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Vodafone Plc Interim Update – 29 January 2015

Company Overview

Reuters: Vodafone Group Plc (Vodafone) is a mobile communications company. The company provides its services to mobile voice, messaging, data and fixed line. Vodafone has equity interests in telecommunications operations in nearly 30 countries and around 50 partner networks worldwide.

Vodafone Red offers consumers and businesses a package with mobile data allowances, unlimited calls and texts, plus cloud and backup services to secure personal data.

Vodafone Cloud allows customers to store their personal digital content, such as contacts, photos and videos in the Vodafone network and to access it on the move from any connected device. Vodafone OneNet integrates landlines and mobiles providing a communication solution. Vodafone Secure Device Manager gives customer a way to manage many of their smart devices

Index FTSE 100 Ticker VOD.L Latest Close 235.10
52 Week High 252.12 52 Week Low 178.00 P/E (F) 42.7
Dividend Yield % 5 Dividend Cover 0.5 CEO: Vittorio Colao
CFO: Nicholas Read Price Target 175.00

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Vodafone shares recover from 2014 lull on hopes of a brighter future for the group; operational and financial highlights

Following a turbulent year, Vodafone’s most recent trading update showed the pace of decline in service revenue slowing from that seen earlier in 2014, prompting renewed hope among investors and a reversal in the group’s share price.

In detail, Vodafone’s financial results for the first quarter of the financial year showed renewed competitive pressures in many European markets having a further detrimental impact upon service revenues, which left investors with little incentive to renew their interest in the shares.

However, by the close of the first half these pressures had began to ease and the pace of decline in both group, as well as divisional revenues, had fallen from being in the low-mid double digits in some cases, to an average of mid single digits.

Consequently, after falling to within inches of our second price target in October, the shares appear to have broken free from their earlier downward trend and have now returned closer toward their 2013/14 highs.

Core Markets Revenue Performance

Segment Q1 Decline in Service Revenue Q2 Decline in Service Revenue
Group -4.2% -1.5%
UK -3.2% -3.0%
Germany -4.9% -3.4%
Italy -16.1% -9.7%
Spain -15.3% -9.3%
AMAP/Emerging Markets +4.7% +6.8%

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Vodafone Plc Share Price / Daily Intervals

VODL JAN 2015 ANNOTATED CHART

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The road ahead for Vodafone Plc is a challenging one

On balance the group has done well by positioning itself for long term growth in emerging markets and enjoys the benefits of a portfolio of businesses which are diversified across Europe.

However, it will take some years and a great deal of investment for emerging market revenue to be able to offset the pressure upon core developed markets, which leaves us concerned about the earnings outlook and valuation for Vodafone Plc over the near to medium term.

In this regard, we note that despite intermittent periods of improvement, service revenues are in decline across all of Vodafone’s mature businesses. While this decline has been slower in the UK and the Netherlands, it has reached double digit figures across the remainder of the group’s European regions during recent quarters (Italy, Spain).

With this in mind it makes sense that the group has focused the majority of its efforts to date upon Spain and Germany as these are key markets (ONO & Kabel Deutschland) at both ends of the performance spectrum and a more expansive offering of services could help to shore up the group’s position here.

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Vodafone reaches a fork in the road within a crowded telecoms market

One of the key problems facing the group and its shareholders is that large cap telecoms businesses, such as Vodafone, have long ago exhausted their options for organic growth in core markets and traditional lines of business (EU mobile airtime). Therefore, such businesses have now arrived at a fork in the road.

While Vodafone has proved successful in its efforts to establish an emerging markets base, further development of this will require substantial additional investment and time before these divisions are of a scale whereby growth is sufficient to offset pressures elsewhere.

In the mean time it, it can either buy its way toward growth and greater shareholder value in core markets, or seek to build out its service offering organically in order to capture a greater share of the market, at the expense of slower competitors. Although in the telecoms space, both options entail their own complications.

In mobile telecoms Vodafone’s market share is in excess of 25% in its key markets, which presents regulatory/competition problems when it comes to M&A. In addition to this, such markets are fiercely competitive in terms of mobile telecoms alone and therefore, margins are under pressure at such singular operations.

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Vodafone pursuing a slice of a bigger pie in the hope of a “best of both worlds” outcome

At present the group appears to be pursuing both organic as well as inorganic growth, evidenced by its takeup of 4G spectrum and its acquisition of fixed line broadband and television infrastructure upon continental Europe.

This comes as part of its wider strategy to move toward becoming an integrated “Unified Communications” company as opposed to just a telecoms provider. Such a strategy will eventually see the group providing a combination of mobile & fixed line telecoms as well as broadband internet and pay television services across key markets.

However, the problem is that Vodafone is late to the party in terms of unified communications and at a disadvantage in some markets due to its lack of fixed line infrastructure and television content.

While the steps taken by Vodafone already may help to shore up support for the brand in Germany and Spain, it faces an uphill battle in the UK, which accounts for 25% of group revenues and is its second largest market by a long stretch.

We feel that those companies who are best placed to lead the field in the development of a unified communications offering are both Sky Plc and BT Group Plc.

Both companies are investing heavily in the launch of their own “quad-play” packages which will see customers able to house their satellite television, land-line telephones, mobiles phone contracts as well as home and mobile broadband subscriptions under the one roof.

Although such packages have proved relatively unpopular to date, we believe that with the right service mix and if sold at the right price, it is a concept that will be able to gain traction with UK consumers.

In terms of development, Sky Plc has recently negotiated a deal with Telefonica that will see the media conglomerate renting airtime from UK subsidiary O2. This is likely to see the group entering the quad-play field with the most advanced, and one of the most attractive, offerings available.

