Vodafone: Improving Situation But Share Price Upside Provides No Margin Of Safety

Summary

• Vodafone's share price has declined 40% since 2015 to 2020 pre-covid level due to stretched balance sheet and performance issue.
• Vodafone operates in highly competitive and mature market, thus limiting future high performance growth.
• While recent earnings have shown that performance is improving, issues in key markets such as Italy and Spain still persist.
• We estimate Vodafone's fair value to be USD 19-20 (10-14% upside from current level; US ADR). The potential upside is not attractive and provides no margin of safety.

Current Situation

Vodafone's share price has cratered from 221 pence (UK exchange) in December 2015 to 139 pence in 2020 (pre-covid impact). The decline can mainly be attributed to:

• Over-leveraged balance sheet (D/E has increased from 52% in 15FY to 130% FY; Net Debt/EBITDA has increased from 2.5x to 3.8x)
• Unsustainable dividend payout (Dividend/share increased from EUR 0.10 in 2005 to EUR 0.21 in 2013 then steadily declined to EUR 0.15 in 2018 before it was cut to EUR 0.09 in 2019; this is despite net income being on a declining trend)
• History of overpaying for acquisitions (EUR 26Bn impairment loss in 2006, EUR 13Bn in 2007, EUR 28Bn from 2009 to 2014 and the recent EUR 5bn from 2019-2020)
• Competitive market environment (as evident in their stagnant revenue)
• Cash drain issues in their India Unit

What has changed?

The market has recently appraised Vodafone's recent FY20 result due to:

• Service revenue finally growing again
• Focus on efficiency and cash generation
• Balance sheet deleveraging

While these are all positive developments, we believe that upside at current price (USD 17.56 for US market/138.96 pence for UK market; as of this writing 7 June 2020) is limited.

Limited Upside at current price

We forecast Vodafone's fair value to be GBP 1.56-1.62 / USD 19.27-19.95 representing a 10-16% upside from current level. This is based on DCF 1.5% terminal growth rate and 7.5x EV/EBITDA. We are forecating Revenue of EUR 48.7 Bn in 2025 FY (1.6% CAGR from 2020 FY) and Adjusted EBITDA (inc. JV) of EUR 15.9 Bn (1.7% CAGR from 2020 FY).

Our forecast is based on a couple of assumptions:

• Germany: 2% CAGR revenue growth '20-'25 FY and -2% CAGR decline in EBITDA due to stagnant mobile revenue and fierce competition in fixed service with OPEX savings not being enough to fully offset slowing revenue growth. (to be discussed further)
• Italy: -2% CAGR revenue '20-'25 FY and Adj. EBITDA (ex. JV) decline due to extremely fierce competition in mobile market (caused by Iliad and Fastweb) and limited benefits from convergence offerings. (to be discussed further)
• UK: 2% CAGR revenue increase '20-'25 FY and 6% CAGR EBITDA (ex. JV) due to improving mobile environment and stabilizing ARPU driven by 5G roll-out and continued OPEX savings. (to be discussed further)
• Spain: -3% CAGR revenue decline '20-'25 FY and -6% CAGR EBITDA (ex. JV) due to limited impact of greater data usage on ARPU and negative impact of loss on soccer rights on fixed revenue. (to be discussed further)
• Other Europe: +6% CAGR revenue '20-'25 FY and +9% CAGR EBITDA (ex. JV) based on historical trajectory
• Vodacom: +2% CAGR revenue growth '20-'25 FY and -1% EBITDA CAGR (ex. JV) based on historical trajectory
• Other ROW: +0.4% revenue growth '20-'25 FY and +1% EBITDA CAGR (ex. JV) based on historical trajectory

Revenue and EBITDA Margin(2020-2025 FY, EUR Bn):

Germany

We are forecasting Germany's revenue to be growing 2% CAGR to 2025 mostly driven by Fixed Service revenue (+4% CAGR to 2025)

Germany's telco market is already mature and that operators there are focusing more on offering premium service and convergence.

Germany's mobile market customer segment is split into 2:

• Premium users who are willing to pay and use more advanced services (prime target for convergence services; this is where Vodafone competes in with Deutsche Telekom)
• Users who see mobile services as basic means of communication (competition here will be led by MVNOs)

Vodafone and Deutsche Telekom (NYSE:DT) is equal in terms of competitiveness where both offers add-on bundles such as netflix, etc.

