Description

Long: Vodafone (VOD LN Equity)

Price: 139 pence

Market Cap: £75 Billion

TEV (as reported): £110 Billion

TEV / EBITDA: 7.5x

P / E: 8.7x

Dividend yield: 5.5%

FCF yield (as reported): 9.0%

FCF yield (true ownership): 14.7%

Read this writeup wiith charts and graphs (highly suggested) here:

https://docs.google.com/leaf?id=0B6RZm3GPDn8nZjJjNmVjZWEtNGFhNC00YmZmLWEwYTQtYjBhZTlhOGFhNDdk&hl=en

I really like this idea.  I think you have the opportunity to buy a great, high quality company with low leverage, an intrinsic 15% free cash flow to equity yield, with 5-10%/year growth going forward.  It's just not easy to see from afar.  My writeup has a number of charts and graphs which make this easier to follow.  I'm unable to paste the pictures into VIC, so I posted a pdf version with pictures here: https://docs.google.com/leaf?id=0B6RZm3GPDn8nZjJjNmVjZWEtNGFhNC00YmZmLWEwYTQtYjBhZTlhOGFhNDdk&hl=en.  Of course please don't forward the address around.  Pull down a readable copy and come back here with questions / comments.  This is a big company and a big industry so I imagine there are some people very well-versed in this opportunity and I'd be very interested to hear your views.

Peter

Layout: There is quite a bit of detail to discuss regarding this complex company.  To keep it quick: the first 5 pages present a summary overview.  The appendices provide more in depth explanation and delve deeper into key issues. 

Summary Thesis

Vodafone is a particularly undervalued company within an undervalued and underappreciated sector.  Vodafone is a stable, growing, high cash flow company, with leading market positions, a strong brand and advanced wireless networks that will drive future growth in data & smartphones.  Vodafone is the top non-incumbent wireless provider in all the major European markets, the #1 provider in the US market and is a leader in key emerging markets.  Vodafone is perceived as a service quality leader in its markets and has entrenched itself in a valuable position as the highest quality mobile network in key developed markets ahead of the coming mobile data revolution.  The company has consistently grown free cash flow (post capex) and is poised to continue in the future.  Today VOD can be bought at a 15% free cash flow yield on a growing free cash flow base (after leverage of ~30% debt / TEV).

This opportunity exists because a) the market does not understand the magnitude of owned cash flow hidden within VOD due primarily to consolidation accounting and currency movements, b) the market generally misunderstands the steady cash flow history of the European wireless market oligopoly and the capex requirements of 4G/LTE rollout c) some market participants fear the coming mobile data revolution will be value destructive for wireless providers rather than recognizing the opportunities inherent in mobile data and wireless' protected position as sole provider of data and voice (unlike wireline a decade ago).

Vodafone operates in a competitive market with large barriers to entry.  These markets are in the early stages of a mobile data transformation, so developments must be watched closely.  If competition increases and W. European mobile operators compete away the upside of the data opportunity, VOD appears undervalued by ~50%.  If the data transformation improves the underlying markets, investors shake-off their wireline hangover and re-rate the sector to value its modest but steady growth prospects, VOD could offer 2-3x upside.  In any event, VOD's hidden cash flow offers a downside-protected vantage point to watch the mobile data revolution unfold.  VOD's 15% free cash flow yield also offers superior growth compared to European wireless pureplay free cash flow yields of ~6-9%, and European incumbent (~50% wireline exposure) free cash flow yields of ~11%.

Company Overview

Vodafone Group Plc provides mobile communications services in Europe, the Middle East, Africa, the Asia Pacific, and the United States. It offers voice services, such as mobile voice communications and voice roaming; messaging services, including text, picture, and video messaging on mobile devices; data services, such as email, mobile connectivity, Internet on mobile, and data roaming; and fixed broadband services, fixed voice and data solutions, mobile advertising, and business managed services. The company also provides various devices, such as handsets, mobile data cards, and mobile USB modems. As of March 31, 2009, it had 302 million proportionate customers. The company was formerly known as Vodafone AirTouch plc and changed its name to Vodafone Group Plc in July 2000. Vodafone Group Plc was founded in 1984 and is based in Newbury, the United Kingdom.  Vodafone is primarily a wireless company, with fixed line assets contributing less than 10% of total revenues.

