Recommendation: Buy

Stock Price: 173.9 GBp (ADR’s are trading at $27.51; each ADR represents 10 ordinary shares)

Price Target: 217 (25% upside)

Upside: 243 (40%)

Downside: 167 (-4%) 

Market Cap: £85B

EV (adjusted): £116B

EV/EBITDA (reported): 8.3x

EV/EBITDA (including share of VZW’s EBITDA and Net Debt): 5.3x

FCF Yield (consolidated (not including VZW)): 6.3%

FCF Yield (including share of VZW FCF): 11.4%

Dividend Yield (Ordinary Dividends only): 5.6%

Dividend Yield (Including Special Dividends): 8.0%

Description/Thesis

The general thesis on VOD has been around for several years, but the main catalyst has been playing out without a proper rise is stock price.  Please see PGTenny’s writeup from January 2010, as it is very good and provides a lot of detail on the business which I won’t rehash.  VOD has risen a bit the past month, but is still quite attractive on a risk/reward basis.

Verizon (VZ) owns 55% of Verizon Wireless, with Vodafone (VOD) owning the other 45%.  Verizon consolidates their stake in VZW, while VOD’s stake is accounted for as an equity interest (and thus EBITDA and FCF are understated).  The market continues to undervalue VOD’s stake in VZW versus VZ’s stake.  VOD’s European business has undoubtedly been struggling, particularly in Italy and Spain (where revenue is down 12% in the latest period), due to weak macro environment and competitive pressures, but it should be near a trough and now only accounts for 43% of EBITDA (17.5% Southern Europe), with Emerging Markets (19%) and VZW (38%) performing well.  If you put a 5x EBITDA multiple on VOD’s core European business, a 6.5x multiple on their EM wireless business, a 5x multiple on VZ’s declining wireline business, and adjust for minority interests and VZ’s large pension liability, VOD’s stake in VZW is being valued at only ~5x EBITDA, while VZ’s stake in VZW is being valued at ~9x.   

VZW is a partnership and is only required to pay enough dividends to VZ/VOD to pay the taxes they owe on the investment.  From 2005-2011 VZW didn’t pay any additional dividends as they paid down intercompany debt.  The thesis was that after paying off debt VZ would have VZW start paying large dividends to VZ/VOD (in order for VZ to be able to continue to pay their dividend and interest payments, as little/no FCF is generated by their wireline business) which would cause the valuation gap to close.  As predicted, VZW started paying dividends in 2012, with a $10B special dividend in January 2012 and an $8.5B special dividend in mid-December (45% of which went to VOD).  But despite this catalyst, the valuation gap hasn’t closed, and is actually significantly larger than a year ago.       

VZW currently generates ~$16B in FCF (not including spectrum purchases) and should continue to pay out $10B+/year in special dividends.  VOD paid a £2.0B special dividend following receipt of the £2.8B ($4.5B) special dividend from VZW in January 2012.  VOD initiated a £1.5B repurchase program following receipt of £2.4B£ in mid-December 2012.  If add £2.0B/year of special dividends (currently doing share repurchases instead of special dividend) to the £4.7B in ordinary dividends (5.6% yield) VOD has an 8% yield.  In the past 2 years (through 9/30/2012) VOD has paid out £18B in dividends (11.3B£) and repurchases (£6.7B), not including the current £1.5B repurchase announced in December, as well as decreased their net debt from £30.5B to £23.3B.

Valuation

Verizon’s stake in Verizon Wireless: Verizon Communications (VZ) is comprised primarily of their 55% stake in VZW, their Wireline Business (including Fios), and a 23% interest in Omnitel (77% owned by VOD and worth ~$5B).  They also had $31B in under-funded pension and OPEB obligations at YE 2011 (now likely ~$27.5B after contributing $3.5B in 2012).  Adding pension/pension obligations and subtracting the value of the Omnitel stake from EV and applying a 5x multiple to wireline EBITDA (20x EBITDA-CAPEX), the remaining VZW stake is trading at ~9x EBITDA. 

VOD Value: Applying a 5x EBITDA multiple to VOD’s European business, 6.5x to EM, a 7.5x EBITDA multiple to VZW (versus implied 9x value of VZ’s stake in VZW), and adjusting for minority interests, you get a value 25% above current prices.  And at 5.5x and 7.5x European and EM EBITDA and 8x VZW EBITDA it’s worth 40% above current prices.  VOD currently trades at an 11.5% FCF yield if you add in a proportionate share of their 45% stake in VZW.  It also has a 5.6% dividend yield, including only ordinary dividends and an 8% dividend yield if add in likely special dividends using dividends received from VZW (currently doing repurchase instead of special dividend).  This seems cheap and fairly low risk (and likely some inflation protection) in a world with 2% yields on 10-Year Treasuries.  The downside also seems pretty limited.  Even if you apply a 4x EBITDA multiple on the core (ex-VZW) business and 6.5x EBITDA (9% FCF yield) on VZW stake you only get 4% downside.

Stub Value (if Buy VOD and Short Verizon): Instead of buying VOD outright, one could go Long VOD and Short VZW.  Applying the correct ratio you end up with a stub which is long VOD European and EM wireless and short VZ wireline.  Adjusting for minority interests/etc, the stub trades at 3.3x EBITDA, 4.5x EV/(EBITDA-Capex), 16.5% FCF yield, and 14.5% dividend yield.   

Catalysts

Continued share repurchases and special dividends by VOD as a result of annual special dividends from Verizon Wireless.  VZW should continue to pay $10B+/year in dividends, of which $4.5B (£2.8B) would go to VOD.  VOD paid a £2.0B special dividend following receipt of the £2.8B special dividend from VZW in January 2012.  VOD initiated a £1.5B repurchase program following receipt of £2.4B share of $8.5B VZW dividend in mid-December.  In the past 2 years (through 9/30/2012) VOD has paid out £18B in dividends (11.3B£) and repurchases (£6.7B), not including the current £1.5B repurchase announced in December, as well as decreased their net debt from £30.5B to £23.3B.

Potential partial/whole acquisition of VOD’s 45% interest in VZW by VZ.  These options (along with a merger) have been speculated about for many years (including recently).  I think an acquisition of VOD’s entire VZW stake is unlikely since VZ has a significant debt load and all of their current FCF is from VZW.  A partial acquisition is possible but VOD likely has demanded a substantial premium and seem unlikely to agree on a fair price.   

Risks

Continued weakness in European business.

Weaker growth/declining margins at Verizon Wireless as US market matures.    

Sale of VZW stake at lower price than expected.

Changed accounting in 2013/2014 will cause lower consolidated EBITDA (Omnitel and other joint ventures will begin being accounted for using the equity method (same as VZW currently) instead of proportionate stake).  This won’t cause any change to the actual business/profitability but the lower consolidated results may be misunderstood, similar to Verizon Wireless.