Selling Vodafone: Mistakes Made And Lessons Learned

About: Vodafone Group Plc (VOD)
by: John Kingham

Vodafone was one of the first companies to join the UK Value Investor model portfolio way back in 2011.

VOD should never have entered the portfolio in the first place.

I've removed VOD from the model portfolio and my personal portfolio, and the proceeds will be reinvested into a new investment next month.

Vodafone (NASDAQ:VOD) was one of the first companies to join the UK Value Investor model portfolio way back in 2011.

At the time, Vodafone was a steady dividend growth stock with an attractive 5.5% dividend yield, but much has changed since then.

The company itself has changed, following the 2013 sale of its 45% stake in Verizon Wireless. This produced a windfall of $130 billion, much of which was returned to shareholders.

Note: This sale was largely responsible for the 55% decline in the value of the Vodafone's shares, but that decline was effectively offset by a related return of cash and shares.

The company's track record has also changed, with Vodafone's revenues, profits, dividends and capital assets all stalling or going into decline over the last few years, while its borrowings continue to go up.

And my investment strategy has changed, or more accurately it has evolved considerably since 2011. Over the years, I've added investment rules for profitability, capex intensity, indebtedness and other factors, and Vodafone now struggles to pass any of these "quality company" standards.

In fact, Vodafone is no longer a good fit with my investment strategy, primarily because of its weak growth, weak profitability, high debt levels and high capex requirements. And that's why I've finally decided to sell.

Vodafone's weaknesses eventually caught up with it

Buying Vodafone: The world's largest mobile communications company

Vodafone started out in the early 1980s as a joint venture with the aim of commercialising military mobile communications technology. The UK government had just started to sell mobile phone network licences and Racal Telecom (as Vodafone was then known) was the second company to acquire one.

The company joined the UK stock market in 1988 and spent much of the 1990s growing both organically and through a series of acquisitions. The peak of this era was marked by Vodafone's £112 billion acquisition of Mannesmann, which turned Vodafone into the world's fourth largest company with a market cap of £224 billion (or about £320 billion, adjusted for inflation).

Interestingly, that (inflation adjusted) £320 billion price tag came at the peak of the dot-com tech bubble, when investors everywhere were buying anything vaguely internet or tech-related. Today, almost 20 years later, Vodafone's market cap is barely a tenth of its year 2000 peak. So if ever you need an example of the madness of crowds, just look at Vodafone's dot-com share price.

Inevitably Vodafone's share price tanked during the dot-com bust, but the company continued to expand. It did this through "partner networks", which allowed it to offer telecoms services overseas without having to invest in expensive infrastructure.

By the time Vodafone crossed my radar in 2011, it had an impressive track record of growth, which you can see in the chart below:

Just what I like to see: Relatively steady long-term growth

The company also had what appeared to be reasonable debts, with a net debt to operating profit ratio of less than three (£30 billion net debt and £12 billion operating profit, to be precise).

This picture of steady growth and low debts was exactly what I was looking for. I wanted to invest in large, successful and well-known companies with long histories of progressive dividend growth, and Vodafone offered all of that and more.

However, fast forward to today and this investment in Vodafone has not exactly set the world alight. Annualised returns have been okay at just over 8%, but much of that was down to luck with special dividends and the large return of capital following Vodafone's sale of its 45% stake in Verizon Wireless.

Without the special dividend and Verizon Wireless windfalls, the results would have been much worse. That would have more accurately reflected Vodafone's financial performance since 2011, which has been weak at best and shareholder value destroying at worst.

Given Vodafone's weak performance and recent dividend cut, the rest of this post-investment review will focus on why, with the benefit of experience and hindsight, Vodafone should never have entered the portfolio in the first place.

Mistake 1) Ignoring Vodafone's weak profitability

Back in 2011, I didn't pay much attention to profitability. I did look at Vodafone's return on equity (ROE) and return on capital employed (ROCE), but according to the somewhat messy spreadsheet and notes I created at the time, neither of those ratios affected my decision to invest.

