Vodafone: Timely Dividend Cut Brings Valuations To Attractively Low Levels

Having struggled with the twin problem of tepid growth and high leverage, Vodafone's (VOD) 40% dividend cut is a welcome step at this stage. It will help the company stay near the lower end of its 2.5x - 3.0x leverage range, and give it some breathing space to expand 5G coverage through capex investment which it desperately needs in order to sustain long term growth. Vodafone will also utilize a part of ~€1.5B cash saved from the dividend cut to follow through its rapid transformation journey.

Fundamentally, mobile customer churn continues to reduce and fixed broadband customers continue to increase. Yet, the company still lacks clear revenue drivers over the short to medium term.

Spain and Italy also continue to be a problem. The company missed its UK and Spain growth numbers by ~40bps each. The company's ambitious >€1.2B opex reduction target continues to be on track with 1/3rd of the reduction set to be delivered in FY19. The company is heavily investing in digital transformation with 2/3rd of end-to-end contacts now automated through its TOBi platform.

In our view, the company has taken a step in the right direction by cutting its dividend at this stage, which will enable it to re-adopt a progressive dividend payout policy, along with helping reduce leverage and interest costs.

However, we are cautious about the growth trajectory at this point and expect to gain some clarity over the next few months.

We also believe, given the company's strategic and financial heft, that investors will eventually return to the stock with renewed confidence. We think management's decision to cut the dividend was a financially sound one which will pay off in the long run.

FY18/19 Earnings Discussion

The company met FY19 guidance for EBITDA and FCF. Reported revenue declined -3.2% YoY, primarily due to the sale of the Qatar business and FX impact. However, organic revenue increased by 0.3% YoY. Most of the core markets performed in line, but Spain and Italy continued to drag. FX headwinds rendered Turkey and the "Others" segments reporting strongly negative YoY growth figures.

(Source: Earnings Presentation, Earnings Transcript, and Author Research)

Broadband customers, one of the key areas in terms of size and growth, slowed in FY19. The company added just 1 million new customers as compared to the 1.3 million additions in FY18. Broadband growth has moved into a secular downward trend.

(Source: Earnings Presentation)

On EBITDA, the company posted another successful year with a YoY improvement of 50bps in EBITDA margins. This was supported by the company's ambitious program to cut opex by €1.2B, of which €400M savings were delivered in FY19 itself. This was achieved on account of good progress on its digital transformation plans and operating model redesign fronts.

The company has also taken a step in the right direction by signing new infrastructure sharing deals in Spain and Italy. This is on top of similar partnerships in the UK for 5G networks. These will additionally help in saving about €200M in annual capex and opex.

Company's net interest expenses increased by 69% YoY to €1,369M in FY19 from €808M in FY18. The company's adjusted leverage stood at 2.9x at the end of FY19, at the higher end of the 2.5x-3.0x range that the company is targeting to maintain.

Effective tax rate expanded by 380bps to 24.4% in FY19 from 20.6% in FY18. This variance is expected in a company with diverse geographical footprint and changing revenue mix.

Increased interest and tax expenses meant the company underperformed on EPS, which saw a huge reduction of about 55% YoY.

Guidance Discussion

The company has given a relatively modest EBITDA guidance of €13.8M - €14.2M, which implies a 2% growth (mid-point) over rebased FY19 EBITDA of €13.7B and a -1% decline (mid-point) over reported FY19 EBITDA of €14.1B. We believe Vodafone should be able to achieve this on account of the opex cost-cutting program (€400M/annum already in place, expected to increase further in FY20). There will be one-time drags of €100M from IBM deal and €150M from acquiring new international calling license charges and rising costs of the existing ones. Revenue is unlikely to improve in next 1-2 quarters, so growth is mainly expected to come in 2H20. To note, guidance will also be impacted by the acquisition of Liberty's assets in H2.

One of the major focus areas will be de-leveraging to the targeted leverage ratio range of 2.5x-3.0x. The reduced dividend is expected to reduce the current 2.9x to 2.6x over the next three years, while mandatory commercial bonds buyback will add 0.2x. Company's new LTPI 3-year cumulative FCF target of €17.7B is expected to further boost the deleveraging process. We don't think these targets are too ambitious and Vodafone should be able to achieve these targets on its aggressive cost-cutting programs and growth push in 5G-networked data areas.

Valuation Discussion

At ~0.6x Price/Book, Vodafone appears cheap at these levels. Recent financial results have also been affected by one-offs to the bottom line which along with the dividend cut, will not have helped investor perception.

We are of the view that due to temporary impacts and concerns around Vodafone's leverage and tepid growth, the market is over-discounting Vodafone shares. Management seems to have figured out a way to de-lever and push growth in new areas such as 5G. We are optimistic about the company's prospects and thus, believe the stock is undervalued.


Overall, we think management has taken a wise decision to cut the dividend by 40% to provide the company some financial headroom to push Digital transformation, de-lever and move to a progressive dividend policy on account of new revenue and EPS growth realities. FY19 results were mostly in-line, with some consistent growth issues remaining in Spain and Italy markets. FY20 guidance is modest, and we expect the company to meet it, given its cost-cutting focus. There are some risks on future growth and ability to de-lever fast, but still, at ~0.6x book, we think the stock looks compelling at current levels.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.