[Company Map Chart - couldn't be pasted]

Key strengths (qualitative)

• § Wireless is now a necessity service, oligopolistic market with large barriers to entry, stable cash flow
• § Leading brand and market position - #1 or #2 to national incumbent in every major western market. Leading network quality and owned spectrum.
• § Pan-European footprint and high quality network attracts high-end customers (travelers, business)
• § New management focused on cash flow maximization rather than emerging market acquisitions
• § Data poised to spur growth, improve customer base by shifting to contracted customers
• § Reducing capital costs, even with 4G/LTE rollout
• § Despite some cyclical exposure, recent downturn has illuminated how defensive the sector is - US continued cash flow growth, W. Europe free cash flow down only ~3.5% market-wide

Key strengths (quantitative)

• § VOD intrinsic 15% free cash flow to equity yield on a superior company. Compare to ~9% FCF yield for W. Europe wireless pureplay, 11% for wireline/wireless incumbents
• Free cash flow largely hidden - a) non-consolidated subs (Verizon Wireless, SFR), b) currency, c) Indian buildout overhang
• § VOD has lowest capex / EBITDA ratio in industry - generates more profit per dollar invested in network than peers
• § Mobile data transformation offers potential increased growth trajectory (est. 4-5% growth steady state, 11%+ growth potential)

Catalysts

• § Realization of Verizon Wireless hidden value - at least partial realization expected within 1-2 years (see appendix B)
• § Continued cash flow growth. Rebound from economically sensitive business use and roaming, potential new growth trajectory from data
• § Market re-rating as data fears subside, and market learns to separate wireless prospects from wireline companies (very few successful standalone pure-play wireless co's)

Key risks

• § Substitute technologies - Wireless could face wireline's fate if it loses control of the access point to competing technologies. Biggest potential threat is wi-fi/wi-max. Initial research suggests these are not a legitimate threat due to higher cost, geographic limitations (can't provide coverage outside cities), transmission capacity not impressive next to 4G/LTE. But this is the key risk and merits continued work and observation. (See Appendix D)
• § Competitive industry with high sunk costs undergoing significant change. This can be a scary place to be if current market discipline is lost and competition begins to spiral downward - progress must be monitored closely, but discipline has been maintained to date as illustrated by market wide cash flows, and there is enough of a value shield hidden within VOD to watch situation unfold from within a VOD position.
• § Continued acquisitions - historically VOD has been highly acquisitive, particularly in emerging markets. New management appears more focused on maximizing cash flow than extending footprint.

Valuation Overview

Hidden Cashflow

As shown in the Company overview chart, I believe VOD's true economics are significantly understated in their consolidated financials, and what appears to be a 7.5x TEV / EBITDA, 9% FCF yield company is really a 14.7% FCF yield, 5.2x EBITDA company once the hidden cash flow is accounted for. 

Comparables

In addition to a favorable valuation comparison, VOD's European operating metrics and growth prospects are superior to its competitors, with industry-leading margins, and, a metric few look at -- very low capex as a % of EBITDA, meaning VOD generates significantly more profit from its network investments than competitors do.  The US market's strong growth behind ~30% of VOD's free cash flow gives VOD a superior growth profile against the largely flat European comps.

Cash flow growth and back of the envelope value implications

For illustrative purposes, I've taken a conservative free cash flow yield + growth approach to valuation.  These valuations assume the required equity return on a low beta business such as VOD is 15-17%, which I expect is conservative. 

Regional cash flow characteristics (See appendices)

Historically, W. Europe has seen flat but steady cash flow generation for past 4-5 years, as operators competed away growth opportunities.  The recent downturn caused the first industry-wide cash flow decline over the past 15 months, but the decline was only ~3.5%.  Vodafone has declined more than competitors in the downturn owing to its high proportion of roaming fees and business customers, overlaid with competitive disadvantages of not having the iPhone in its European markets (which rolls off this year).

The US wireless industry has continued growing cash flow generation steadily, with the quality players (Verizon and AT&T) leading.

VOD's emerging markets account for ~10% of cash flow and encompass a wide range of markets.  Generally, emerging market cash flow has been growing very quickly, spurred by significant EBITDA growth and capex declines as initial coverage rollouts are completed. 

Simplified cash flow projections

Shown below is a back of the envelope summary of cash flow growth prospects.

• a) Good - continued M&A, data growth and it's impact on restructuring the European market (pre-paids > contract) helps European market cash flow grow slightly above GDP again, US market cash flow continues growth at reduced pace following economic downturn.
• b) Bad - European growth sub-GDP going forward, US competes away most of its data growth potential
• c) Ugly - W. Europe driven to negative cash flow growth, USA drops to GDP growth and EM penetration muted.

