Fri, 13 Sep 2013
Verizon's wireless buyout could shake up things for Vodafone shareholders, but the telecom industry is positioned to remain profitable and have good dividend yields, says DividendInvestor editor Josh Peters.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. What impact will Verizon Communications' purchase of the remaining stake of Verizon Wireless and Vodafone have on dividend investors? I'm here today with Josh Peters, the editor of Morningstar DividendInvestor, and also the director of equity income strategy at Morningstar, to take a closer look.
Josh, thanks for joining me today.
Josh Peters: Good to be here.
Glaser: Let's take a look at the nuts and bolts of this deal first. Why is Verizon finally ponying up this money to fully control Verizon Wireless?
Peters: Verizon Wireless has long been Verizon Communications' most valuable asset. But under the structure of this joint venture, which dates back more than 10 years, Vodafone had to get $0.45 on the dollar of any cash that was paid out, and Verizon Communications would get the other $0.55. So this created a situation where Verizon can't help but share a lot of the cash that this business is generating with a partner that wasn't really controlling or helping operate the business at all. Now they are going to be in a position to continue to manage the business, but as well as collect 100% of the cash that it generates going forward.
Glaser: How is this deal going to be structured, and what could that mean for shareholders who are expecting dividends from both Verizon and Vodafone?
Peters: You're not looking at a significant difference for Verizon Communications. The company did announce a dividend increase little under 3%, which they were probably going to do anyway, so really just the status quo there. The stock yield is in the mid-4% range. It's a pretty mediocre type of total return when you consider that relatively low dividend-growth rate. But it's not bad. We think the stock is moderately overvalued, but there is not a big effect here going on. Other than that, the company will certainly be looking to devote most of the rest of its cash flow to debt reduction to help pay down the debt involved in the cash portion of the deal.
For Vodafone, this is whole new company now after the close of this transaction. For each Vodafone ADR--I've done the back-of-the-envelope math--it looks like you get $5 of cash, as well as about 0.26 Verizon shares, which right now would be worth about $12. Then you'll also get that remaining stub that represents the rest of Vodafone's businesses around the world, and they're actually going to do a reverse stock split after the transaction. They call it a consolidation; it seems to be a British custom if there is a large distribution like this. But basically you get cash, Verizon stock, and then the post-deal Vodafone [shares].
Now, one of the drawbacks here is, for me, as somebody who has owned Vodafone in our Harvest portfolio for more than a year, I don't actually want to own Verizon. There are lot of investors, especially in Europe, that might not want to own Verizon and might not even be able to because of ownership rules within their portfolio mandates. That could put some downward pressure on that valuation.
Another thing you have to be aware of is the potential tax implications. The distribution of cash, and maybe the distribution of stock--we don't know yet for certain--might be a taxable event. If you own Vodafone shares in a taxable account, this could mean a big tax bill even though you're only getting a certain amount of cash, $5 per ADR in cash.
The post-deal Vodafone, post-sale Vodafone, that looks a little bit more attractive to me, but I also want to see what kind of valuation that's going to carry. What's implied right now in the market price between the two different stocks and the cash piece is about a 10 times free cash flow multiple for the rest of Vodafone. That seems reasonable but not screamingly cheap, and it fits neatly with the fair value estimate we actually had before the deal was announced, which was $33 an ADR.
In all, this a lot of sound and fury without necessarily a whole lot of direct benefit. You're always waiting, as a Vodafone shareholder, for this value to be unlocked, and now here is the key, here is the lock, you hear it click, and there is nothing more in there than you thought.
Glaser: What about dividend growth at Vodafone, though? Will the new Vodafone be able to continue to grow the dividend at a pretty steady rate, or do you think they're going to be using cash for acquisitions or for something else?
