Vodafone: 5G Tailwind And Expanding Commercial Business To Be Major Growth Drivers Ahead
Summary
- Ramping up 5G transition to boost both retail and commercial businesses.
- Major initiatives have been taken by Vodafone to increase market penetration. This includes the launch of Europe's first 5G standalone network.
- Successful Vantage Towers IPO enables Vodafone to cut down on borrowings and make new technological investments.
- Discounted valuation offers a great opportunity to buy this well-established company operating in a transitioning industry.
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While the company has delivered a stagnant performance in the past few years given the lack of technological upgradation and advancement, Vodafone Group Plc (NASDAQ:VOD) is expected to observe a strong recovery in growth in the coming years given the accelerating 5G transition and strong commercial business momentum.
With up to 100 times faster speed and significantly low latency rate, 5G proves to be a significant upgrade over 4G, therefore offering a strong value proposition for the smartphone users to upgrade and pay an additional amount for such premium services. Moreover, the benefits of 5G also result in wider applications in multiple industries such as automotive, healthcare, VR gaming, IoT, and many more. With Vodafone sitting at the core of this 4G to 5G transition by providing base infrastructure, the transition can result in accelerated growth in its commercial business and notable recovery in its retail telecom business that has struggled lately with declining roaming revenue.
Vodafone Business can bring Vodafone Group back into the growth phase
While most of the readers would be familiar with the company’s mobile services, fixed broadband, and TV services business, but might not be much familiar with its ‘Business’ segment. The segment currently accounts for 28% of the total revenue. This segment includes various solutions to address the growing needs of its business customers ranging from micro to large companies. It has a network of 6 million business customers with strategic partnerships with multiple big players like Microsoft (MSFT), IBM (IBM), Amazon (AMZN), Google (GOOGL), Cisco (CSCO), among others. Under the segment, the company provides mobile, fixed broadband, unified, cloud, security, and IoT solutions. The overall addressable market opportunity for the segment is significantly large with an estimated value of over €100Bn. Below is the break-up of the segment’s TAM:
Source: Vodafone Business Investor Briefing
The company has been investing aggressively to fuel the growth of its Business segment through continuous innovation and development of offerings. It has invested €7.7Bn in capital expenditure in TTM at the group level. The company has been aiming to prioritize investments in high ROCE opportunities, namely, Cloud & Security, IoT, and Digital solutions which are expected to account for 55% to 85% of the capital allocation as per Vodafone business investor briefing.
Heavy capital expenditure on such solutions would ensure efficient utilization of invested capital and fuel growth from attractive high-growth spaces. Moreover, expanding and improving the set of offerings would result in making VOD a one-stop solution for meeting multiple business needs. Additionally, a strong customer base of individual offerings can help promote cross-selling and up-selling of other Vodafone’s offerings. For e.g., existing business customers of network carrier business can be offered a package plan at reasonable rates that might include cloud and security solutions that the customer earlier used to procure elsewhere.
Unlike its traditional mobile and fixed broadband businesses that are expected to grow at a 4-Year CAGR of only 1%, Unified offerings, and Cloud and Security offerings are expected to register a growth of 12% each for the next four years, while the IoT market is expected to grow at a stronger CAGR of 16%. Incremental investment in such high-growth solutions indicates the determination of VOD's management to come back into the growth phase.
5G Impact
Strong value proposition from 5G and increased data consumption due to higher 5G bandwidth would lead to growth in ARPU of retail business, and low latency and higher bandwidth rates would lead to increased application of the company’s offerings across multiple industries. In order to tap this opportunity for increasing market penetration, Vodafone has taken multiple initiatives.
The company's 5G technology has proved to be advantageous for multiple businesses, including Ford (F). Ford was able to speed up and further automate its manufacturing process by implementing 5G at its core.
Adding to that, since Covid disruption resulted in lockdowns, travel restrictions, the businesses were forced to go digital. 5G has played a strong role in fueling this digital transformation by making the online ecosystem more reliable with improved bandwidth and performance.
As we can see below, strong growth in 5G connections is expected in the coming years as the transition ramps up.
The number of expected 5G connections worldwide:
Source: Statista.com
ResearchAndMarkets.com 4G to 5G report suggests a strong boost of 300% to 1000% data consumption growth compared to 4G. This growth in data consumption would add to the strong earnings growth potential for Vodafone.
"We went on to the front foot on 5G. We were one of the first to launch across Europe. I think we landed that message in the minds of businesses and consumers very effectively. Of course, it wasn't mass scale. It was small, but it was widely dispersed through our European market. So actually, from a perception perspective, we are very much seen as a leader in 5G...I'd say 3G was browsing. 4G was video. 5G, this is about enterprises, about businesses enabling their capability moving forward in an IoT world, and we have the world's largest IoT platform."
-Nick Read, Vodafone CEO, H1 earnings call
The statement by Vodafone's CEO indicates the strong optimism for the future of 5G and highlights Vodafone's vision of how 5G can change the way businesses operate. With respect to that, the company has taken multiple initiatives to utilize the once-in-a-decade opportunity fully.
Major initiatives have been taken to make the most out of the 5G opportunity
In early April 2021, the company launched Europe’s
first 5G standalone ((SA)) network, powered by 1,000 antennas operating in the 3.5GHz range that would provide coverage in 170 cities. It also plans to deploy network slicing technology on its 5G standalone network that would further optimize the connection and deliver better bandwidth rates and latency performance.While 5G NSA can be launched easily by network operators using the existing LTE infrastructure, 5G SA requires more investment and adds complexities of running multiple cores in the network but it provides a superior user experience with a virtualized cloud-native architecture, enabling more advanced network slicing capabilities and supporting edge computing. It helps to bring ultra-low latency, thereby expanding the use-cases to self-driving vehicles, smart hospitals, and other next-gen applications. Vodafone Germany said that it will be operating a total of ten 5G data centers by 2023, with an intention to manage the new 5G SA network. This indicates the company’s eagerness to expand its market share by improving offerings and utilizing the 5G opportunity to its fullest.