The fixed market in Germany is challenging as operators there are competing based on pricing. DT and VOD are bulking away from these and are now focusing on convergence and higher speed. Vodafone's recent move to introduce Gigabit will help bolster its fixed service revenue going forward.

Italy

We are forecasting Italy's revenue to decline -2% CAGR with Mobile declining -7% CAGR and Fixed growing +8% CAGR.

Italy's mobile market is highly competitive with 5 major players competing (Telecom Italia (TIM), Vodafone, Wind Tre, Iliad and FastWeb; FastWeb has recently been approved to be the country's 5th telco). Iliad and FastWeb's entry is highly disruptive and their low pricing strategy is highly negative on the incumbents (Telecom Italia and Vodafone) as the Italian mobile subscribers is mostly pre-paid. These can be seen in both TIM, Vodafone and WindTre shrinking revenue. Future mobile revenue growth for Vodafone is dimmed due limited overall future subscriber growth will be very small as the mobile penetration is already above 100% (136.2 subsciber per 100 inhabitant) and that ARPU will decline as Vodafone is responding to Iliad and FastWeb by releasing their MVNO "Ho" to compete in the space.

As opposed to mobile, the fixed market is more resilient and offers more upside. Fixed service revenue has been increasing 14% CAGR from '15-'20 FY. We are expecting this positive trend to continue albeit at a slower rate (4% CAGR from '20-'25 FY) due to strong competition from Telecom Italia (TIM has been focused on boosting their convergence service and they also have the rights to soccer stream).

UK

We are forecasting UK’s revenue to increase +2% CAGR from ‘20-‘25 FY with mobile revenue increasing +3% CAGR and fixed to increase +2% CAGR.

The UK mobile market has changed as it used to be driven by handset launches but as handset prices increase, customers are keeping their handsets longer. Future market growth will only come from consumers buying extra SIMs and using more data. The UK mobile market is mature and highly saturated. Operators have moved away from aggressive customer acquisition strategy to more deepening customer relationship with convergence services and offering unlimited data plans with bundles. VOD has recently added (net) 800k subscribers primarily due to their unlimited data offerings and convergence bundles (+90k net additions in converged customers). We are expecting this trend to continue going forward.

The focus for UK telco players will be on the offerings of multi-play converged service packages and superior speed. The fixed market offers brighter upside as broadband penetration is still only at 50% and Vodafone offers a compelling proposition with their Gigabit offerings and bundles with Apple TV.

Spain

We are forecasting Spain's revenue to decline -3% CAGR '20-'25 FY, with mobile declining -2% and fixed declining -8%.

Vodafone is losing hard in Spain with mobile subscribers declining ~930k from '18-'20 FY, fixed bb customers -59k, fixed line voice -460k, converged customers -24k. The market is heavily dominated by Telefonica (VOD's latest Spain revenue is only EUR 3.9Bn compared to Telefonica's EUR 12.8Bn). It is very tough to break Telefonica's dominance especially with the recent focus on convergence as Telefonica has the upper hand with the football rights that can be bundled with other offerings.

Valuation and Financial Projection

We are projection consolidated Vodafone's revenue to be growing at 1.6% CAGR from '20-25 FY and Adj. EBITDA to grow 0.9% primarily driven by the proposed OPEX savings is not going to be enough given the slower rate of revenue growth.

Vodafone is currently trading at 7.63x LTM EV/EBITDA.

Our DCF analysis using 7.7% WACC and 1.5% terminal growth rate and 7.5x EV/EBITDA which is in line with historical multiple resulted in an implied fair value of USD 19.27 - 19.95 for the US exchange and GBP of 1.56-1.62 for the UK exchange; a ~17% upside from current level. We think that the potential upside is not attractive enough as it doesnt provide a comfortable margin of safety. VOD might be attractive at USD 13-14 level, but not at the current price level.

DCF based on terminal growth rate:

DCF based on EV/EBITDA:

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VOD over the next 72 hours. 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.

We might initiate a long position if share price drops to USD 13-14 (US Exchange)