How Investors Chronicle Fails Its Readers with a Vodafone Sell Recommendation

Posted on 30/01/2011

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The Vodafone building on Fanshawe Street, corn...

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On 18th January Investors Chronicle – a 150 year-old investment journal owned by the Financial Times – made the following trade recommendation on Vodafone, the multinational mobile telecommunications operator:

Vodafone is aiming to push through its yearly highs but may struggle along the way, says Marcus Bullus at www.mbcapital.co.uk. With the shares already stretched on the upside, the realities of a saturated mobile phone market and consumer retrenchment could soon weigh on its showing on the price-charts. Traders should try and sell Vodafone short from current levels (around 178p), placing a tight-stop loss.

This, along with a candlestick chart showing the last two months of Vodafone’s share price, was the extent of the analysis provided, as can be seen from the following link to the original piece: Investors Chronicle City Trade: Cut off Vodafone.  I simply cannot believe that a reputable financial publication can get-away with such half-arsed analysis.  It may well be the case that the mobile-phone market is becoming more saturated and that consumers may retrench, but the IC provides no evidence as to whether or not these trends are actually occurring, nor do they show how such factors may impact Vodafone’s revenues and profitability.  In addition, Vodafone currently has a 4.8% dividend yield and the board is targeting a dividend growth rate of at least 7% per annum over the next three years.  Such a high dividend yield, combined with expected dividend growth means the downside for the Vodafone share price – and therefore the upside for this trade – is likely to be miminal, particularly as Vodafone currently has a dividend cover ratio of approximately 2x.  The IC neglects to mention to its readers that the potential profit on this trade is therefore likely to be negligible.

In addition to failing to warn its readers about the small potential upside on this trade, they also fail to mention any of the possible risks that could send the Vodafone share price much higher.  Vodafone is currently trading at a trailing P/E ratio of 8.3x earnings, which in itself is relatively low for a company which is expected to grow revenues and earnings over time, thus providing the potential for a re-rating.  Because Vodafone owns minority investments in companies such as Verizon Wireless, SFR, Safaricom, Bharti Airtel and Polkomtel, which either pay low or no dividends, Vodafone is unable to access all the cash generated by these companies.  Consequently, a change in dividend policy of these subsidiaries may lead to a re-rating of Vodafone’s shares as the parent would see an improvement in free cash flow received as a percentage of reported earnings.  Also, a sale of any of these assets might also lead to a re-rating, as Vodafone would receive cash today for an asset providing little or no cash flow.

It just so happens that Vodafone is pursuing such a strategy, having begun selling-off assets in 2010 when they received $6.6bn for a 3.2% stake in China Mobile.  Vodafone has pledged to use 70% of the cash to buy-back shares (with the rest being used to repay debt).  Vodafone has also indicated that it may sell its stake in SFR (valued at ~£7bn) and Polkomtel (~£800m).  I would expect to see the Vodafone share price rise as each sale is announced.  In addition, Vodafone’s largest associate – Verizon Wireless – currently pays no dividend at all despite earning EBITDA in FY10 of $26bn.  All Verizon Wireless cash flows in recent years have been used to reduce debt, but this is expected to be fully-repaid in the next 12-18 months, while Vodafone’s partner Verizon is likely to need the cash itself given its own dividend is barely covered by earnings.  The only way for Verizon to access the cash at Verizon Wireless is to initiate a dividend.  With a 50% dividend pay-out ratio at Verizon Wireless, Vodafone would receive approximately £2.4bn, boosting its own free cash flow (defined as cash from operations less capex) by around 30%, giving the business a free cash flow yield of 11.4% based on the current share price.  The initiation of a dividend by Verizon Wireless will therefore – in my opinion – be a significant catalyst for an upward re-rating of Vodafone’s shares, something that I suspect will happen in around 12-18 months.  Not that Investors Chronicle readers are necessarily aware of this. After-all, for a subscription of £145 per annum, what should they expect?

Disclosure: Cautious Bull holds a long position in Vodafone shares.

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