By Stephen Kletscher
Company Overview
Vodafone Group Plc (NASDAQ:VOD) is a global telecommunications company that operates networks in 72 countries around the world. Although it is based in Europe (74.7% of revenue), Vodafone has operations across Africa and Asia (12.7% of revenue), including a substantial presence in South Africa (12.6% of revenue). Vodafone has the 4th most mobile customers in the world with 536 million customers. It generates $63 billion in revenue with a market capitalization of $58 billion. Vodafone has recently expanded into cloud and security services for both public and private cloud.
Investment Thesis
As of 21 December 2018, Vodafone Group Plc is trading for $19.46 per share. The price has declined 39.4% YTD and 9.2% in December 2018. It has steadily decreased in share price by 40.8% for the past five years (Figure 1). Due to this selloff, Vodafone has a sustainable dividend yield of 8.92%. This makes it one of the top yielding stocks in the market.
New management is implementing a cost efficiency savings plan that focuses on reducing operating costs and generating better returns from current infrastructure. To help offset the high fixed costs of owning and building towers, management is focusing on renting out masts by forming joint ventures with other telecommunications companies. Vodafone has reduced costs for three years in a row. Management thinks it can reduce operational costs by $1.52 billion in just Europe with an operating cost reduction target of 13% (Figure 1).
Additionally, Vodafone will not increase its dividend in the immediate future in order to provide more free cash to reduce its substantial debt of $39 billion. However, it will continue to pay the current dividend with no intention of cutting it. It is expected to increase free cash flow from $5.2 billion to $5.4 billion in 2019 driven primarily by cost cutting. Vodafone has a 1.35 ratio of free cash flow to dividend payouts, which shows that it has the cash flow to sustain the current dividend. It also has a 4.0 interest coverage ratio. Vodafone’s debt is primarily long-term and covered by an operating cash to debt ratio of 29.32%. Despite a significant amount of debt, I believe that the dividend is safe. New CEO Nick Read is the former CFO of Vodafone and has indicated that the dividend will not be cut. In fact, he has previously stated that the dividend would increase once debt returns to the lower end of a target range. Although the debt is substantial, this is typical for telecom companies with the need for large investments in infrastructure, particularly as Vodafone continues to invest in building out its 4G/5G network. Vodafone has a debt to equity ratio of 0.8, which is lower than competitors such as Verizon (1.90) and Deutsche Telekom (2.007). Vodafone also has a lower P/E ratio (10.86) than the telecom industry average (12.89) and competitors Verizon (17.91) and Deutsche Telekom (20.11). Vodafone is at a relatively cheap valuation compared to peers. It has an EBITDA multiple of 6.58 compared to a 7.17 for Verizon, 6.53 for Deutsche Telekom, and 12.07 for the telecom industry as a whole.
Previous years of significant M&A activity have caused an inefficient and overly bloated company. The company is currently struggling to deal with the issues of integrating several previous acquisitions such as KDG in Germany, ONO in Spain, and Ziggo in the Netherlands. Management plans to reduce $612 million in costs through synergies of acquired companies. Vodafone has a strong track record of cost saving synergies in previous acquisitions. New management plans to restructure the company by selling off underperforming assets and reducing costs of companies in less profitable markets. By selling off underperforming assets Vodafone will increase free cash flow to invest in more profitable areas and reduce debt.
Despite recent issues in Spain and Italy, significant EBITDA growth continues in key areas. Key markets such as the UK and Germany had half-year EBITDA growth of 12.1% and 7.3% respectively. Due to strong competition causing losses in Spain and Italy, half-year EBITDA growth was only 3% and top line growth was only 1%. Cost cutting measures in Spain and Italy should increase profitability while shifting cash towards more profitable markets. Revenue in high future growth potential emerging markets was up 7.4% in Q2 of 2018.
Investment Risks
Vodafone is based in England and is one of the largest companies in the FTSE 100. Because a majority of its business is in the Eurozone, Vodafone is sensitive to a potential “hard Brexit.” Brexit will affect the ability of Vodafone to recruit from the broader European talent pool. A “hard Brexit” could also result in data redirection from the UK, meaning Vodafone would have to relocate data centers to somewhere in the Eurozone. The previous CEO of Vodafone had indicated that Brexit may cause Vodafone to shift its headquarters to mainland Europe, which would result in the additional costs that come with moving headquarters. However, these costs are unlikely to be too substantial because Vodafone already has substantial offices in Germany that they could expand.
In May of 2018, Vodafone agreed to a deal to purchase Liberty Global’s Germany and eastern Europe assets for $21.8 billion. This deal is now facing a full EU antitrust investigation. The EU may prevent the deal from going through, causing some uncertainty with the company’s future. The stock has performed poorly since the deal was announced, declining 31.6%. I believe that the market has priced in the deal and the substantial debt that accompanies it.
The significant debt of Vodafone is a substantial concern for the future of the company. Total debt is currently $49.79 billion. The acquisition of Liberty Global will add more to the debt. Although management has a solid plan in place to focus on debt reduction, the debt load is significant and will continue to weigh heavily on the balance sheet in the future. As mentioned previously, the debt is well covered by a 29.32% operating cash to debt ratio and 4.0 interest coverage. It also has a 1.35 FCF to dividend payouts ratio, meaning dividends are covered as well.
Recommendation
The overall recommendation Vodafone Group Plc is a buy. Although there are some reasonable concerns with Brexit and the substantial debt load of acquiring Liberty Global, I believe that this stock has been oversold. Vodafone has a solid plan to turn itself around with a new CEO focused on reducing costs and debt. It has great earnings growth in significant markets such as the UK, Germany, and emerging markets. The strong growth outlook and significant cost efficiency measures suggest a positive turnaround for the company. I have a price target of $26.48, which represents a 36% upside without counting the dividend. I think that Vodafone is a solid long-term buy and hold stock as it continues to cut costs and increase growth in high potential emerging markets. With the high dividend yield and strong growth potential, I believe that Vodafone is a compelling value opportunity.