The British red telecom giant announced not only a CEO-change, but also a strategic shift (both often come as one). Meanwhile, the share price is advancing its year-long decline, reaching even a fresh quarter-century low (!), as investors seem totally unimpressed. In the past, Vodafone has been a reliable dividend payer, although the payout was cut in 2019 and not raised again since then. The 10.7% yield seems tempting. Can it get worse or is it worth a shot?

Summary and key takeaways from today’s Weekly
– The record-high dividend yield of Vodafone seems tempting.
– However, despite not being in immediate danger of a cut, I don’t think that it is worth it.
– There are simply too many negative developments and also risks to this. I’ll pass on this one.

Vodafone’s (ISIN: GB00BH4HKS39, Ticker: VOD) services likely don’t need a long introduction.

The European telecom giant, headquartered in the UK, is one of the world’s biggest of its kind. Especially after the (in Germany) highly controversial takeover of the former Mannesmann D2 operations, Vodafone has become one of the leading European forces. But the empire building didn’t stop there.

After a few experiments here and there (USA and India), but also further investments and takeovers throughout Europe, today, the company is trying to focus on its core markets which are Europe and certain African countries.

The business is in trouble, though. We don’t need to make a secret out of it.

There are no stocks offering a fully covered 10% dividend yield without reason. Period. However, the share price has fallen so ultra-low that the question arises whether the price is now low enough to justify an entry.

At some point the worst should be priced into an asset.

It has been rumored in the past and will likely be done even more so in the present and future that either activist investors, big institutional investors looking for valuable infrastructure or private equity (or all of them) will be knocking strongly on Vodafone’s door.

Europe’s biggest activist, Swedish Cevian Capital, already tried its luck in 2022 – but after a meager six months quickly realized that the case seems to be hopeless. Since Cevian’s exit, the stock has fallen by another 40%. As the dividend has been kept stable, the yield first crossed 8%, then 9%, even 10% a good month ago.

Many claimed it was already a good deal with a yield of 6%.

Next stop 11%, as we are now sitting at 10.7%?

Experienced investors know that such high yields not only usually come with disproportionately higher risks, but indeed are warning signs that a cut is likely coming, soon. On the other hand, there are always investors with full coffers ready to make an offer – if or when the price reaches a certain level.

Today, we are going to have a look at Vodafone.

We’ll discuss the past results, check the financial health as well as the safety of the dividend. But maybe Vodafone also becomes a take-over target, allowing for a quick buck to be made?

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Megalomaniac empire-building

You can safely say that a core part of Vodafone’s growth strategy was to acquire certain operations it didn’t own. At the end of 1999, two key deals were done:

• the merger of its US assets with Bell Atlantic Corp to create what is today Verizon Communications (ISIN: US92343V1044, Ticker: VZ)
• only a few months later, Vodafone made its first offer for Germany’s industry giant Mannesmann which ended with a hostile takeover

These deals resulted in a 45% ownership stake in Verizon Wireless (which was sold for 130 bn. USD in 2013 to Verizon Communications) as well as Vodafone massively increasing its European reach, entering the single-biggest market Germany.

The “good” thing is that Vodafone paid with its own massively overvalued shares for Mannesmann.

Although there was of course a hefty dilution with this deal (until today still the biggest public corporate takeover of all time, see here), it was comparatively limited for such a deal size (value of 180 bn. USD in 2000, a mind-blowing 320 bn. USD today on an inflation-adjusted basis).

Vodafone’s stock was sitting at its still until today all-time high during the Dotcom bubble, which was above 4 GBP per share.

Also, Vodafone subsequently after the Mannesmann deal starting selling off non-core and not needed parts of Mannesmann, receiving back cash in the double-digit billions.

Above, you can not only see the far-away top in early 2000, but also that the current share price of only 70-some GBp is a good chunk lower than even at the bottom of the Dotcom bubble.

This is rarely a good sign.

A quarter-century without performance (share price appreciation) one could say. Or with lots of value destruction.

There is a certain elements of truth to this. Even counting dividends, this is not the type of investment result you likely want to see over a longer timeframe.

When you look at older financial statements, you will often find big accounting losses, due to heavy write downs of intangible assets and goodwill – a sign of way overpaying for its acquired assets. I think that the Mannesmann deal was strategically good for Vodafone, because as said, it paid with its own grossly overvalued stock and then received lots of cash back through asset sales.

However, what happened afterwards was rather problematic.