Valuation

I've used what I view as conservative free cash flow generation growth/yield valuations to approximate potential value (keep in mind the market may not realize much of this value until it can see Verizon's cash flow and growth in the business and until anxiety passes over the W. European wireless outlook):

APPENDIX A - European wireless - the key driver Est. ~57% of value - a stable, low growth oligopoly

A.  Key stats in Key Vodafone Markets - see market by market breakdowns in back

[Chart cannot be pasted - see webpost]

B. Key themes in European wireless

VOD's European markets all have distinctive characteristics, which are discussed in more detail in the market summary section in the back.  Presented here is just a brief summary of VOD's overall position and the shared characteristics of the major European markets.

VOD strongly positioned in Europe

As seen on the prior page, VOD is the only operator with a presence in every major European market.  In each of these national markets, VOD is the strongest independent wireless provider with the #2 position (behind the national telco incumbents).  VOD generally has the highest quality networks across Europe, though the quality differential has been reduced as competitors have caught up in the past few years.  This combination of quality service offering and pan-European presence has made VOD the carrier of choice for some of the most attractive portions of the market - business, high-end customers accustomed to travel.  VOD is able to charge a premium to its peers in most markets as a result (akin to Verizon's position in the US).

VOD has been hit in the last 15 months with a recession that disproportionally hurt its business and travel/roaming fees.  It has also faced the disadvantage of being locked out of iPhone exclusivity in all its key markets except for Italy (where iPhone is open).  VOD is positioned for growth as the economy recovers and it begins to offer the iPhone handset (began offering in France/UK already, expected soon in Germany/Spain). 

The market as a whole has exhibited disciplined competition, which will be discussed in more detail below.  The market is well-protected, with the highest profile new entrant (Hutch, with its "3" service in UK and Italy) being relegated to "also ran" status and has yet to turn EBITDA positive despite its €30B investment over the past 7 years.  Hutch has long been expected to merge with a larger player as it is not considered viable as a standalone, which could lead to further consolidation in the UK, and consolidation in Italy

The market is expected to continue a new wave of consolidation that began with an announced T-Mobile and Orange (FT) merger in the UK, the market with the most cutthroat competition.  O2 and E-Plus are expected to merge or partner in Germany, as the government has only announced enough spectrum for 3 4G players in this 4 player market.  A transaction with Hutch's 3 could lead to consolidation in Italy and further consolidation in the UK. 

European market organized differently than US

The European wireless market is different than the US in many ways, most notably, a) preponderance of pre-paid customers (>50% in most markets as opposed to US ~10%), b) higher penetration (120-150% population penetration vs. US' ~90%), c) more competition among service providers, d) customers only billed on outgoing calls, incoming calls billed inter-carrier, e) European wireless co's typically own their own towers, e) smartphones have not penetrated European wireless to the extent they have penetrated the US, but dongles (laptop wireless) have penetrated much more.

Generally, much of the market structure is set to improve in coming years - pre-paid customers should convert to post-paids as data and smartphones penetrate further (already happening), tiered pricing will be introduced for data, M&A activity should consolidate competition, and players are beginning to share infrastructure and towers, which should reduce costs and encourage further co-operation. 

W. Europe is a Stable Market - a surprise to many. 

The European wireless market has exhibited remarkable cash flow constancy as it has matured.  However it is generally perceived as a declining or at risk market, and is priced as such.  I believe that this is due to the lack of pureplay wireless companies for investors to look at, the taint of declining wireline businesses, and too much focus 'in the weeds' of wireless metrics at the expense of the bigger picture. 

While W. Europe wireless has seen an EBITDA decline in the past 15 months, this decline is quite reasonable given the economic backdrop, and underscores how resilient this sector is in a downturn having endured only a ~3.5% hit to marketwide free cash flow generation during the worst economic downturn in recent history.  Unlike the US, approx. 50% of W. European wireless subscribers are pay-as-you go rather than contracted customers, creating greater economic sensitivity (the US in contrast has continued cash flow growth through the downturn with its 90% contracted subscriber base).

The easiest way to see this stability is graphically.  I've focused on Vodafone's key European markets (Germany, Italy, Spain, UK and France) in the chart below, these markets represent approx. 90% of VOD's European assets.

[Charts cannot be pasted]

The market as a whole continues to grow cash flow, bottoming out in 1Q09, at a 3.5% decline from 2008's peak.  The small decline seen during 2006 came largely as a result of regulation (MTR cuts, which will be discussed later).  VOD has seen a larger hit to its European EBITDA, due to greater economic sensitivity from its higher mix of business customers and roaming charges, and due to being locked out of iPhone exclusivity, which is important to its high-end user base, in Germany, UK, France and Spain.  VOD is or will be offering the iPhone in all of these markets going forward.  VOD also suffered a disproportionate decline in the Spanish market where it had made large inroads in Spain's foreign communities, which were hard hit by the economic downturn.

