Vodafone: A High-Yielding Telecom Facing Growth Challenges

Vodafone (VOD) was founded in 1984 in the U.K. and has grown into one of the world’s largest telecom conglomerates. 

Along with its joint venture partners, the company has about 625 million mobile customers, 27 million fixed broadband customers, and 22 million TV customers throughout Europe and dozens of other countries worldwide.

Mobile services, which enable customers to call, text, and access data, account for nearly 70% of Vodafone's revenue and an even higher proportion of profits. Fixed line services include broadband, TV offerings, and voice and account for most of the remainder of the business.
Source: Vodafone Investor Presentation
Vodafone operates in about two dozen countries, but Europe accounts for more than 75% of the firm's revenue. The company is especially dependent on Germany (30% of sales), the UK (13%), Italy (13%), and Spain (10%).

Business Analysis
Telecom is largely a scale business due to the industry's capital intensity and low pace of growth. Operators must invest heavily to maintain competitive wireless networks and deliver internet and TV services. For example, Vodafone's capital expenditures routinely exceed $6 billion per year, or about 16% of its sales.

Meanwhile, with low population growth in developed markets and generally high penetration rates of wireless, broadband, and TV services, new customer growth is often hard to come by.

As a result, it's very difficult for new entrants to acquire the subscriber base needed to fund the network infrastructure and spectrum licenses necessary to compete with the incumbents, effectively keeping them locked out of the market.

Simply put, it's a lot easier to maintain an existing large base of subscribers in a mature market than it is to build a new base from scratch. Especially when various services can be bundled together to provide customers with greater value and fewer reasons to consider switching providers.

As the number one or two mobile operator in most of its markets and Europe's largest next-generation network provider, Vodafone enjoys an entrenched competitive position and should remain a cash cow for years to come.

However, the European telecom market, which accounts for nearly 80% of Vodafone's revenue, is much more fragmented and challenging than America's. Regulators in Europe have historically wanted to maintain a more fragmented marketplace to drive greater price competition.

Europe and America have similarly sized telecom markets. But while Verizon, AT&T, T-Mobile, and Sprint generate almost all of the U.S. wireless industry's revenue, Europe has more than 100 telecom firms spread across its member states, which are reluctant to give up control overseeing their own industries.

This results in more intense competition and makes it difficult for operators to generate the profits they need to invest in new infrastructure and meeting rising demand for data usage.

In fact, while North America has upwards of 90% coverage of 4G networks, Europe remains stuck at around 60%, and there are concerns that the region will be at a competitive disadvantage implementing 5G as operators worry about recouping the substantial investments required.

Vodafone has responded to these challenges by making numerous acquisitions to increase its scale and gain synergies, implementing efficiency plans to free up more capital for upgrading its networks (especially for 5G), pursuing network-sharing agreements to save costs, and investing in emerging markets.

Overall, the European telecom market seems likely to continue providing more challenges than opportunities, even for some of the largest firms such as Vodafone. The company is unlikely to ever achieve much more than low single-digit sales and earnings growth, and much of its cash flow will need to be plowed back into 5G investments.

Key Risks
Vodafone's business will probably remain challenged by difficult regulatory environments and unfavorable demographic trends across its core European markets, especially in Spain and Italy which account for nearly 25% of sales and have some of the weakest fundamentals.

Meanwhile, Vodafone's capital allocation track record does not inspire much confidence in management's M&A strategy. Since 2009 Vodafone has recorded more than $50 billion in impairment charges, which essentially recognize that an acquired asset is now worth less than what Vodafone initially paid for it.

In July 2019, Vodafone paid about $21 billion to acquire Liberty Global's cable TV and broadband internet businesses in Germany, the Czech Republic, Hungary and Romania. If management is unable to realize their expected cost synergies, or if cable TV subscriber growth takes a turn for the worse, then this could be another deal that goes astray for Vodafone.

Regardless, an acquisition of this size significantly increased Vodafone's leverage. This contributed to management's decision in May 2019 to reduce the company's dividend by 40%, which allowed Vodafone to prioritize faster deleveraging and improve its financial headroom as it looked ahead to costly 5G investments.

While the firm still maintains an investment-grade credit rating, paying down debt will remain a core focus in the next few years to get to management's leverage target, likely keeping its pace of dividend growth to a minimum.

Closing Thoughts on Vodafone Group
Vodafone is one of the world's largest telecom companies, with an entrenched presence in its core European markets. However, compared to America, this is a difficult region to compete in due to its higher fragmentation and less business-friendly regulators.

Combined with Vodafone's need to continue deleveraging and invest heavily in 5G, conservative income investors might want to steer clear in favor of more dependable telecom businesses such as Verizon (VZ) which have clearer paths to profitable long-term growth.

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