I eventually decided to add profitability (specifically the 10-year average return on capital employed) into my investment process in 2014, after seeing Tesco struggle and hearing some sound arguments for ROCE as a measure of quality and competitive strength.

More recently, I've added net return on sales (or net profit margin, i.e. net profits as a percentage of revenues) as a second profitability metric. The idea was to put in place an additional barrier against weak companies, as well as companies where small movements in revenues have a dramatic impact on profits.

My current minimum standards for these ratios is 5% for return on sales and 10% for return on capital employed, both averaged over a 10-year period.

With the benefit of hindsight we can go back to Vodafone and calculate its return on sales and capital employed to see how it would have fared against those standards way back in 2011.

Reasonable profit margins but thin returns on capital

Let's start with the good news. Vodafone's average return on sales to 2011 was 19%, which is comfortably above my 5% standard. However, the company's return on capital employed averaged a far less attractive 6%, which is below my 10% standard.

Vodafone's weak returns on capital employed highlight an unpleasant truth about this and many similar telecom companies: They need lots of expensive tangible and intangible assets (e.g. mobile phone masts and licences to use various parts of the electromagnetic spectrum) to provide telecoms and other services to customers.

In Vodafone's case, this situation was made even worse when it acquired the assets of other companies at extortionately high prices. This "acquisition premium" ends up on the balance sheet as intangible "goodwill" (totalling an incredible £106 billion in 2002), but be in doubt that the cost to investors is all too tangible.

Having been around the block a few times since 2011, I now also realise that companies with low returns on capital employed often have high levels of debt. This situation usually occurs because the company's thin profits are not enough on their own to fund the necessary investment in capital assets to drive growth. And being too lenient with Vodafone's debts was my second mistake.

Mistake 2) Failing to spot Vodafone's large debts

As I've already mentioned, in 2011, I did look at Vodafone's net debts. These came to £30 billion, which is a lot. But compared to its adjusted operating profits of £12 billion, it isn't all that much.

However, a few years ago, I realised that my debt rules, as they were in 2011, were woefully inadequate and far too lenient. After several iterations, my current approach is to look at total debts rather than net debts (i.e. debt offset by cash), and to compare those total debts against the company's 10-year average net profit (i.e. profit after interest and tax) rather than operating profit (profit before interest and tax).

These small adjustments in focus make a big difference to the amount of debt a company can have and still be called "prudent".

In Vodafone's case, its total borrowings in 2011 were £38.3 billion compared to net debts of £30 billion. On the profit side, Vodafone had 10-year average net profits of £6.7 billion compared to 2011 operating profits of £12 billion.

So with total borrowings of £38.3 billion and average net profits of £6.7 billion, Vodafone had a debt-to-profit ratio of 5.7, which is materially higher than my current limit of five.

With the benefit of hindsight, it's clear that by this stage of the analysis, Vodafone wouldn't have made it into the model portfolio. Its profitability was too weak and its debts were too high. However, there was an even bigger mistake which stopped me from seeing Vodafone as a loss-making basket case rather than the steady growth company I thought it was.

Mistake 3) Looking at Vodafone's adjusted earnings

Many companies calculate adjusted earnings because it allows management to show the "underlying" performance of the company, without the skewing effect of non-recurring items such as acquisition-related costs or profits on the sale of fixed assets (e.g. buildings, phone masts, etc.)

Back in 2011 I based my calculations on adjusted earnings because they tend to be smoother year-to-year than reported earnings, and smooth earnings was what I was after.

But the flaw in that plan is that many unpleasant expenses fall into the "one-off" or "non-recurring" bucket, and those expenses can be conveniently ignored by management through the use of "adjusted" earnings.

In Vodafone's case, some very large differences between its adjusted and reported figures occurred between 2002 (which is as far back as I would have looked in 2011) and 2007. On an adjusted basis, the company produced adjusted net profits of almost £34 billion during that period, but on a reported basis, it made a loss of almost £52 billion over those six years.

