Description

Vodaphone is a $126bn market cap company so I know this isn’t for most on this board. Vodaphone is a mobile-phone service provider with operations and investments spread throughout the world. This is a massively over-capitalized company run by management under increasing pressure to do something value creative. With a little creative financial engineering, Vodaphone is trading as low as 7x net earnings.

VOD has a market cap of 70 billion pounds (above price is local price quoted in pence), net debt of 20 billion pounds and 35 billion of non-consolidated tax-adjusted investments. The company’s enterprise value of 55 billion compares with 7.5 billion of EBIT and 12bn of EBITDA (i.e. 4.5x EBITDA). Just as an illustration, were the company to spin off its stakes in Verizon Wireless and SFR (the main components of non-consolidated investments) tax-free the net market cap of 30 billion would compare with pro-forma earnings and free-cash-flow of 5 billion pounds, or 6x earnings and a 17% FCF yield. One can argue, indeed the public markets DO argue, that intrinsic value isn’t much higher given the competitive issues and capital allocation history. However, management is relatively new and the private markets continue to chug along at 8-12x EBITDA depending on the country. Most recent European deals have been at least at 8x EBITDA including one in the UK at 10x within the past month.

The company’s most important markets are Germany, Italy, UK, Spain, and Japan.

In Germany, which they acquired via their acquisition of Mannesmann in 2000, VOD has 27mn subscribers each paying 25 euros per month on average (i.e. ARPU). Like most European markets, competition is intense in Germany. Competitors include T-Mobile, E-Plus and O2. Vodaphone shares the number one position with T-Mobile. Of all the operators, O2 seems to have the most momentum but is much smaller. Vodaphone’s offering of 3G data and ancillary services seems above average, but I am judging from afar. The segments churn (the rate at which customers disconnect) runs at a low 1.5% per month suggesting that their customers see them as at least fair.

In Italy, they have a good business, but it is almost all prepaid. Despite this, churn is very low at 1.5% per month, ARPU is actually higher than it is in Germany, retention costs are among the lowest in Europe, and SAC (subscriber acquisition costs) of 19 pounds per sub is Vodaphone’s lowest by a factor of 2. The segment is 24% owned by Verizon. There are 22.5mn consolidated subs with an ARPU of about 29 euro per month.

Their UK business is terrible. Monthly churn is 2.5%, meaning they need to replace 30% of their 15mn subscribers each year just to stand still. This game of musical chairs is aided and encouraged by massive subsidies for new subs, the highest in Europe, along with escalating retention costs, which are the highest in Europe as well. You’d think that potential acquirers would stay from the UK, but not so. Competitor O2 is being purchased by a strategic buyer for 10x EBITDA.

The Spanish business is a good business as well, with 12 million customers, half of whom are prepaid. The ARPU is among the highest in Europe at 34 euro per month. Churn is a little higher than I would like at 1.8%, but operating expenses are relatively low and so the higher margins offset the marginally higher churn figures.

Another of the company’s problem businesses is Japan which, with 15mn subs, could be a source of value creation in the future but for now suffers from high retention and SAC costs, a function of a very competitive market. Interestingly, this segment is showing some signs of stabilization as the company’s 3G offering seem to have gained some traction with net additions in the past few months.

In addition to these core markets, as mentioned above Vodaphone has exposure to Verizon Wireless and SFR (I think I described SFR in my Vivendi write-up a few years ago). These are both great businesses. Verizon w/l is owned 45% by Vodaphone. This business is growing at 15% per year with expanding margins and industry leading operating metrics. There is further room for growth as data service uptake is still pretty low. As that revenue source grows and as long as churn stays at current low levels, EBITDA margins could continue expanding from 43% last year, to 46% this year (they had a 46% margin in Q4 2005). I estimate EBITDA in 2006 of $17bn on which a multiple of 7-10 is realistic. Less debt of about $12 billion provides an investment value of about 28 billion pounds at 7x. Tax effect as you like, but a realistic after-tax value may be around 23 billion pounds. SFR is a French mobile business, a good business in a relatively benign competitive environment. At 8x EBITDA, SFR’s pretax value is 10 billion pounds.

The market gives very little value to these non-operating assets. Or conversely they are overly penalizing the operating business for lack of growth and legacy capital allocation issues. I am not that pessimistic because it seems that all of that is out in the open and is therefore mostly priced into the stock. Furthermore, at 4x EBITDA there is NO credit given for value enhancing actions by management. With the over capitalization and increasing shareholder agitation, I believe that Sarin and company will very likely attempt to create some value for shareholders this year.

At EBITDA multiples ranging from between 4x for the UK to 9x for Spain, Vodaphone's intrinsic value is between 160 and 180p, a discount of between 28-36%, or upside of between 40-60%.

Catalyst

Sale of Verizon Wireless, tax-friendly swap of assets with Verizon, or other shareholder friendly actions; continued share purchases.