So why are some left with the impression of a market in decline?

The wireless market is challenging to follow because it is rapidly evolving and throws off a lot of metrics to follow: MOU, subscribers, data/voice usage, voice price/min, data price/mb, termination rates, pre-paid/post-paid subscribers, etc.  These metrics interact arithmetically, e.g. prices, MOU, data/voice all are very different for pre-paid vs. post-paid customers, for business customers vs. consumers.  Shifts in consumer preference, mix, marketing strategies, multiple handsets (over-penetration) can move these metrics wildly, but it appears most of this micro-trend following misses the bigger picture of stable cash flows.   

The lack of any scale, pureplay, W. European (or US for that matter) wireless companies that publicly report means it requires some digging to get a clear look at bigger picture trends like EBITDA and cash flow.

The market graph above looks like the picture of rational, oligopolistically competitive market participants in a defensive industry with high capital barriers to entry and falling ongoing capital costs.  But without zooming out to this wide angle lens it is difficult to appreciate this stability "in the weeds" of all the metrics thrown off by the industry.  Some of the most common metrics that cause doomsaying are:

1.  Declining Average Revenue per Customer - Declining ARPU is concerning, however it stands to reason in markets as highly penetrated as these (130%+ penetration) that incremental customer growth should go hand in hand with declining ARPU.  At this stage, "customer additions" are not the actual addition of a new customer to the market, rather it is an existing customer picking up a second handset.  That creates 2 subscribers but only one customer, who is not going to use double the wireless services, nor should he pay double the price.  Assuming that customer was priced based on usage, you would now have 2 new customers paying half the price of the original customer.  While this doesn't work on such a one to one basis, the analogy helps explain why ARPU declines in this type of overpenetrated market should be viewed relative to customer adds.  Viewed through this lense, the ARPU declines below, set against subscriber adds, look reasonable, taking into account FY09 and 1H10's were actually negatively impacted by the economy (data shown is market wide, on Vodafone's 3/31 FYE). 

Further, as discussed below, ARPU reduction also reflects MTRs and data penetration (higher margin revenue without MTR costs attached). 

[Chart cannot be pasted]

2.  Declining Mobile Termination Rates (MTR)

Declining Mobile Termination Rates have caused a lot of concern in the W. European wireless market.  Unlike the US market, the European market only charges customers for outgoing calls.  When a mobile operator receives a call on its network, it gets paid by charging a mobile termination rate to the operator that initiated the call - e.g. the outgoing provider will receive 10c / minute in voice fees from the customer, and will have to pay the incoming wireless provider 5c / minute in termination charges.  In the early days of wireless, MTRs acted as a gov.-mandated subsidy from the wireline industry to the wireless industry in order to help support the fledgling wireless industry (while wireline charges MTRs, rates are ~1c/min as opposed to wireless 5c, originally 20c).  Now that wireless is a mature technology, EU regulators have mandated large reductions in termination rates over the past 5 years, essentially taking away the old subsidy from wireline. 

This has contributed to significant drops in revenue for wireless companies (for instance Vodafone's MTRs in Europe declined from 25% of revenue to under 10%).  However, MTRs are low margin revenue, because while mobile operators collected MTRs as fees, they also paid MTRs out in equal amounts/minute to other wireless operators.  In the early days of low wireless penetration and high mobile MTRs, wireless received a subsidy from wireline through MTRs.  However today, with more minutes used on wireless networks than wireline and wireless MTRs reduced closer to wireline levels, that subsidy is largely eliminated and wireless co's receive little profit through the MTR system.  Thus, though it creates troubling revenue trends, MTR cuts have limited bottom line impact, which many observers do not seem to understand. 

In any event, despite MTR headwinds, mobile operators behaved rationally and preserved overall cash flow, and MTR declines are now largely a historical issue with the brunt of the cuts taken. 

[Chart cannot be pasted]

3.  Declining prices per unit of use (e.g. price per minute of voice, price per byte of data) - The key to keeping unit price declines in perspective is understanding rapidly falling unit costs.  Akin to Moore's law, transmission capacity is constantly increasing and getting cheaper to provide (see section on 4G capex costs), much in the same way my wife's new mac laptop cost significantly less than the one she purchased 5 years ago, but packs a lot more punch.  The marginal cost of voice/data usage is nil, once a network has the capacity to provide it.  And as part of ongoing capex, the network is constantly rolling out upgrades and increasing capacity.  The capacity increases are coming at a flat overall capex spend, as each new generation of transmission equipment is available with multiples of the transmission capacity at fractions of the price (e.g. current "3G+" transmitters offer approx. 10x the capacity of original 3G, at lower prices).  It is a competitive industry, and much of those savings are passed along to the consumer, primarily through additional services.  (See Appendix D)

APPENDIX B- Verizon Wireless - the VOD / VZ partnership & hidden value

Verizon Wireless (VZW) is owned 55% by Verizon Communications (VZ), 45% by Vodafone (VOD).  As a result it is consolidated in VZ's financials, while VOD's results reflect only a) a 45% interest in VZW's net income, as equity associate income below the EBITDA line, b) zero net cash flow (VZW is a partnership for US tax purposes, so it's owners have to pay tax directly, VZW only dividends out enough cash to pay it's owners' share of US taxes generated).

