I’ve been wrong about Vodafone (LSE: VOD) (NASDAQ: VOD.US) lately. With the shares continuing to rise, my concerns about overvaluation are starting to look silly — particularly to those holding the shares and counting their gains.
Cash challenged
The directors keep saying they expect cash flow to improve but, although overall revenue rose 8.9%, the firm reports free cash flow at break-even or, to put it another way, zero free cash flow.
Work remains to be done on cash flow, particularly when we see that the firm’s free cash flow calculation excludes several hefty items. For example, the calculation ignores expenditure of £167 million on restructuring costs, a £365 million UK pensions contribution payment, £359 million of Verizon Wireless tax dividends received after the completion of the disposal, £328 million of interest paid on the settlement of the Piramal option, £116 million of KDG incentive scheme payments that vested upon acquisition and a £100 million payment in respect of the firm’s historic UK tax settlement.
Add those back in and the ‘real’ free cash flow result is negative.
Grounds for optimism
Vodafone’s Chief Executive sounds chipper about the firm’s immediate prospects. He reckons there is growing evidence of stabilisation in a number European markets, and Vodafone is seeing strong demand for data.
The company aims to deliver wider 3G and 4G data coverage, aided by a two-year, £19 billion investment programme, which is well under way. Improved voice quality and reliability, and increased access to next generation fixed-line services should see customers trade up to bigger data allowances because of an improving experience. If that happens as hoped, forward cash-flow performance could get a boost.
Vodafone’s markets are highly competitive, and regulatory and macroeconomic risks remain, says the man at the top. Yet, with the firm barely halfway through its investment programme, a service more differentiated from the competition is not yet fully realised. Just 6% of European customers use 4G, and over the next 18 months, Vodafone expects to achieve 90% 4G coverage in the region. That creates potential to increase penetration, stimulate data usage and grow customer spend, reckons the chief executive.
Vodafone’s business still seems well placed for growth. The industry has moved beyond mobile voice communications and there’s increasing demand for data transfer, such as texting and internet applications.
Double-barrelled growth prospects
The potential for recovery and up-selling in Europe combines with mouth-watering growth prospects in up-and coming markets such as India to keep investors positive on Vodafone.
Last year Europe delivered around 64% of Vodafone’s non-American earnings, with the rest coming from the fast-growing emerging regions of Africa, the Middle East and the Asia Pacific. However, if Vodafone keeps growing its emerging-market business by double-figure annual percentages, around 50% of earnings could originate from up-and-coming regions within five years.
Such attractions keep Vodafone’s valuation high, along with a little bit of takeover speculation since the firmshed its US assets, I suspect.
At a share price of 221p, the forward P/E rating runs at about 35 for year to March 2016 and there’s a forward dividend yield of 5.3%.
Vodafone still looks expensive. Luckily, there are several other firms on the London stock market with strong trading franchises that can really drive wealth creation if we buy the shares at sensible prices.