Vodafone's strong 1H came down to forex

Vodafone reported fiscal 2010 first-half results that were better than our expectations, but the improvement comes entirely from foreign currency gains and acquisitions. Therefore, we will be maintaining our fair value estimate of 161p per share. Excluding foreign currency, the results would have been a bit worse than our projections. Reported revenues increased 9.3% year over year, but excluding foreign exchange gains and the full consolidation of Vodacom, its South African subsidiary, service revenues would have declined 2.6%. Our expectation for the full year is for a slight revenue gain on a constant-currency basis. In Western Europe, mobile termination rate cuts and reduced international travel more than offset increases in data usage and broadband services. In Africa and Central Europe, the firm continues to struggle in Romania and Turkey. However, Turkey is now well into its turnaround plan and will likely begin to show improvement soon. Asia-Pacific and the Middle East increased revenues 12.3% as India continues to grow rapidly with a 48.2% increase in subscribers from the previous year.

On the margin side, we had anticipated the current economic environment would lead to a significant reduction in earnings before interest, taxes, depreciation, and amortisation margins, and we were not disappointed. However, due to faster cost-cutting than we expected, Vodafone managed to hold margins above our estimates. EBITDA also benefited from strong results from Verizon Wireless. Vodafone's EBITDA margin was 45.5% versus our projection of 43.8% for the full year.

Our biggest concern is the price war that has broken out in India. Several new players have entered the wireless market, and pricing is now about one US cent per minute, probably the lowest rates in the world. With India being one of the fastest-growing and largest markets in the world, there is a land grab going on with many players eschewing profitability for growth. We expect consolidation at some point to bring back rational pricing, but this is a risk to our thesis.

Management also announced that the current £1 billion cost-cutting plan would be completed this fiscal year, rather than next, and another £1 billion plan would be completed by the end of fiscal 2012. We think the price war in India is a big driver of the additional cost-cutting and expect the majority of these savings will go toward infrastructure spending, marketing, and retention, but will also likely slow the margin decline. We also think this margin improvement will offset additional revenue shortfalls. Despite some of the organic weakness in the half, Vodafone remains confident reiterating its expectations of operating profit in the range of £11.0 billion-£11.8 billion and free cash flow at the upper end of the range of £6.0 billion-£6.5 billion. The firm also increased its dividend 3.5%.

Fair value estimate: 161p ¦ Fair value uncertainty: Medium ¦ Economic moat: Narrow

Thesis
(Last updated 31-07-2009)

We believe the telecom industry is more stable than many other industries against swings in the broad economy, and diversified firms like Vodafone are generally less sensitive than telephone companies focused on one country or geographic region. However, even Vodafone isn't immune to the current situation, and subscribers are using their phones less at the margin.

Vodafone is the world's largest wireless phone company by revenue. It is split into two regions--Western Europe and everywhere else--with Europe accounting for about three fourths of reported revenue and profits. Vodafone's scale in Europe gives it an advantage over competitors, allowing it to source equipment at lower prices. The firm can also develop a product in one country and roll it out to others at minimal additional expense. Vodafone has done a great job of using these advantages to enter new markets. Its scale advantages result in a narrow economic moat, in our opinion.

As subscriber growth has slowed in developed markets, Vodafone has increased its exposure to emerging markets. The firm typically enters new markets via acquisitions, and it made two major acquisitions recently: the second-largest wireless operator in Turkey and the fourth-largest in India. It has also made additional acquisitions in Africa. We think this is a great strategy. India in particular is booming, and Vodafone has jumped into third place in the race for the largest subscriber base there. In fiscal 2009, ended in March, the firm's Indian operation increased its customer base by 56% year over year, to 69 million, and increased revenue there 47%. However, Turkey actually lost subscribers as political turmoil affected the economy. In addition, Turkcell, the largest wireless firm, has done a great job competing and has continued to outperform Vodafone in Turkey.

More disconcerting has been the rapid slowdown in Europe, particularly Spain and Romania. Vodafone's service revenue in Spain declined 4.9% year over year in fiscal 2009 after adjusting for currency changes and acquisitions, versus 10%-plus growth in the previous year. Vodafone claimed it was hit particularly hard because of its previous success among immigrants, many of whom worked in the construction industry. In Romania, which has been a strong point for Vodafone in recent years, service revenue dropped 10.3% in the fourth quarter. Eastern European economies were hit hard in the first calendar quarter of 2009 as local currencies were hammered versus the euro. As most workers are paid in local currencies, but many have mortgages and other loans in euros, the currency depreciation has caused a dramatic drop in people's standard of living.

Also, outside the United States, most wireless phone users still pay on a per-minute basis. Vodafone continues to add net subscribers in each of the countries it serves, but people are using their phones less, which has hurt the average revenue per user, or ARPU. As growth slows, competition has increased, putting downward pressure on prices. In addition, the European Union has mandated lower prices, which are also hurting revenue. Despite the slowdown, though, we remain impressed by Vodafone's global scale.

