Vodafone is the perennial under-achiever. It has failed to deliver on past promises, and has just embarked on yet another re-badged strategy after Vittorio Colao was appointed chief executive in July. The latest plan is to focus on cash generation, cost-cutting and speed. But actions speak louder than words, and I suspect this will be another false dawn.
Vodafone (LON:VOD), tipped as a BUY by Credit Suisse
Credit Suisse argues that with 280 million customers and a broad global footprint, the group should be a defensive play in times of turmoil, and also benefit from the pound’s travails. But this over-simplifies the situation. A large part of Vodafone’s profits come from lucrative corporate contracts, such as with merchant banks. As the recession bites and unemployment balloons, their consumption of mobile services will definitely come under pressure.
The bulls also point to the firm’s low valuation of around ten-times prospective earnings. Once again, this analysis looks shaky, since it ignores Vodafone’s £27.7bn debt pile. Once you strip that out, the stock is on a challenging 2.5 enterprise value to sales multiple. Gearing could become an issue due to the vast majority of the group’s loans being denominated in euros and US dollars, which will have jumped in sterling terms as the pound has weakened.
Worse, the City is assuming net debt will fall by March – yet using current exchange rates, the opposite may occur, potentially jeopardising the group’s credit rating. Adding to the balance-sheet woes was the decision in December by the Indian high court to force Vodafone to pay a $2bn tax bill following the purchase of its Essar division back in 2007.
Analysts have penciled in earnings growth of around 6% for the next two years, which I cannot see being exciting enough to push the stock higher. These targets may even prove too ambitious. Organic service revenues grew by only 0.2% in the last quarter, and could turn negative in 2009.
And there is another dark cloud on the horizon. Disruptive technologies, such as Wifi, Wimax and VoIP could all seriously damage its lucrative earnings before interest, tax, depreciation and amortisation profit margins of 36%. If profitability fell by 5%, I could easily see the stock retreat below 100p.
Furthermore, around 30% of Vodafone’s £100bn enterprise value is locked up in Verizon Wireless, a non-dividend paying minority stake. Its American partner Verizon Communications (55% owner) would appear to be the only realistic buyer, but it seems any sale would incur a deal-wrecking capital-gains tax bill. That scuppers investor hopes of a near term one-off cash pay-out. Finally, income seekers highlight the company’s 6% yield as providing support for its valuation. But this is a double-edged sword. If the board was forced to go back on its promise of a ‘progressive dividend’ then City sentiment would go up in smoke. If you are looking for an annuity-type return, cautious investors might instead want to consider Vodafone’s 25-year sterling bonds, which are presently yielding 7%.
Gone are the days when mobile operators commanded p/e ratios of 20 or more. Investors have recognised that these are utility-like businesses, with growth largely available only in developing countries, such as India. And with pricing under constant pressure, I can only see Vodafone’s shares moving south from here.
Recommendation: SELL at 135p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments.