It's Time to Ring Up Vodafone
The U.K. telecom is a cheaper play on Verizon Wireless than is Verizon. And it will offer a fatter dividend.
Despite a defensive profile that should serve investors well in volatile markets, shares of British mobile-network operator Vodafone have been weighed down with the negativity that has burdened many European stocks as the sovereign-debt crisis rolls on.
Since Vodafone received its best news in years on July 28—the announcement of a 2012 $4.5 billion special dividend from Verizon Wireless, of which it owns 45%—its stock (ticker: VOD) has risen 4%. But over the past 12 months, it's underperformed the market slightly. It's also badly trailed shares of Verizon (VZ), which owns the other 55% of Verizon Wireless—even though the mobile-communications outfit is each company's most important asset.
Investors who are ignoring Vodafone are making a big mistake because significant changes—in the telecom industry and in Vodafone's structure—should boost returns nicely over the next two years.
A Vodafone employee opens up for business at a company store in London.
The decision by Verizon Wireless (often called VZW) to pay a special $10 billion dividend in January is a watershed event. Vodafone will pass its portion along to shareholders, leading to a total dividend of $2—and a 7.5% yield—per American depositary receipt. Best of all, a big payout is likely to become an annual and growing event.
Though Newbury, U.K.-based Vodafone recently has retrenched in France, China and some other markets, this squares with its aim of divesting smaller, unstrategic minority interests. The market doesn't seem to acknowledge how global Vodafone remains, particularly with respect to emerging markets. In fact, it's the No. 1 or No. 2 telecom service provider in fast-growing Turkey, India and Egypt, as well as South Africa and other sub-Saharan nations. Countries like these already generate over 25% of Vodafone's Ebitda (earnings before interest, taxes, debt and amortization, a measure of cash flow) and probably will contribute more over time. When VZW's strong results are included, less than half of Vodafone's Ebitda comes from mature European markets.
Vodafone is taking steps that could lead to a higher stock price. It's already pared its net debt by 14% over the past year, to 26.2 billion British pounds ($42 billion). Now 31% of equity, that debt probably will keep falling.
Revenue from mobile data, rising at more than 20% annually, and from messaging, climbing at an 8% yearly clip, easily are outrunning the drop in voice revenue. And earnings are expected to rise about 8% in the company's next fiscal year, which starts on April 1.
These trends, plus market-share gains in key European mobile markets, easing regulatory pressures and the fast-growing global popularity of data-hungry smartphones, make Vodafone look inexpensive.
Its ADRs, which trade on Nasdaq and each represent 10 ordinary U.K.-listed shares, could rise more than 20%, to $35-$38, over the next two years. Including dividends, the total return could top 35%, with significantly less volatility than the average stock, given Vodafone's relatively stable business. (Vodafone ordinary shares closed in London Friday at 180 pence. The ADRs finished near $29.)
MUCH FURTHER DOWN THE ROAD, perhaps five years or so, there could be an endgame for Verizon Wireless. Relations between Vodafone and Verizon have warmed this year, thanks mainly to efforts by Vodafone CEO Vittorio Colao and the arrival of a new Verizon boss, Lowell McAdam.
Neither would comment to Barron's, but each would love to own the wireless unit outright. However, a sale by either side could trigger billions of dollars in tax liabilities, among other complications, so the status quo will continue for now. But, given VZW's growing value and the amount of attention investment bankers have devoted to the issue, a purchase by one of the parents—or even a full-blown merger of the parents—could occur during this decade.
Last week, Vodafone reported that revenue in its fiscal 2012 year's first half, ended Sept. 30, had risen 4%, to £23.5 billion, while basic earnings per share had slid 9%, to 13.06 pence (21 cents), mainly because of higher taxes and because the comparable fiscal 2011 stretch included a large extraordinary gain on the sale of China Mobile. Operating profits rose to £9 billion ($14.4 billion) from £5.2 billion ($8.3 billion). Meanwhile, Verizon reported that, in its third quarter, also ended Sept. 30, Verizon Wireless had gains of 9% in revenue and 20.5% in data usage, an operating income margin of 29%, and a record 47.8% Ebitda margin.
"Vodafone's stock is significantly undervalued," avers Bruno Lippens, a portfolio manager with Pictet Asset Management, "essentially because the market still doesn't appreciate VZW" and the way the dividend will translate into reliable future cash. While there's no formal annual commitment, Verizon Wireless has little net debt and produces about $1 billion monthly in Ebitda. "Absent massive investment [needs], I don't see an alternative" to paying out a regular annual dividend, adds Lippens, who sees some 40% upside in Vodafone. Pictet owns about a 1% stake.
