2023-05-21 23:52:15 ET
Summary
- Vodafone Group Public Limited is a global telecommunication company.
- Management has initiated a transformation strategy, seeking to focus on its areas of strength as a means of reinvigorating growth.
- We are not sold by the plans, believing them to be insufficient to achieve any meaningful improvement.
- Vodafone's fundamental weakness remains, with its declining performance in Germany a particular concern.
- With FCF strength and some reason to be bullish (Vodafone Business/Africa), we believe its current valuation warrants a rating upgrade.
Investment thesis
This is the second time we are covering Vodafone. We initiated the stock at a sell, citing continued weakness in its financial performance and no clear route to generating shareholder value.
Our updated investment thesis is:
- Vodafone's performance continues to be weak, with its largest market experiencing negative growth in Q4.
- We do not buy Management's turnaround strategy, as it feels insufficient to generate long-term value beyond what the company can currently achieve.
- Despite this, we believe it is valuable to initiate such as a strategic plan, as it holds Management accountable to specific KPIs and narrows employee focus.
- Vodafone has key areas of strength, such as Vodafone Business, its Brand, and its African operations.
- Vodafone's valuation is the primary reason to upgrade our rating of the stock. At its current level, Vodafone's FCF is far too valuable to ignore, despite the concerns.
Company description
Vodafone Group Public Limited (VOD) (VODPF) is a telecommunication company , operating across Europe and internationally. The company is listed in the UK, as a constituent of the FTSE 100.
Share price
In response to Vodafone's most recent earnings release, the share price declined c.9%, with investors unimpressed by both the company's performance and Management's response.
Strategic Overhaul
Vodafone began its earnings release in a way I have never seen before. Management explained everything wrong with the business, and why it is losing. For those who do not have time to read my prior paper, the following succinctly illustrates the issue.
Vodafone has found itself in a position where a large part of its operations are mediocre, if not poor, yet its scale and brand value keep the business ticking along.
To quote one of our biggest criticisms of Vodafone "There does not seem to be a long-term strategy for transforming the business, it all seems to be around maintaining the status quo and selling what can be sold when possible."
Management may have read my paper, as they have announced a turnaround plan. The corporate world loves a transformation story, as it creates hope for outperformance and thus improved sentiment. Investors must always consider this with more than a pinch of salt, as execution is far more difficult than planning.
Before analyzing Management's plans, it is worth defining Vodafone's key strengths in the market, and its weaknesses. This will allow us to consider how the plans marry up, in order to assess the viability of the plans.
Vodafone's key strengths:
- Network. There are very few companies globally with Vodafone's reach. The company has significant operations in Europe, as well as Africa. This gives the company scale economies and the ability to exploit shared expertise to generate strong margins.
- Africa. With continued development in the region, Africa represents an opportunity many companies are looking to exploit. We expect that telecoms will continue to perform well as individuals are lifted out of poverty and demand for internet services increases. Vodafone is deeply ingrained in the region and generates strong returns.
- Brand. The Vodafone brand is incredibly valuable, with strong recognition in Europe and Africa. The value here is both defensive, as the company can compete for market share, and offensive as it allows Vodafone to expand into new markets with trust.
- B2B and IoT. Vodafone Business has outperformed the consumer side for many years, with its Services sub-segment growing at over 10% Q/Q. This is driven in part by the factors stated above, but also by better scope for innovation, utilizing its expertise.
Vodafone's key weaknesses:
- Structurally complex business. Despite its depressed market cap, Vodafone is an enormous business with over 100k employees and £155bn in assets. This makes structural changes to the business difficult, as it is reliant on cultural and operational change across borders and departments.
- Poor economics. In the last decade, telecoms has been a race to the bottom, with competition and declining costs leading to difficulties in profitably gaining market share. As well as this, the market has not represented any material scope for outperformance, as infrastructure spending is unlikely to be monopolized.
- Poor customer service. Partially due to the above, we have seen a decline in the quality of customer service, as Vodafone has cut costs. This is shared among many of its peers.
- Capital allocation. Management's capital allocation has been questionable at best. Despite the sale of its Verizon share, the company found itself with a bloated balance sheet for much of the decade. With an unwavering dedication to dividends, the company has been unable to invest in expansion, as it tirelessly deleveraged with cash flows and the sale of valuable assets.
- Capex. Vodafone has continued and extensive capex commitments, that act as a drag on cash. This makes it difficult to fund wholesale expansions when factoring in deleveraging.
Management's strategy is:
- "Balanced focus on Business & Consumer". This would involve focusing on maximizing the business segment. This is the correct decision in our view as it is far more profitable and allows for greater differentiation relative to the consumer. We do question whether Management is not already doing this.
- "Consumer back-to-basics to win the market". Similar to the above, this looks to be a strategy to achieve greater differentiation. The key here is offering sufficient value which encourages customers to switch. It is difficult to see what Vodafone can offer that is cost-effective.