Over the last several years VZ has used its controlling stake in VZW to divert all of VZW's cash flow to VZ by way of intercompany debt repayments.  VZ needs this cash to pay its hefty dividend, as VZ's wireline business generates negative cash flow - see chart below.

During 2009, VZW repaid approximately 50% of the intercompany debt that was outstanding at the start of 2008 (VZW reported the interco debt balance is down to $6.3B as of 10/29/09).  The remaining VZ interco debt is due in 2010.  VZW is generating $13-15B of free cash flow per year as the Jan '08 acquisition of Alltell rolls into VZW's results.  VZW has also agreed to sell certain Alltell assets as mandated by the FCC, to AT&T for $2.3B, expected to close in 4Q09. 

In summary - by the end of 2010, VZ will no longer be able to suck cash out of VZW through interco note repayment, VZ generates negative cash flow from its non-VZW assets and has a hefty dividend to pay, and VZ will need to figure out a solution to this problem.

1. the simplest (and I think most likely) solution - VZW begins paying full dividends to its parents.  As seen below, VZ would need to receive almost its entire 55% portion of VZW free cash flow to have enough cash to pay its dividend without taking out parentco debt.
2. More complex solutions?

• a) VZ takes out debt at the parentco, repays VZW's external debt with cash flow. VZW would likely be building cash balances within 2 years, would be a difficult decision for VZ to explain to its shareholders - parentco would become highly levered, VZ would be paying interest on debt while maintaining cash balances
• b) Ownership restructuring or M&A - widely speculated, difficult to predict, but expect VOD would not be interested in anything that generates a large tax bill. VZW announced intention to purchase sub in early 2006, VOD rebuffed.

[Chart cannot be pasted - key chart, see webpost]

So, there are two interesting observations for Vodafone from the VZW ownership situation - a) approx. £3.5B of annual cash flow owned by Vodafone is not showing up in its reported cash flows, and b) that hidden value will be exposed at some point, likely in the next 1-2 years, after interco debt is repaid. 

APPENDIX C - Verizon Wireless - the high growth US business

Not only is Verizon Wireless an interesting catalyst / hidden asset - it is also an attractive business.  There is more discussion on VZW and the US market in the key market maps appendix, but a quick summary is this is a growing business, with EBITDA and cash flow increasing every year. 

This clear current growth makes the US wireless market generally more attractive than the W. European market, and I think the differences between the two are driven by a few key factors:

a) US wireless is still increasing the pie - US wireless penetration is ~90% versus Europe's 130-150%.  This means that as the US adds subscribers it is actually adding (some) new customers, whereas Europe is simply giving an existing customer a second handset (see W. Europe Appendix).

b) The US wireless market is 90% contracted post-pay subscribers with much fewer no contract pre-pay users (versus W. Europe <50% contracted customers).  This increases stability, reduces churn, and forces greater pricing discipline on the operators as post-pay subscribers require larger handset subsidy investments with locked in prices over a longer period of time.

Further, segmentation in the US market reduces competition.  Generally, the US is segmented into 2 quality high-end players (AT&T & Verizon), 2 bargain nationwide players (Sprint & T-mobile), a few regional pre-paid players (notably Leap, MetroPCS) and a few MVNOs.  While the US market is also quite competitive and has seen slowing growth during the economic downturn.

[Charts cannot be pasted]

The US market is very attractive, but like the European market, it is difficult for investors to assess this, as public companies and published financials only reflect integrated wireless/wireline operators (AT&T, Verizon, Sprint), or sub-scale low end new entrants that are not generating positive cash flow.

Verizon is positioned as the highest quality operator in the US.  Verizon has done a tremendous job of maintaining its market position and growing cash flow over the past few years since AT&T was given iPhone exclusivity.  There is speculation that a Verizon iPhone could lead to an exodus to Verizon's superior network.  There is heated speculation for/against a Verizon iPhone being released in 2010, but its all rumor.  What makes sense to me is that the technology exists for CDMA/UMTS worldphones, and has been around for a while.  With Verizon the largest wireless company capable of carrying the iPhone by any measure (subscribers, revenue, EBITDA), I tend to think Apple wants to access that subscriber market, if nothing else than as a defensive maneuver against HTC, Droid and Blackberry.  In any event, Verizon has continued to perform very well, despite being shut out of the iPhone the past 2.5 years, and a Verizon iPhone only offers upside, be it 2010 or 2012.