Channing Smith, co-manager of the Capital Advisors Growth Fund, which owns about 245,000 Vodafone ADRs, concurs. Verizon itself, he adds, needs a VZW dividend, because its fixed-line business doesn't cover its own dividend, and it has an underfunded pension fund.
Depending on which Street estimate is used, Vodafone's VZW stake is worth $65 billion to $75 billion, roughly half of its $140 billion market capitalization.
Also valuable is Vodafone's rapidly growing emerging-market exposure, through a 70% stake in India's closely held Vodafone Essar and a 65% stake in Vodacom Group (VOD.South Africa), with mobile operations in South Africa and other sub-Saharan nations. Emerging telecom markets are growing about twice as fast as developed ones.
In its first half, Vodafone's emerging-market operating profits grew 12% in local currencies, despite a small £9 million ($14.4 million) loss at its 140-million-subscriber Indian unit. But that business is likely to become profitable soon.
Says Robin Bienenstock, a London-based analyst at Bernstein Research, who rates Vodafone Overweight: "They've gone for the quality play in each country."
In Europe, after many years of regulatory cuts to mobile termination rates—fees one operator charges another for terminating calls on its network—wireline regulatory pressure seems to be receding. The MTR rate cuts "are leveling off now after three to four years. The glide path forward looks less onerous from 2013," says Philip Parker, a fund manager with Aviva Investors, which also holds about a 1% stake.
At the same time, Vodafone is gaining share in some of the most important European nations, such as Germany and the U.K., notes Chris Brown, chief investment officer of PAX World Management, which holds about one million Vodafone ADRs. And, he thinks, the gains are likely to continue.
More good news is coming from growing use of smartphones, which, because of their owners' penchant for Internet data, are more profitable to mobile-network operators despite increased investment requirements. Just 22% of Vodafone's European subscribers have smartphones, versus 40% in the U.S. Global shipments of smartphones are rising 40% annually, according to research firm IDC, and the vast majority of the world's five billion mobile subscribers don't have one. Says Capital Advisor's Smith: "Mobile Internet usage continues to be in the early innings of growth."
VODAFONE'S SHARES APPEAR CHEAP, relative both to its European and American peers. European rivals do have lower price-earnings ratios, but that reflects their domestic focus and significantly lower growth prospects. Meanwhile, AT&T (T) has a higher P/E but not better growth, and much of Verizon's better expected growth is due to VZW, which it shares with Vodafone. In addition, Vodafone's dividend yield is significantly higher than both American companies'.
The Bottom Line
Over the next two years, Vodafone stock could provide a 35% annual total return. And ultimately, investors could benefit more, depending on the endgame for Verizon Wireless.
As Pictet's Lippens points out, Vodafone doesn't compare well on one measure—the ratio of enterprise value (net debt plus market cap) to Ebitda, at about eight times. But this doesn't include Vodafone's share of Verizon Wireless' prodigious Ebitda, since the British company doesn't consolidate VZW into its operating results. If it did, Vodafone's EV/Ebitda ratio drops to 5.2 times, among the lowest in the telecom group, making Vodafone a cheap play on VZW.
Though Verizon should get some credit for controlling VZW, the spread between its share price and Vodafone's ADR is near the wide end of the historical range. In addition, Vodafone has emerging-market exposure, while Verizon doesn't. And unlike Verizon, Smith observes, Vodafone has relatively minor fixed-line assets. "Vodafone should deserve a Verizon multiple. Once investors see that the VZW dividend is consistent, they will pay up for the stock," he predicts.
Vodafone isn't without warts. Wireless growth in Europe is weak, in great part because the penetration rate exceeds 100% in some countries. Also, regulation there can still be onerous, even if it's easing, and falling phone fees, the sovereign-debt mess and economic weakness all present challenges. Vodafone's Ebidta margin has dropped there over the years, but still remains a healthy 30%. Regulatory pressure could heighten in emerging markets, and Internet-based mobile calling services, like Skype, are a rising threat. But these just result in substitution of data revenue for voice.
Nevertheless, Vodafone's coming 7.5% dividend yield alone—backed by regular VZW payouts—eventually will attract a crowd. As the market begins to appreciate Vodafone's stable business and global growth, stock gains will follow.
E-mail: editors@barrons.com
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