We're Calling Vodafone Undervalued

It has now agreed to acquire Liberty Global’s operations in Germany, Romania, Hungary, and the Czech Republic. This deal, if it receives regulatory approval, will significantly strengthen Vodafone’s convergence strategy. However, we remain skeptical of its ability to receive regulatory approval, particularly in Germany. In the past, the German regulators have stopped at least three attempts to consolidate the German cable market. That said, Vodafone claims that the regulatory environment has changed and it expects approval. We think all these deals position Vodafone to compete more effectively. The company has also dramatically increased its enterprise business, which now accounts for 27.7% of revenue and tends to have long-term contracts.

Vodafone has also improved the quality of its networks, enabling it to compete more on quality and less on price. Management believes customers who want the fastest and most reliable wireless network will be willing to pay a premium for that service. We are beginning to see this strategy work, as many new customers are opting for higher-priced packages. We anticipate this will increase as quality becomes increasingly important with the growth of data usage.

Scale and Network Quality Set Vodafone Apart We believe Vodafone has a narrow economic moat as a result of cost advantages and efficient scale. Vodafone is one of the largest wireless phone companies in the world, with 274.9 million proportional customers, excluding India and partnership networks. Where it doesn't have its own operations, it has formed strategic partnerships. More important than its global size is the scale it has within its various markets and the quality of those networks. Thanks to Project Spring, the quality of the company's network is almost always in the top two, allowing it to compete more on quality than on price. As telecom networks are expensive to build and maintain, the more customers an operator has on its network, the more people it can spread its fixed costs over, thus reducing the average cost per subscriber.

Vodafone’s scale also provides it with some advantages over competitors, allowing it to source equipment at lower prices. The company can develop a product in one country and roll it out to others at minimal additional expense. In addition, many countries are selling additional spectrum. Thanks to Vodafone’s scale, it can afford to bid for more spectrum, which improves the quality of its network, thereby attracting more valuable heavy data users. The high costs of building and maintaining a network tend to limit the number of operators in a country, which leads to an efficient scale moat.

In fiscal 2014, Vodafone acquired Kabel Deutschland, the largest cable TV operator in Germany, and in the following fiscal year bought Ono, the largest cable TV operator in Spain. These acquisitions hurt the company’s short-term return on invested capital due to the high prices paid, but they were strategically important. With these deals, Vodafone can now offer converged services in both countries. Likewise, the additional capital expenditures from Project Spring in fiscal 2015 and 2016 hurt ROICs, but the improved network is attracting higher-value subscribers. The faster growth rate in Germany and improved ROICs in fiscal 2017 and 2018 demonstrate that returns are once again improving, and we expect these gains to continue and to be back above the company’s cost of capital in about two years.

In Germany, the acquisition of Kabel Deutschland provided Vodafone with a faster broadband network than Deutsche Telekom, the incumbent telecom operator, enabling it to offer a converged product that is primarily on its own network. While Telefonica’s acquisition of E-Plus made it the largest wireless operator by subscribers, Vodafone has a higher-quality wireless network. The proposed acquisition of UnityMedia from Liberty Global would enhance its fixed-line and broadband capacity further as the combined networks along with planned additional build-outs would pass about 25 million houses or about 67% of the population by 2022.

Similarly, in Spain, the acquisition of Ono provided Vodafone with a fixed-line network to support its wireless operations and provide converged services. Importantly, because Spain is the country that is probably furthest along in the movement to converged services, operating there provides insights into how to compete in other countries.

The U.K. has been one of the slowest countries to move to converged services on the retail side. This was primarily due to no company owning both fixed-line and wireless telecom networks. However, this changed when BT, the incumbent telecom operator, bought EE, the largest wireless operator, in 2016. While Vodafone has to wholesale fixed-line capacity on the retail side to offer a converged service, half of its revenue in the U.K. is from its enterprise business. In 2012, Vodafone acquired Cable & Wireless Worldwide, which provided it with the second-largest telecom backbone in the U.K. for enterprise business, enabling it to offer converged services to its enterprise clients. While there has been lots of speculation that Vodafone could acquire Liberty Global in order to obtain Virgin Media and offer its own converged retail product, we don’t think this is likely, given the relatively small size of its U.K. retail business versus the cost of acquiring all of Liberty Global.

In Italy, there is no cable TV operator, so broadband competition has occurred from multiple operators building out fiber networks. These are beginning to consolidate, and Vodafone has joined its fiber with that owned by Enel and Cassa Depositi e Prestiti. Combined, the network will pass 9.5 million premises with plans to cover 19 million by 2027. While this is enhancing Vodafone’s opportunities to offer converged services, the wireless market is becoming more competitive with the recent entrance of Iliad. While we don’t believe Iliad will have the dramatically negative impact on Italy that it initially had on France, we do expect it will pressure prices and margins.

Overall, we believe with these acquisitions and Project Spring, Vodafone has elevated the quality of its networks to where generally only the incumbent telecom operator can match its network quality. Thus, for customers who are interested in quality, which tends to be those willing to pay a premium, the decision is between just two companies--Vodafone and the incumbent operator--leaving others to fight just on price for lower-quality customers. Over time, we believe this will lead to higher average revenue per user and ROICs and better margins.

Operating in Many Markets Brings Many Issues Vodafone's many markets have different regulatory issues and currencies, which increases the uncertainty of its results. Hence, we give the company a fair value high uncertainty rating. In most markets, Vodafone is the number-two wireless company, making it the focus of competitors. This increased competition is becoming even more critical as growth slows and markets increasingly move to converged offerings, whereas Vodafone was traditionally a wireless-only operator. The company has a clear history of overpaying for acquisitions, as evidenced by the GBP 69.7 billion of goodwill written off since fiscal 2006. The company still carries GBP 22.8 billion of goodwill on its balance sheet. In addition, the Indian government continues to seek $2.5 billion in taxes for Vodafone's acquisition of Hutchison Essar in 2007, despite the Indian Supreme Court ruling that the money is not owed.

Reliance Jio launched as a new well-financed telephone company in India that has acquired extensive amounts of spectrum; it also rolled out fiber in preparation for its launch. While it is late to the game, Reliance is a well-known brand in the country and has given away data for free, causing Vodafone to write down the value of its Indian operation by EUR 5 billion in its quarter ended September 2016. However, Vodafone’s agreement to merge its Indian operations with Idea Cellular will make it the largest wireless operator in the country and offer lots of cost-cutting opportunities that will provide additional cash flow to fight RJio. It also provides a method for Vodafone to reduce its exposure to the country.

Many of Vodafone’s businesses are subject to political, economic, and currency risks, as evidenced by the 2011 uprising in Egypt. Brexit is likely to add volatility to the currency and stock markets. However, with Vodafone moving to the euro as its functional currency effective April 2016, currency volatility should have less of an impact than in the past.