Peters: There's been a lot of fear that if Vodafone got a big pile of cash, they would turn around, make acquisitions, overpay for stuff, and basically blow it. I think the risk of that is pretty small. Once all these transactions, including Vodafone's pending acquisition of Kabel Deutschland is completed, you're looking at a pretty clean balance sheet. But Vodafone will still have some debt; they're not going to have an unlimited credit card with which to go shopping for more assets in Europe or elsewhere in the world. The payout ratio is also going to come down significantly, too. Because of that consolidation, they're no longer going to be recognizing the earnings of Verizon Wireless. They're effectively going to rebase their dividend at about half its current level.
Now, as a shareholder, you still get the cash, you get the Verizon shares that pay a dividend, and you're essentially being made whole through those pieces. But Vodafone itself is going to be shelling out a lot fewer dollars. The payout ratio on free cash flow is going to be more in the 50%-55% range. That's a level that provides a huge cushion for the ongoing challenges that they see in some of their European markets, maybe now in emerging markets, as well. They've committed to actually raising the dividend, adjusted for all these other factors, 8% this year; before they were just going to try to hold it flat. Annual dividend growth thereafter, I think, is likely to be modest. We're still looking at maybe low single digits, maybe midsingle digits if Europe picks up and emerging economies continue to perform well. But I'm really, as a holder here, thinking in terms of what's the valuation? What am I going to have to pay for this relatively modest level of growth before I decide what to do?
Glaser: For Vodafone shareholders, they really have to think about their tax situation maybe more than the potential future earnings stream from Vodafone?
Peters: There is the tax situation. There are the yield characteristics of these different securities with post-deal Vodafone and Verizon. Right now, I'm just sitting tight, waiting to see how things evolve from here. But if we were to see Vodafone move much above our current $33 fair value estimate, I'd probably be looking for replacement that has less drama attached, less baggage attached.
Glaser: As you look across the entire telecom sector then, does this deal change your thinking about the income-production potential from all telecoms? Does it make you more interested or less interested in other names? What is something you could replace Vodafone with right now?
Peters: One aspect of this deal incidental to it that, I think, is interesting is that Verizon had been rumored to be very interested in moving into the Canadian wireless market, where right now you've got three big players; Rogers Communications--which is a stock I own in our Builder portfolio where I look for more dividend growth, but that stock yields about 4% and is certainly a good income producer--as well as TELUS and Bell Canada. They've traditionally had a very profitable and growing, nice, slow, but positive growth oligopoly in the Canadian telecom industry, especially on the wireless side. The idea that Verizon, with a huge amount of resources to deploy, might come in especially encouraged by some really favorable regulatory setup for new entrants in the Canadian market, was a threat. We actually upped our fair value uncertainty ratings on the [other Canadian] names from medium to high for a while.
In the end, it turns out Verizon wasn't all that interested in going into Canada in the first place. Frankly we didn't think it would in the end anyway because they would have to invest billions of dollars to buy up spectrum, buy up some of the smaller new entrants that are already there and already struggling in Canada against the big three oligopoly, and then wait out what might take five or 10 years to still be the number four player in Canada. When do you actually start generating free cash flow from an operation like that? The math never really worked that well. We can't be too surprised that Verizon backed out. But that also suggests to us that the oligopoly there that we think supports these companies' narrow economic moats is very much intact.
The Canadian government might want more competition. They've tried several times to introduce it, but you've got a country whose land mass is bigger than the United States' with 1/10 the population. You can only fragment that industry so much. Rogers is a name that I'm happy to own now that we've got the Verizon element there, that rumor out of the picture.
And just thinking globally, telecom is not much of a growth industry in most markets, but it is consolidating, and as you see these transactions, where smaller struggling competitors get rolled up into stronger entities, that tends to support profitability for everyone. The fact that telecom companies are expected to pay good dividends, and most of them do, that prevents a lot of capital perhaps from being destroyed by empire building or just reckless growth projects; investors want the cash back. To me, I want some growth, but I don't need a whole lot to own these names.
Glaser: Josh, thanks for your thoughts on the deal today.
Peters: Thank you, too, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.