Valuation
We have made several adjustments to our model, lowering our fair value estimate to 161p per share from 180p. We now expect revenue to increase about 4.6% annually over the next five years, versus 6% previously. We expect a slow economic recovery in Europe will hurt revenue over the next two years, more than we'd previously thought. We continue to expect operating income before depreciation and amortisation to decline to about 38% of sales by fiscal 2014 from almost 50% in fiscal 2009. The lower margin will be a result of an increase in spending on marketing to new customers and retention efforts for its existing customers, in order to offset the slowdown in revenue growth, as well as continued mandatory cuts in fees dictated by the European Union. We have raised our cost of equity to 11% from 10.5% because of the increased risks of the current environment.

Risk
Vodafone's many markets have different regulatory issues and currencies. In most markets, it is the number-two wireless company, causing it to be the focus of competitors. This increased competition is becoming even more critical as growth slows in many markets. The firm took a £23.5 billion exceptional write-down of goodwill during fiscal 2006, an additional £11.6 billion in fiscal 2007 on top of £5.4 billion of specific write-offs upon exiting Japan and Sweden, and £5.9 billion in impairment charges in fiscal 2009, but it still carries £54 billion of goodwill on its balance sheet after its Indian acquisition. Vodafone would love to get control of its operations in France and full control in Italy. It might overpay for control if the opportunity presented itself.

Management & Stewardship
Vittorio Colao replaced Arun Sarin, who retired in 2009, as CEO after previously serving as CEO of Europe and deputy CEO for Vodafone. Previously he was CEO of RSC MediaGroup, a leading publisher in Milan, a position he took after leading Omnitel Pronto Italia to a merger with Vodafone. John Bond became chairman in July 2006 after a distinguished career at HSBC, one of the largest and most global banks in the world. Most of senior management has come up through the ranks or from firms Vodafone has acquired. Internal promotions have helped retain key employees and integrate acquisitions. We like that many of the firm's option grants are performance options that require a specific return on the stock, some as high as 18% annually, before they vest. CFO Andy Halford was previously CFO of Verizon Wireless, which he helped lead to the fastest growth rates in the United States in 2003 and 2004. Vodafone's corporate governance is good.

Overview
Growth: Vodafone enjoyed tremendous growth over the past decade as it entered Europe. It is still entering new emerging markets, which provide growth opportunities. But given the firm's size and the current economic environment, we expect growth to slow, averaging about 4.6% for the next five years.

Profitability: Reported earnings have turned positive as Vodafone now reports earnings based on international accounting, which, like US accounting, excludes amortization of goodwill. Return on invested capital without goodwill is around 17%.

Financial Health: Vodafone has taken on debt to pay for acquisitions. However, it produces large amounts of free cash flow, which should enable it to easily handle increased interest payments.

Profile: With 303 million proportional customers (total customers multiplied by its ownership interest), Vodafone is the second-largest wireless phone company in the world behind China Mobile (in which it owns a 3.3% stake). It is also the largest carrier in terms of the number of countries served and is the most global wireless company in the world. Vodafone has majority or joint control in 24 countries and minority or partnership interests in many others.

Strategy: Vodafone has ratcheted back its strategy recently, aiming to build the largest wireless customer base in select regions, rather than worldwide. It has integrated networks for seamless cross-border operations within Europe and is working with Verizon Wireless to develop phones that can be used in the United States and Europe. It also wants to gain control of the companies in which it is a minority shareholder.

Bulls Say
1. Vodafone's scale and scope around the world provide cost advantages, as programmes can be developed in one market and then rolled out to the rest at minimal additional cost.

2. The firm generates significant free cash flow, which it is using to increase dividends, make acquisitions, and invest in the business.

3. Vodafone's 45% stake in Verizon Wireless is estimated to be worth £18.5 billion-£24.7 billion--or about one third of Vodafone's market capitalisation. The firm recently acquired outright control of Vodacom, its South African subsidiary.

4. Because the firm is not an incumbent telephone operator, it has no legacy problems like major underfunded pensions, civil-servant employees, or regulations mandating universal telephone service.

5. Vodafone has developed M-Pesa, which allows money to be transferred via mobile phone, for emerging-market customers who don't have bank accounts.

Bears Say
1. Competition is increasing globally, and Vodafone is a target. European rivals are merging and becoming more global, and strong emerging-markets players are developing. This competition is driving down average revenue per user.

2. Vodafone could overpay for acquisitions, especially to buy complete control in France or Italy.

3. Verizon Wireless uses CDMA technology, while most of Vodafone's operations use GSM. Currently, these two technologies are not very compatible, which prevents Vodafone from seamlessly connecting one of its biggest operations to the rest of its network.

4. Governments are mandating that wireless firms lower interconnection and roaming fees, hurting sales and margins.

5. Vodafone has been given a $2 billion tax bill by the Indian government for its acquisition of Hutchison Essar in 2007. The firm is disputing the claim in the Indian court system.