The insatiable appetite led to more acquisitions and takeovers, first starting with small deals for warm-up (see here). In the 2000s, Vodafone bought or created several operations in Hungary, Ireland, Finland, Luxemburg, the Czech Republic or Turkey – among several others. In 2011, a consultancy company was bought. In 2012, the company Cabel & Wireless Worldwide was swallowed for a 1 bn. GBP.

And so on.

Bigger deals came with the acquisitions of two cable operators in Germany and Spain for a combined 15 bn. GBP during 2013–2014. But also more than 15 bn. GBP were spent on the Indian market. In 2019, Germany’s other cable operator, UnityMedia, was bought for a total enterprise value of more than 18 bn. EUR (see here).

All in all, many transactions.

First lots of buying, but then also lots of selling of smaller, not-fitting-anymore parts to raise some cash for debt repayments.

No matter how you twist it, at the end of fiscal 1999 (end of March 1999), net debt was only 1.9 bn. GBP (see p. 24 of the 2001 annual report here).

It rose to 6.7 bn. GBP over the next two years.

At the same time revenues (after subtracting joint-ventures and adding acquisitions) rose to 15 bn. GBP. Operating cash flows at the end of fiscal 2001 were close to 7 bn. GBP.

I think these numbers weren’t problematic.

Keep in mind that Vodafone later on changed its accounting currency from GBP to EUR, as most revenues were and still are generated in EUR.

But look what happened over the next twenty years (here’s a screenshot of the last ten years; net debt includes leasing liabilities).

Since fiscal year 2014 (including three quarters of 2013) until today – despite all these transactions and investments – sales barely rose. The high was already in fiscal year 2015 and hasn’t been reached since then.

At least, operating cash flows grew somewhat, one could say. But there is also a multi-year trend of no real growth, as cash flows have been staying between 15–18 bn. EUR.

However, spending is huge, as this is a capital-intensive business.

Capital expenditure is one thing. But you need to factor in also intangible asset purchases, which is nothing different than bidding for and buying cellular frequency licenses from governments (they call it “licenses and spectrum”).

Both combined, over the whole decade have been between 7–14 bn. EUR p.a., in most cases around 8–9 bn. EUR p.a. So, this is company currently generating around 8–9 bn. EUR in free cash flow per year, accord to the data from TIKR.com.

However, Vodafone itself is talking of 4–5 bn. EUR of “adjusted free cash flow”, as they calculate differently.

The goal for the new fiscal year is to achieve around 5 bn. EUR of these adjusted free cash flows. The problem is that these adjusted figures ignore expenses for licenses which are of recurring nature, albeit with a fluctuating quantity.

Counting them results in free cash flows of only 1.4 bn. EUR for fiscal year 2023 and 3.3 bn. EUR for fiscal year 2022. Significantly lower numbers. When you know that the yearly dividend at the current level causes cash outflows of 2.5 bn. EUR, then you will see that last year’s results didn’t cover the dividend.

Until 2019 the dividend was raised yearly – until it wasn’t. The cut then (the only so far) came after a management change (the predecessor of the current CEO) and was about 40% from the prior level.

Could this happen again?

Net debt according to the chart above from TIKR rose from 15 bn. EUR to now 49 bn. EUR. Over the last years, the net debt load has even been 60 bn. EUR, temporarily.

After some asset sales and starting to effectively pay down debt every year since fiscal year 2020, Vodafone managed to lower the debt burden somewhat.

But 49 bn. USD is more than sales of a whole year (less than 46 bn. EUR).

These numbers include leasing liabilities. The “true” financial debt is 33 bn. EUR – still not a small number.

What Vodafone did quite well was the placement of ultra long-term bonds, meaning most of the maturities are far away in the future and at fixed interest rates. However, you can also see that during the zero-interest period Vodafone had to offer 4–6% in yearly interest payments – a hefty premium. You can expect refinancing to result in bonds with 8–9% today.

Here’s an overview of when the bonds need to be repaid:

No need to panic at this front. But it is ballast that has been and likely will continue to negatively influence the stock price.

The next chart shows that over the next years debt of several billion EUR will mature each year. With cash on hand of 11.7 bn. EUR, at least there should be no immediate danger or bottleneck.

But it is clear that Vodafone needs to improve it results and cash flow generation.

What’s next for Vodafone?

The markets already started to worry during 2015–2016 about the sustainability of Vodafone’s debt load and also the dividend, as this was the time when the stock had its last high (after the Dotcom-crash) above 2 GBP.

In 2019 then, the dividend was cut. Since then until now, it could be kept successfully. When you measure the debt level and no-growth as a success. However, the dividend yield is already higher than it was with the higher overall payout in 2019 (i.e. before the cut).

