'd be raking in 22.10% annually. Even at lower valuations than 15, if the company's headwinds come with more impact than expected, and the stock price drops to a blended P/E of 7.5, the lowest measurable on the graph, you would still not be losing money. One could argue, however, that the only way it could drop to this valuation is a dividend cut, which would change the mathematics and results somewhat.
The fact remains, if the company managed to merely maintain current, already under-historical valuation, you'd be looking at annual returns of almost 30%.
So let's talk dividends
I don't believe a dividend cut is currently in the book for Vodafone, for several reasons. The company has not been opaque on this issue at all, but all in all very supportive of a continued, uninterrupted and uncut dividend. The company has significant amounts of FCF with which to cover the dividend, and the EBITDA growth that they forecast during early 2018 has, in most ways, materialized in FY18 numbers.
Furthermore, the new CEO doesn't see the leverage on Vodafone's balance sheet as a dividend issue - he sees them as completely separate things, as the board decides the company's dividend policy, and the policy includes the distribution of a certain amount of dividends. His argument and the argument of the board is that Vodafone's future midpoint FCF over the next 3 years covers the dividend, which currently amounts to ~€4B a year. The CEO goes on to say that they're confident in the policy that they have, and the board sees the dividend, at current levels, as covered.
The company expects to de-lever not through the cutting or lowering of the company dividend, but through the expansion of EBITDA and through the disposal/divestment of company assets such as cell towers, which the current CEO has spoken about several times.
The message here is clear as cut crystal - management is confident in generating projected FCF of €17B over the next 3 years. If this happens, there won't be a problem with the company's dividend because they've already included 5G rollout investments.
Should they cut it?
I believe they should. I believe Vodafone should, if only somewhat, reduce the company dividend. Doing so would no doubt put further stress on the company's stock, but it would be the responsible thing to do regardless, taking into consideration the company's proposed leveraging.
As such, I've taken a dividend cut into account at the time of purchase of the stock, and intend to wait somewhat, provided the share doesn't crash further, before loading more, as the situation for 2019 becomes clearer.
There isn't much margin for failure in the company's calculations, and while they no doubt have other wells they can tap for further capital to cover the current, almost-10% dividend, I don't think it's the responsible thing to do.
So. Dividend cut - I'm pretty okay with it, should it happen, and I won't cry anyone a river, because of the company share that I own and that I'm happy with - Vodafone.
Vodafone is a rough company to recommend to dividend-oriented value investors, due to the associated number of risks and future challenges. However, the easy recommendations are not the ones I want to focus on, because easy recommends are just that - easy.
I like the interplay of risk and recommendation, based on solid fundamentals. And there are solid fundamentals to point to here, despite all the challenges.
Vodafone is a company with deep roots spreading through all of their core market - Europe. They have Europe, despite current headwinds. This provides them with a solid base for their operations and expansions into the rest of the world - and in many of these markets, they are thriving.
Vodafone isn't facing any challenge that smaller, or other telecommunications companies aren't also facing. We're talking:
- 5G rollout and associated CapEx.
- Difficulty to achieve further organic growth - best-case is small amounts of growth of flat numbers.
- Challenges in emerging markets.
- Regulatory frameworks from different continents.
However, in many of these, Vodafone is actually ahead. Their 5G rollout is already on its way, and the associated costs have already been included in current numbers. Despite the headwinds, the company has achieved organic growth in low numbers, and they have plans to face the challenges in emerging markets.
Despite all the talk surrounding the dividend, management believes it well-covered and provides a traceable logic that, while not without risk, is in my view acceptable for the time being. We'll have to keep an eye on the company to make sure they manage this well, but it's not something where I believe a dividend cut is imminent.
- A massive company that fulfills a basic, human need for communication in key markets throughout the world.
- Profitable with a very high dividend yield that, in the near future, seems sustainable.
- No challenges faced by the company is unique or things they haven't faced before.
- New management focused on disciplined M&As and deleveraging, through various means, of the balance sheet.
What are we left with?
I believe the key, as with all investments that I do, is patience. Vodafone, while they could surely drop further, is what I consider to be attractively valued for what you get. A blended P/E of 17-18 and a share price of $16-1$8 presents what I believe to be an appealing entry point for the 4th-biggest telecommunications operator in the world.
The risk-reward ratio seems favorable to me at these valuations, and we're likely to see more information once the company finishes, or is denied, the acquisition of Liberty. I will be buying more of the company if the stock drops below $17. It's a real return-to-fundamentals sort of stock where the question becomes - what are we buying, and what are we paying?
I believe paying this price per share for this company, given all that they have and all that they control, is something that a value-oriented investor should consider.
So - buy at current price, buy more below $16-$17, provided nothing in the company changes.
Thank you kindly for reading.
Disclosure: I am/we are long VOD, TLSNF. 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.