- "Leaner organisation focused on value" & "Portfolio right-sized for growth". These two points we are taking in conjunction, which look to focus on the operational side of the business. Vodafone will look to rationalize roles, as well as focus on improving low profitability segments to bring them in line with the better performers.
Our view is that the plans look great, and are specifically targeted at the first 3 weaknesses we have identified. The last two are arguably systemic issues without a clear resolution. This said, we are not wholly impressed. The reason is that this strategy is what the company should have been doing anyway. These plans do not represent an avenue for change but imply more of the same, hoping execution will be successful this time.
Early examples of execution are:
- €150m investment in customer experience and brand spending increased to €100m.
- 11k role reduction in Europe and employee inventive plans adjustments to align with business goals.
- Capex reallocation to high ROCE markets and review of underperforming segments.
- Sale of Vantage Towers, Hungary, and Ghana.
Actions look to be in the correct direction but it's hard to not expect more. Further, we are less keen on asset sales when they are not wholly reinvested into growth.
Overall, we are underwhelmed with Vodafone's new transformation strategy. We believe the company's fundamental weaknesses will remain exposed, with this strategy unlikely to generate a material improvement.
Q4/FY performance
Vodafone's full-year performance is slightly disappointing, with Germany continuing to drag on performance contributing to a slowdown. Further, inflationary costs continue to be an issue, leading to a (1.3)% decline in EBITDAaL.
Germany
The performance in Germany is grinding to a halt, with declining customers now contributing to a fall in revenue. APRU has slightly improved, which is offsetting what is a serious issue for Vodafone.
The company is in the process of executing an improvement strategy (yes, a turnaround within a turnaround), which involves widening its product offering, price increases, increased speeds, and product innovation.
Vodafone Business
Business is the only glaring strength within the business. Revenue growth remains strong and is led by Digital services. Management is seeing growth across Corporates and SMEs, with the IoT business hitting €1bn in revenue.
The total addressable market is estimated at €140bn, with an 11% growth rate in digital markets expected. Given Vodafone's performance thus far, we expect this to continue on an upward trajectory.
Europe
Europe (Vodafone)
Europe remains mixed, with inflation, high competition, and pricing action offsetting each other to a net negative EBITDAaL position.
Africa and Turkey
Africa & Turkey (Vodafone)
Africa and Turkey remain strong, although their relative position in the Group means the impact on the bottom line is small compared to the likes of Germany.
Outlook
Management is forecasting flat EBITDA, with c.£3.3bn in FCF. This looks like a reasonable estimate at this stage. Pricing action in late 2022 will begin to generate positive returns, offsetting inflationary pressures. The issue is that Germany does not look to be turning around.
Wall St. analysts are currently forecasting a (3.1)% decline, likely taking a bearish view of what is occurring in Germany, as well as reflecting their views on the turnaround strategy.
Valuation
Due to the sale of Vantage Towers (and other assets), Vodafone's EBITDA is inflated. For this reason, we will calculate our own Adj. EBITDA to assess the company's valuation.
Adj. EBITDA = LTM definitional EBITDA (£21.6bn) - Other operating income (£8.5bn) - The expected lost EBITDAaL from the asset sales (£1bn) = £12.1bn. Based on this, Vodafone is trading at c.5.5x EBITDA.
In our prior analysis, we believed its 8x EBITDA multiple was relative to what was a mediocre outlook. Since then, the business has sold a valuable asset, continues to see its main market decline, and is facing a difficult year.
With c.£3.3bn in FCF, Vodafone should maintain its 9% yield in the coming year.
The bear factors are offset by continued strength in Vodafone Business, dividends, and a cheaper valuation.
What we want to see
Given our critical view, we believe it is only fair if we suggest options for the business. We would like to see Vodafone commit a portion of FCF annually to investments in growth segments, similar to Liberty Global ( LBTYA ) (The irony that Liberty took a position in Vodafone is not lost on us). Airtel Africa ( OTCPK:AAFRF ), a telco business we rate a " Strong Buy " has expanded into payments in Africa, supporting the company's growth and margin improvement. It has received investment from the likes of Mastercard ( MA ), supporting what is a successful expansion through leveraging its brand. The Vodafone brand is highly valuable and there are many non-telco industries it can still leverage its expertise in.
Final thoughts
The primary factor for our initial negative coverage was the lack of strategic direction. We have that now and despite our conclusion of it, this is a good thing. The company now has good direction and KPIs upon which to judge its ongoing performance. Our concern is that it does not feel sufficient to achieve the turnaround required to make this a long-term choice.
With a steep re-rating of its valuation, Vodafone is now trading close to its 15-year low EBITDA multiple. The company is still fundamentally highly profitable and generates considerable cash flows. Vodafone's existence is not being challenged, just its relevancy. At a 9% yield and 5.5x multiple, we see the company no longer as a sell but as a hold subject to review. If the Germany performance cannot be improved, the company will quickly become expensive at even this level.
For further details see:
Vodafone: Transformation Strategy Underway With 9% Yield (Rating Upgrade)