APPENDIX D - Mobile Data revolution and its implications

Data will provide tremendous opportunity for growth, as it allows mobile to offer more value-added services for consumers, and consumers spend more and more time on their mobile.  Mobile has the opportunity to displace a substantial portion of desktop computing.  Today's iPhone 3G has the same processing power and memory as a 2001 iMac, and it fits in the palm of your hand.  Cloud computing offers the ability to get current/next gen desktop computing power from any device, limited only by one's ability to receive/transmit data.  4G technology has the capacity to offer wireless television, potentially making wireless co's a factor in the TV market.  In short - 4G offers wireless the potential to further disrupt wireline, cable television and desktop computing.  While profit potential for these types of services ma be competed away within the industry, wireless operators' gatekeeper position on mobile connectivity should allow the industry to get paid for significantly more value-add services than just voice, texting and limited websurfing. 

Further, data should help transform some key areas of the W. European market - e.g. increasing proportion of contracted users (contracts needed for data access), increasing importance of network quality, introducing tiered use pricing etc.

In short, mobile data will transform the way we live.  The wireless industry's position as sole point of access to mobile data (see wireless vs. wireline discussion below) positions the industry for a new growth trajectory.  Yet many question whether data is a positive or negative for the industry.  Key concerns are discussed below.

Key Risks viewed by the market --

1.  Will Mobile Data create a Wireline/VOIP type trap for wireless carriers? 

Some (notably Collins Stewart) have compared mobile's future to wireline's present.  However I think this analysis rings hollow.  Wireline faced a number of problems, the least of which was actual VOIP uptake (which alone, would have just been a transition from voice to data over the same fixed network owned by the same wireline operators). 

What hurt wireline?

Wireline's decline was not caused by VOIP/data itself.  If all VOIP was run over wireline's broadband, wireline would have been a net winner from the data revolution.  Wireline's issue was the emergence of two new technologies that broke telco's monopoly on communications access - wireless and cable IP.

In voice, wireline lost it's monopoly to a superior new technology (wireless).  In data and VOIP, wireline lost it's monopoly to a new competitor with existing infrastructure and installed base (cable).  Once wireline's monopoly was broken, its customer base rapidly atrophied, mainly to the superior technology of wireless (see chart below).

[Chart cannot be pasted]

Data actually provided wireline with a brake on its decline.  Without the destruction of wireline's monopoly on access, data and VOIP would only have shifted revenues on a customer's billing statement from its telco, and wireline would likely have grown its entire pie in the process.

Why is wireless different?

Mobile operators face no such threat.  In this case the "challenger" (mobile data) and the "incumbent" (mobile voice) are both owned by the same oligopolistic entities.  Potentially disruptive technologies for the wireless operators do not appear viable on large scale - while Wifi/Wimax are viable over small geographies, higher capital costs, slower speeds than LTE and less geographical coverage do not make them a viable competitor to mobile networks. 

Wi-fi and femtocells may be used by wireless carriers to add capacity to densely populated coverage areas, but large scale coverage is not feasible by most accounts.  Independent Wi-max network plans have repeatedly failed, wi-max has lower geographical coverage and lower capacity than comparable LTE technologies and is now generally considered a non-threat by most observers I spoke with. 

Simply put, wi-fi or wi-max could be rolled out if it were cost-feasible, but the resulting network would simply be another wireless network that would have to charge customers for it's services and be compensated for it's radio and capex spend, without the advantage of a large installed base and accepted technologies.  Telco's themselves would adopt these technologies if they were more cost effective than 3G/LTE, in fact, they are adopting wi-fi on a limited basis for offload in dense urban areas.  However, none of these technologies offer a better alternative to LTE, and all would need to be paid for by subscribers just like wireless.

The shining example of Wi-max's pending failure is the Clearwire JV in the US.  Originally slated to beat LTE to market by 3-4 years, following delays Clearwire is now poised to rollout essentially simultaneously with Verizon's LTE technology.  Owing to LTE's capacity and coverage superiority to Wi-max, Verizon's superior spectrum and existing wireless subscriber base, the odds are against Clearwire's mobile success in any form other than cheap wholesale capacity for the benefit of it's parents (and possibly the wireless co's, though they may not even bother to make phones compatible with wi-max).  The way Sprint/TWC/Comcast/Google clubbed together mainly contributing spectrum assets (worthless without development) rather than cash, points to the fact that the partners may not believe this is a commercially viable technology, rather a way to use other people's money to build an otherwise non-viable network for their own benefit.  Google's decision to pass on the most recent fundraising round and be diluted underscores its lack of faith in Clearwire's success.