It is clear that the period of relentless empire building has caused huge damage to the company.

It will be crucial to see the new CEO perform well. Prior, she was CFO. Now, she is talking about focussing on the customer’s needs as well as on quality, not quantity. While these may be marketing phrases (what else shall she say?), their’s a good chance that she’ll be able to deliver.

But it is a pretty hard task, make no mistake about it.

One of her presented initiatives is to tie pricing to inflation. This should at least bring nominal increases, allowing for new top line growth. Maybe the old sales-high from 2015 will be reached again? However, likely not in this fiscal year, as sales are guided to stay more or less flat, also due to sold assets.

We’ll have to wait and see.

The other thing is cost savings. As squeezing a lemon works only for so long as there’s effectively no juice left anymore, increasing sales faster than costs rise (as they do during inflationary periods), will be key to execution. 11,000 jobs are to be axed over the next three years.

The earnings announcement wasn’t celebrated. In the first reaction, the stock tanked further and kept on declining until today (as of writing this Weekly).

What is somewhat problematic and disturbing is that Vodafone’s most important market, Germany, is showing signs of weakness. With 30% of sales and the highest margins (40.6% EBITDAL compared to a group-wide 32.1% EBITDAL, they use this strange metric), Germany is key.

But recently, sales were even declining and the speed of the decline even increased towards the end of the last fiscal year.

In the UK, Vodafone which is currently number three after British Telecom and O2, will merge its local business with the current number four, Three UK (yes, their name is “Three”).

This should make the combined entity number one with a market share of then around 36%, while the other two competitors have ca. 31–32%, each. No cash will be involved, as only the assets and debts will be put together. Vodafone will be holding 51% of the new entity – if approved by the regulator.

At least, this could bring synergies. But you see, it is again rather about costs, not organic growth.

Organic growth will be difficult, as Vodafone’s European markets are too mature to produce meaningful growth. The African operation are growing, even nicely. But they are too small to move the needle much.

I found it surprising that the biggest European activist investor, Swedish Cevian, last year first initiated a position to try to turn around Vodafone, only to fold about half a year later. Something is not right.

All in all, this story is not only complex, but it is mainly about the lack of growth and creativity which only leads to cost savings and synergy targets. Whether they will be met, is another story.

For me, there’s no reason for the stock of Vodafone to stage a huge comeback by itself.

What could be indeed interesting is a potential takeover offer.

Either bigger international competitors or big investing houses could try their luck. Private Equity which is heavily debt-ridden seems more unlikely. But what price is appropriate? Maybe they wait until the stock hits the 50’s (pence-wise)? However, there’s no guarantee that someone will start a bid at all.

The valuation seems to be at the lower end, but not at the bottom.

The enterprise value to EBITDA (I don’t like this valuation metric, but it is commonly used by many) shows a 6x multiple. It could be a moderate undervaluation, but it does not seem to be a screaming buy, you would expect to see after a huge sell-off.

Should I value it, I would take the EV / FCF. The enterprise value is around 56 bn. EUR (23 bn. EUR market cap + 33 bn. EUR net debt) and free cash flow … – that’s the difficult question to answer. Even assuming an after-spectrum FCF of 3 bn. EUR, the EV / FCF would be more than 18x. Even 4 bn. would still be 14x – that’s too much, either, for such a highly indebted, not growing business.

That is definitely not cheap.

It shows the debt-issue that makes the company look cheap on metrics that don’t use debt.

Is the dividend safe? For now, it seems so. There is enough cash on hand and Vodafone knows that the only true reason for owning this stock is the dividend. They will only slash it when they will be forced to do so.

Net debt is pretty high, but so far under control, as only small portions become due every year and two-thirds of long-term debt have maturities beyond five years.

At least, there is enough buffer to try to change for the better.

But for me, it is too risky. As Warren Buffet said, “most turnarounds don’t turn”.

I have another issue with this case: If you’re having a company that does not manage to increase its sales at least on a nominal basis during inflationary times while having a utility-like business model (everyone has and needs an internet and cellular connection), then the core obviously is rotten.

I prefer clear and especially clean cases where you have tailwinds, not headwinds.

My Premium PLUS Members last Saturday received my latest report with an investment idea that matches my requirements.

It is experiencing a massively improving environment in its cyclical business.

A few days after my recent Weekly (see here) and the new investment idea, also the famous Barron’s magazine came out with a pitch:

Conclusion

The record-high dividend yield of Vodafone seems tempting.

However, despite not being in immediate danger of a cut, I don’t think that it is worth it.

There are simply too many negative developments and also risks to this. I’ll pass on this one.

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