Vodafone: Inexpensive Defensive

Summary

Vodafone flashed a buy on momentum screening and the price action is justified by positive fundamental developments, while the stock still trades on a cheap valuation.

Planned spin-out of its Tower business creates a significant value proposition along with reduced need for future capital expenditures as 5G spectrum spending nears completion.

New management committed to deleveraging the balance sheet whilst the summer's dividend reset makes the dividend payout ratio more sustainable.

Since the summer, Vodafone (VOD) has gone from $16 a share to $20.5 a share. This stock screens very well on my momentum factor. Given that academic research shows that momentum is a strongly profitable short-term strategy, I wanted to take a closer look at this stock, as I can't buy single stocks on momentum only, I need some fundamental story underlying supporting the investment case.Value opportunity or Value trap?

Vodafone is a mature and capital-intensive business, operating in competitive markets and as such, we can't consider it to be a growth stock. If the recent momentum is not around earnings growth, then what is behind it? Reading up the recent news about the company and the sector, it's clear the market has gotten excited in the last few weeks, at least in part, because "value" stocks have recently become fashionable again, after a long period of under-performance. Vodafone was not exactly a value stock at forward P/E of 22x, but this P/E ratio was more a reflection of depressed earnings (thanks to the weak UK and European economies) than a high stock price in my opinion. Browsing through some earnings estimates, I found UK broker Numis estimating that EPS could go from 5.3c last year to 14.1c by 2022.

Given the capital-intensive and asset-heavy nature of Vodafone's business, price-to-book value is a useful valuation metric to use. Current P/B value is 0.80 compared to its P/B five-year average of 0.88, so that's one metric confirming there is some value on the table. We must also remember that since 2016, UK stocks have generally been cheap due to Brexit uncertainty, so the recent five-year average is a very conservative number to use as a base. Obviously, in theory, fair value P/B should be around 1 if accounting values are up to date, so 0.8 does seem cheap.

How do we know that Vodafone isn't a value trap? What are some potential catalysts for a re-rating? It seems Vodafone's Return on Equity - ROE - has been usually low in recent years while at the same time debt, as measured by net debt/EBITDA does look high. Improvement in these two metrics would prove a massive boost to sentiment around the stock.

Why did Vodafone's shares trough in May?

This appears to be because around this time, the group decided to cut its dividend. At €4 billion last year, the dividend would be too high this year compared to free cash flow and €27 billion net debt. The dividend has been rebased from 15c to 9c which gives the stock a dividend yield of just under 5% and just as importantly, the dividend payout ratio seems to be more sustainable. This reduced dividend also helps to reduce Vodafone's leverage ratio, defined here as net debt/EBITDA, to the bottom end of its 2.5x to 3.0x target range. By reducing the financial risk, management has acted sensibly, ensuring that Vodafone can restore some aspect of defensiveness that the Telecom industry is known for. This, in turn, has helped improve sentiment towards the stock.New clarity on Mast assets sale

The other major headline that has pleased investors is the news around a potential sale of its mobile-phone mast assets. Although this was first announced back in November, there wasn't much clarity back then. In July, Vodafone gave encouraging guidance about the kind of valuation the sale or spin-off should achieve, noting that it had received offers at prices at more than 20 times EBITDA for the division. This greater visibility on value has also helped make the case for a reduction in the conglomerate discount applied to a "Sum-of-the-parts" valuation of Vodafone.

The mast business comprises 61,700 towers located in 10 countries and will become a separately managed business, and this reorganisation should be completed by May 2020. The business is expected to have annual cash profits in the region of €900 million. Vodafone is keeping its options open through either a partial sale through an IPO or a trade sale. The valuation being talked about now for the division as a whole is in the region of €20 billion, which would help Vodafone's balance sheet situation a great deal. The value proposition in the mast business sale, which was previously largely ignored by many investors has buoyed sentiment towards the stock and shown the new management is committed to maximising shareholder value, and shares jumped by about 10% on the day the updated details of the plan were announced.

First quarter earnings announced at the same time as the mast announcement also showed encouraging results regarding revenues from its service business, while the group's core European markets were roughly in line with market expectations and other regions showed improving results.

Specifically, Vodafone struggled somewhat in Italy where the group had to pay €2.2 billion for the spectrum on the new 5G network. The European market is very competitive, and the group has said it is facing these pressures head-on through cost cutting with the target of cutting €1.2 billion from operating costs by 2021 and is on track to meet this target.The Liberty deal

The group has made a bold bet in Germany, which currently makes up 29% of EBITDA, by buying Liberty Global's (NASDAQ:LBTYA) German and Eastern European cable assets. While this is one of the reasons Vodafone's debt has been growing, management believes the investment is justified by making the group more competitive against market leader Deutsche Telekom (OTCQX:DTEGF), especially in the broadband market. It also reckons synergies of €550 million through cost savings can be achieved through the combination of its German assets with Liberty's.

The Vodafone-Liberty deal is potentially the start of a period of industry consolidation in Europe. If smaller players get eaten up and the result is less competitors, reduced competition will enable Vodafone to achieve higher margins in Europe.

Spectrum spending

Another plus going forward is that a period of large capital expenditure is coming to an end, as the auctions for 5G spectrum in Europe are coming to an end by 2021. In the last five and half years, Vodafone has spent nearly €10 billion on 5G spectrum across Germany, the UK, Spain, and Italy. The reduced level of Capex should help ease the pressure on the balance sheet.

In summary, Vodafone has a much smoother runway ahead: announced asset sales, cost savings, balance sheet debt reduction, and an improved trading environment thanks to industry consolidation, not to mention light at the end of the tunnel around Brexit, reducing the overhang on UK stocks, so I do expect the stock's shares to re-rate over the next 12-24 months, and the recent momentum in price action seems justified.

This doesn't mean there are no risks. The Liberty acquisition will, of course, have execution risks. Europe will still be a relatively mature market offering little room for fast growth, and although balance sheet targets are attractive, they still need to be achieved. But, if you can find a value stock, with momentum, that doesn't have any risks, then I tip my hat to you!

Conclusion

Vodafone with its 5% dividend yield looks sustainable now, and potential for capital appreciation of 25% before it gets to book value parity is on course for 30-35% total return over the next one to two years, with further upside potential through a special dividend via the upcoming mast business sale next year. All this with a globally diversified business in a relatively defensive sector means the downside risks are not too high. Buy.

Disclosure:

I/we have no positions in any stocks mentioned, but may initiate a long position in VOD over the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.