[Chart cannot be pasted]

With mobile firmly in control of both mobile voice and data, wireless companies will continue to control mobile access and data expansion will present a growth opportunity rather than a disruptive threat to the mobile operators.

2.  Will Mobile Data Threaten Mobile Voice? 

Yes, data revenues will cut into voice revenues, as wireless carriers create packages that are more data-heavy.  But this is merely a rejiggering of wireless service packages, with all the revenue still going to the wireless carriers.  Data will speed the decline of voice revenue, but will increase the overall pool of revenue for wireless carriers.  At the same time data will not significantly increase capex or opex, as ongoing upgrades (3G > 3G+/HSPA+ > 4G/LTE) are sufficient to grow data capacity without increasing annual spend due to improved technology and falling prices. 

3.  Will data lead to a capex binge?

It does not appear so.  But it's easy to understand why some might fear a capex explosion from data.  The following chart provided by VOD on growing data usage is quite amazing, and is the type of chart that has concerned many investors at first glance: 

[Chart cannot be pasted]

Further, Cisco estimates a 66x increase in mobile internet traffic from 2008 to 2013, a 130% CAGR.  Many have looked at these types of figures and concluded the wireless carrier industry will be in serious trouble (e.g. will a 66x increase in traffic require 66x the capex, or at least 10-30x?).  However, all indications are that based on falling prices and improved equipment, 4G/LTE will be rolled out over time at essentially the same capex spending levels wireless companies are spending now as they continue upgrading their networks to 3G and 3G+HSPA.  This is consistent with company guidance on both sides of the atlantic.  This is possible because:

A.  Networks are built out ahead of usage - VOD's current network, absent any further capex, is only ~30% utilized on average.  Only 5% of cell sites experience peak utilization of 90%, the Company continuously upgrades it network ahead of demand.

B. Natural capacity gains in data vs. voice - The capacity needed to handle 1MB of data usage is approximately 1/5 the capacity needed to handle 1MB of voice usage.  Voice is overbuilt to allow smooth transition from tower to tower and avoid dropped calls, which requires excess capacity in the system.  Data, by contrast, operates in packets, doesn't need constant access (data can sustain wait times to send/receive packets whereas voice cannot withstand more than ~100ms break before dropping call).  As a result, five times more data can be comfortably transmitted over the same capacity as voice.

C. New technologies increase capacity >20x at same capex cost - Upgrading 3G to LTE increases capacity over 20x. 

[Chart cannot be pasted]

And these tremendous capacity upgrades are achievable within ongoing capital expenditure budgets - it is simply the next technology cycle of constantly improving technologies (e.g. spend comparable to the ongoing 3G to HSPA+ upgrade).

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These upgrades can be done at existing capex levels.  Operators are continuously upgrading their networks.  Europe is now essentially fully 3G covered, with the system in varying early stages of "3G+" upgrade (see chart on top for varying levels of "3G+").  New equipment that is put in place is usually "enabled" for future generation technology.  For instance, Huawei's current 3G+ offering has 4G/LTE capabilities, meaning 4G can be run through the same hardware with just a simple software upgrade.  Much of the plain 3G capacity that was put in place was 3G+/HSPA+ enabled, requiring only a software upgrade to get to 3G+.  In this way, upgrades are performed on a continuous, rolling basis as future technologies get cheaper and cheaper. 

Further, future growth is about increasing capacity, not coverage - it is much cheaper to upgrade existing infrastructure than to identify and build new cell sites, run new backhaul lines etc (unlike the US, European mobile operators build and own their towers).  At this point, operators have also begun infrastructure sharing, which would reduce the cost of any new tower rollouts, though this effect will be smaller than is being trumpeted as few new towers are being built at this point.

Consistent with this story, carriers on both sides of the atlantic have guided towards flat capex as 4G is rolled out.  However, the micro buildup of specific, comparable unit capex spending, is dominated by "fuzzy numbers".  It is very difficult to nail down exact numbers because a) no operators have begun 4G/LTE rollouts yet, and unit pricing is not comparable or discussed publicly, b) costs vary significantly from carrier to carrier, tower to tower, depending on the status of existing network, spectrum, existing backhaul (T1/microwave/fiber), existing BTS equipment (upgradable or needs outright replacement). 