That colossal £86 billion difference was, as is so often the case with highly acquisitive companies, due primarily to a mixture of goodwill amortisation and impairments. These are non-cash charges, so management was able to say with a straight face that the company was performing well on an operational basis. That may have been true, but I wouldn't trust a company, its culture or management where it could lose £86 billion of shareholders' money and still be upbeat.

In fact, the money Vodafone lost following its period of acquisition madness was so large that the company made a net loss of £25 billion for the entire 2002-2011 period. If that isn't a horrendous performance, then I don't know what is. But if you only looked at the company's adjusted results (as I did), then you would have been completely unaware of (or at least unappreciative of) just how bad Vodafone's reported results were.

If I'd looked at reported earnings rather than adjusted earnings, then Vodafone, with its negative 10-year reported earnings, would have had negative 10-year profit margins and returns on capital in 2011, and an infinite debt-to-profit ratio because it hadn't made any profits.

If I'd carried out this analysis in 2011, then at this point Vodafone would definitely have found itself entering my dustbin rather than my portfolio. But having bought Vodafone, there was still one final mistake to make.

Mistake 4) Holding Vodafone when I should have sold long ago

As my investment strategy evolved and as Vodafone's growth stalled, it became increasingly clear that it was not the sort of company I wanted in the model portfolio.

By mid-2018, Vodafone was the lowest-ranked holding in the portfolio, according to the UK Value Investor stock screen. On top of that, its growth rate, profitability and debt ratio had all been "too low" since mid-2017. Despite all this, I continued to hold on until a few days ago. Why?

This is actually quite difficult to answer, because you have to tease out the underlying drivers of a complex and subjective decision, and that isn't easy.

There are several reasons why I didn't sell Vodafone a year or two ago and, yes, a desire to avoid selling the company at depressed valuations was one of them. However, the main reason is that there was a disconnect between Vodafone's consistently weak performance and the consistently upbeat statements from the company's now ex-CEO.

For example, the company's per share capital employed (the value of productive assets funded by shareholders and debtholders) and revenues (the amount of money coming into the company from customers) declined between 2010 and 2019. As for profits, Vodafone continued to produce huge reported losses every few years. Over the same period, the company's debt ratio continued to go up, until today its debts are 19 times its average profits. None of this is good, and yet the ex-CEO continued to talk about "sustained momentum" and "confidence in the outlook".

I couldn't understand why the now ex-CEO would be so upbeat when the company's results were so patently terrible. So while Vodafone's share price declined from 230p in early 2017 to 120p in May of this year, I waited because I wanted to see how things would pan out. Either the ex-CEO was right and Vodafone's performance would eventually improve, its dividend would be sustainable and the 9% dividend yield would drive a major increase in the share price. Or, the ex-CEO was wrong to be so upbeat, the dividend would prove to be unsustainable and the share price would remain, perhaps correctly, at very depressed levels.

Well, now we know the answer to that conundrum. Following Vodafone's recent dividend cut, it seems clear that the ex-CEO was wrong to be so upbeat. The company's performance over many years has been terrible, its rising debts were probably unsustainable and its weak returns on capital suggest the need for a major efficiency-driven transformation, funded in part by a dividend cut.

A few paragraphs ago I said that holding on to Vodafone for too long was a mistake. But I don't actually think it was.

My investment strategy and stock screen have gone through quite a few changes since Vodafone was purchased in 2011, and I wanted to see if Vodafone's low rank on the stock screen was correctly "predicting" that the company was now a low quality value trap. In this context I think holding on to a weak company was, in this very specific case, the right thing to do.

Having now seen that the stock screen was a better predictor of Vodafone's future than the ex-CEO's upbeat statements, I'm more willing to trust the stock screen and my own gut feelings as to whether a company is above average or not.

In future, if one of the portfolio's holdings has a very low stock screen rank, very weak fundamentals and my gut tells me it's unlikely to do well without a major turnaround effort, I'll jettison the company much more quickly than I did with Vodafone, regardless of how upbeat its CEO continues to be.

As for Vodafone, I've removed it from the model portfolio and my personal portfolio, and the proceeds will be reinvested into a new investment next month.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.