More recently, Vodafone UK announced a deal with O2 to optimize its 5G spectrum bands to deliver a more reliable and faster 5G network experience to its customers. The company has also been seen expanding its 5G network across various markets. Its 5G network now covers 200+ markets across Europe and is still expanding.
Superior technology relative to competitors
The company operates in a fiercely competitive and concentrated industry. The company derives 77% of its revenue from Europe. Within Europe, its biggest competitors include Deutsche Telekom (OTCQX:DTEGF), Telefónica (TEF), and Orange (ORAN). Within Germany, its largest market (29% of total revenue), while the company struggled in maintaining its market share from 2000-2015, the company has successfully increased its market share from 26.2% in 2015 to 36% in 2020.
While Vodafone had been barely able to sustain its market position in past due to low capital allocation towards technological upgradation relative to the competitors, this seems to be changing now as Vodafone has been the first mover in bringing in the 5G standalone network in Europe, which is regarded a significant upgrade over 5G NSA. Other competitor, Deutsche Telekom is conducting trails for 5G SA while Telefónica aims to launch 5G SA by end of 2021. Similarly, Orange is also lagging behind in competing with superior technology. This provides Vodafone a first-mover advantage to onboard more and more retail and enterprise customers given its technological advantage.
Strong cash flows to support technological advancement initiatives
Being a well-established, stable business, Vodafone has consistently delivered strong free cash flows. TTM FCF as of September 2020 stood at €4.8Bn post spectrum and restricting payments. While TTM CFO also stood strong at €7.6Bn. These solid cash flows enable the company to organically meet technological advancement growth capital and expand its market penetration. The successful IPO of Vodafone’s tower business, Vantage Towers (OTCPK:VTWRF), in March 2021 has further bolstered the balance sheet and liquidity position of the company. The IPO resulted in proceeds of approximately €2.3Bn for Vodafone which it plans to utilize to repay a portion of its €43.9Bn debt (as of September 2020). While the proceeds are insignificant relative to its large debt, however, Vodafone continues to hold an 81.1% stake in Vantage Towers as per Reuters article which can be valued at €10.6Bn based on current Vantage Towers’ market cap of €13.1Bn. This large holding in a publicly-traded company provides a strong vote of confidence in the company’s ability to repay debt.
Top-line and bottom-line performance
The top-line performance has been stagnant in recent years with a 3-Year revenue CAGR of -1.6% due to no significant upgrade in the sector’s technological environment, however, due to strong tailwind from 5G transition, revenue growth can see notable recovery in the next 2-3 years as use-cases of Vodafone’s services increases and it expands market share with best-in-class technology such as 5G SA network.
The company has bottom-line margins with an EBITDA margin of 32.7% and an EBIT margin of 11.3% in H1 2021. EBITDA margin and EBIT margin were up 30 bps and 370 bps respectively on a YoY basis. EBIT margin is expected to see more improvement as the 5G roll-out completes and investments in high margin businesses such as Cloud, security, and IoT start to pay off to their full potential.
Reasonable pricing offers strong upside potential
The company trades at a Forward Non-GAAP P/E multiple of 17.8 times which indicates a significant discount relative to its average 5-Year P/E ratio of 28.8 times and sector median of 20.8 times despite the strong 5G tailwind and growing commercial business. I preferred using the P/E ratio over the P/S ratio for this company since it is operating in the mature phase of the business cycle and has solid profit margins to indicate value for shareholders.
Even for income-oriented investors, the stock offers an attractive dividend yield of 5.7% with a reasonable FCF dividend coverage ratio of 2 times. The yield is significantly higher than the sector’s average dividend yield of 3.95% and Nasdaq dividend yield of just 1.22%.
Risks
Balance sheet debt can be a barrier to growth
The company has a large net debt of €43.9Bn on its balance sheet (as of September 2020). This debt can restrict the company's ability to raise capital in order to take advantage of an attractive acquisition opportunity or to undertake major technological enhancement. It also reduces the safety of dividend payments as the company may decide to preserve capital to make debt repayments. With that said, the company had a long average debt maturity of 12 years as per the FY2020 annual report, making liquidity needs for debt payments less concerning. Moreover, Net debt-to-TTM EBITDA ratio stood strong at 3 times (as of September 2020) which ensures enough buffer to meet debt servicing needs. Successful Vantage Towers IPO has also lowered the balance sheet risk to some extent, however, large balance sheet debt continues to be a medium-term growth hurdle for the company restricting heavy investments.
Technological advancement risk
While the company has been the first mover for 5G SA technology, the introduction of new and better technology by the competitors in the future which Vodafone might not be able to replicate due to its investments constraints (large debt) would lead to higher customer churn rate as they may switch to better offerings. Vodafone's 5G SA network uses a frequency of 3.5 GHz, a higher frequency network by a competitor can provide better performance and speed to customers. This would call for a similar or better upgrade by Vodafone to maintain its market position, which might be unviable from a profitability perspective.
Conclusion
A strong 5G tailwind for both retail and commercial businesses is expected to revive the company’s growth pace which can be a great value creator for shareholders given its historically discounted valuation multiples. Well-established, mature telecom and fixed-broadband businesses ensure downside protection for investors, while, incremental investments in cloud, IoT, security solutions, and enhancement of 5G infrastructure provides strong upside potential within the next 2 to 3-year period. I expect the stock to deliver 20%-25% in total annualized return (price + dividend) for the next 3-year time frame.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
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