So I've looked to the largest, scariest buildout cost estimates I can find to sanity-check company's general guidance that 4G/LTE will not increase capital costs.  The buildout estimates I've found were published by a consultancy called Aircom, which published a report saying a 4G rollout in the UK for a major carrier would cost US$750m (£470m) in the first year alone.  At first glance, this number is concerning against VOD UK's ~£450m FY09 capex spend.  However, I spoke with the consultancy about this estimate, and digging into the details, it appears Aircom may be trying to literally "scare" up some business for its primary service: consulting on how to manage network rollout expenses. 

Aircom's number includes a. spectrum purchase, a non-recurring cost which is accounted for in my analysis separately from capex, b. a rollout on 2600Mhz, actual rollouts will be in the 800Mhz band, offering >2x coverage for same radio equipment, c. an immediate rollout - no UK operators have committed to a rollout yet, real rollouts expected in 2012, equipment costs continue to decline rapidly as technology matures and orders ramp up.    Aircom's estimate including spectrum costs is actually less than my estimate of just UK spectrum costs (I've attempted to be highly conservative on this uncertainty).  But cutting my spectrum cost est. in half for this purpose only, actual capex implied by Aircom would be approx. £220m.  So without adj. for Aircom's other aggressive assumptions on high-frequency and immediate buildout, Aircom's estimate is less than 50% of the current UK capex budget. A 4G rollout is just another kind of upgrade, which rather than being additive to capex would displace much of the ongoing network upgrades that comprise the majority of capex spend.  In short, Aircom's capex estimates appear to support management guidance that 4G upgrade will not require significant capex spend increases.

D.  One-time spectrum purchases - Purchasing new spectrum for 4G in Europe is a one-off event, but a cost that is important to consider.  Below are conservative estimates of VOD's spectrum costs in its key European markets.  I have accounted for them conservatively in my analysis - assuming they are immediately due, and funded with 100% fresh equity. 

These estimates are higher than much of the discussion in the market.  An interesting data point is the French government's recent sale of one additional 3G license to Illiad for approx. 1/3rd the price of the original 3G licenses.  These numbers are roughly 1/2 3G license pricing for comparable bandwidth.

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Appendix E - Corporate Issues to note

Tax - VOD has a very complicated tax structure, and approx. £7B in deferred tax liabilities.  Some of these liabilities are natural deferral of taxes owed at any point, some are due to tax disputes.  The company has a very efficient tax structure, and constantly endeavors to trap profit offshore (e.g. charges license fees for use of brand name to low tax jurisdiction etc.), and has had historical writedowns which may be used in certain jurisdictions (e.g. they received a favorable ruling on a €15B German tax shield from the early 2000s).  However, given the spaghetti of jurisdictions, holding companies etc, it is difficult to diligence the company's tax position.  In discussions with the Company, they believe future "normalized" tax will be more in line with current cash tax (e.g. ~£1.2b higher than LTM reported tax).  I have taken this into account in my analysis.  I have also factored in a recent £2.2B UK tax ruling as an immediate, equity funded expense.

Debt & inflation - VOD has a manageable debt load, approx. 2x EBITDA, in line with comps.  However, a large proportion of this debt is short-term, which could be concerning in a rising interest rate environment.  To sensitize for this, I estimate a 200bps immediate increase in debt rates would reduce free cash flow yield by approx. 50bps.  Debt is hedged to the currency mix cash flow is generated in.

Whether the mobile industry has pricing power in an inflationary environment is untested and a reason to watch the industry closely should inflation begin to grow materially.

Puts - VOD's minority partner in India, Essar, has a right to put its interest in the Company to VOD for $5B.  While there is considerable value in the Indian business that would be acquired, I have accounted for this obligation as a valueless liability, immediately funded with equity, for conservatism.

VOD has the right to contribute $900m to Verizon in exchange for additional ownership to protect itself against dilution in a certain set of circumstances.  While exercising this option should be neutral for VOD (e.g. it has the same stake in a company with proportionally $900m more cash for VOD), I have accounted for this obligation as a valueless liability, immediately funded with equity, for conservatism.

If these two items were given neutral value, adjusted free cash flow yield would increase to 15.5%.

Currency - VOD's primary cash flow currencies are Euros and US Dollars.  It's primarily listing is quoted in Sterling.  This provides for additional volatility in VOD's reported financials.  Currently VOD's financials are benefiting from this exposure, however this may reverse.  My analysis assumes flat f/x rates going forward.  This risk could be roughly hedged if desired.

Catalyst

Resolution of non-consolidated cash flows - VZW dividends, VZW/SFR M&A

Market realization of data opportunity, contrast to wireline dominated comps