The deal between Telefonica and Sky also makes commercial sense for both parties as it provides Sky with entry into an attractive market and increases the prospects of success for Telefonica’s plan to divest O2 UK to Hutchison Whampoa; in a deal that is believed to be worth as much as 11 billion euros.

The Telefonica -Hutchison Whampoa deal will create the largest mobile network provider in the UK by combining what are already two leading players. Therefore, competition regulators are unlikely to approve the deal unless both companies can demonstrate that competition within the industry will not be harmed.

Telefonica’s agreement with Sky should go some way toward demonstrating that barriers to entry are not impossible to overcome while also replacing a lost player with another industry leading figure. Should this get the go ahead from regulators, it would be bad news for Vodafone.

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Sky Plc’s quad-play offering is not the only wolf at Vodafone’s door

In addition to Sky Plc, BT Group also appears poised to launch its own quad-play offering, evidenced by its entering into exclusive negotiations to purchase the UK’s most advanced mobile and 3G/4G network EE from Germany’s Deutsche Telekom. The group is also believed to be making a play for the Orange network.

Both have substantial customer bases in the UK as well as extensive networks of high street stores, a lack of which, has always been a hindrance for BT. After having launched its own pay-television offering in 2014, BT is well positioned to make a splash as it enters the quad-play/unified communications space.

Gaining a network of high-street stores in the process will further bolster its chances of becoming a credible contender for a dominant position within the industry, which is more bad news for Vodafone Plc.

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Balance sheet, dividend and valuation update

In terms of the balance sheet, Vodafone recently announced an increase in net debt off the back of its acquisitions of Kabel Deutschland and ONO. This saw net debt rise back above the £20 billion level after its initial fall to £15 billion in the wake of the Verizon disposal.

Despite this the balance sheet remains in relatively good health although, if the liability side is allowed to swell much further, management could find their options constrained by their own self imposed long term leverage targets.

In relation to the dividend, we continue to see a question mark hovering above the shareholder payout at Vodafone over the medium term.

While management have pledged to continue to increase shareholder returns on an annual basis, we caution that current consensus earnings projections for the 2014/15 & 2015/16 years imply dividend cover of just 0.5X.

This means that the group will probably be forced to draw down on reserves in order to make up the shortfall and avoid a shareholder disappointment, which may work in the short term, but is a self defeating strategy in the longer term.

In addition to this we note that the group, which is in the midst of a cash intensive investment program (Project Spring), has already lost just over £2 billion in annual cash flow as a result of the Verizon divestment. This also bodes ill for income investors.

On balance, we believe that at the very least, expectations are too high for Vodafone in terms of the dividend, which exposes the shares to the risk of an investor exodus in future periods.

From a valuation perspective, we believe that Vodafone is expensive relative to both the UK telecoms sector, as well as its European telecoms peer group. The group currently trades on a forward multiple based valuation of 42X 2014/15 consensus earnings estimates and 40.2 X 2015/16 estimates.

This does not compare favourably with the 29X average for European telecoms and the 16X December average for UK telecoms. Therefore, our central view in relation to the valuation at Vodafone is expensive.

We note that support for this view can be found when investors consider that earnings multiples throughout Europe have risen of late as a result of M&A activity across the sector and thus, are not reflective of long term trends.

This is while the likelihood of Vodafone itself becoming an acquisition target has reduced significantly during the last year as AT&T, Sprint and Japan’s Softbank have each pursued alternative opportunities.

Consequently, we believe it is fair to judge VOD.L’s premium valuation to be the result of pure optimism, which is excessive even against a sector where multiples have expanded considerably during the last 12 months.

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Summary

Vodafone management tell an attractive tale of a company that is investing significant amounts of cash in order to maintain and grow its position across core markets. With this in mind, and considering the record capital return to shareholders last year, it does not take a rocket scientist to see what the attraction has been for investors of late.

However, looking ahead we see a rocky road for Vodafone. One which is fraught with increasing competition, a balance sheet that is once again beginning to swell in addition to declining revenues, margins and therefore, earnings.

For these reasons, we are sceptical of whether or not Vodafone shares will be able to extend the gains made throughout 2014 into the current year.

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The takeaway

On the whole, we believe that there is better value elsewhere in the UK and European telecoms & unified communications space.

While recent acquisitions will help the group to stem the flow of customers who have been jumping ship in Germany and Spain, take up of quad-play packages remains low and we are sceptical of whether or not Vodafone will prove innovative enough in order for this trend to be reversed.

In the UK, which is Vodafone’s second largest market, we feel that Sky Plc will hold first mover advantage with BT Group Plc emerging a close second in terms of unified communications. This reduces the scope for success of an eventual Vodafone entry into the field and in our view, will likely lead to an increase in customer defections over the course of the coming years.

While some analysts have suggested that Vodafone could be forced to make its own acquisitions in the UK fixed line and pay-tv space, in the form of a buyout of Virgin Media, we see this as likely to have only a limited impact on this operation as the group will be late to the party and offering second rate TV and telephone packages.

However, an acquisition of the Virgin Media parent group Liberty Global could add value to the group’s European businesses as well as providing it with a belated entry into quad-play in the UK. Under such a scenario, the outcome for the shares could be positive in the longer term.

Nevertheless, we remain of the opinion that the risks and challenges facing Vodafone over the near term, far outweigh the potential benefits of new or continued investment.

In addition to competitive pressures, a question mark continues to hang over the dividend while from an earnings perspective, EPS estimates remain uninspiring and have led the shares to appear expensive in comparison to both UK telecoms and EU telecoms sector averages.

Consequently, we maintain our negative outlook for the shares and hold our price target at 175.00 pence. This corresponds to a forward earnings multiple of 29 X 2015/16 estimates, which remains at a slight premium to the 26X EU average, while implying 25% downside to the shares at current levels.

 

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