Vodafone Group (NASDAQ:VOD)

Vodafone is a leading global mobile operator with more than 340m proportionate customers around the world. In recent years Vodafone has added to its core European business with emerging market acquisitions, notably in India and South Africa. Vodafone is increasingly offering integrated fixed and mobile services, and owns fixed-line infrastructure in some markets.

The company’s five year price to volume performance can be seen below.

Fundamental Highlights (FY end March)

The company’s comps will be the key to better near term growth. Vodafone Italy (-19.2%), Spain (-15.9%) and Germany (-8.0%) are all down and will remain key operations that have key wireless access. One key region for the company was Norway, which was 9% calendar growth y/y.

Europe still remains the key region for the company was over 50% of sales stem from this region. Rising mobile demand and slower voice declines thanks to flat-rate tariffs and the end of MTR cuts creates the conditions for a return to growth. VOD seems to have found the bottom in most markets during the past six months.

The macroeconomic backdrop in Europe is uncertain, but the sharp recent drop in commodity prices increased consumers’ disposable incomes at a time when smartphones are becoming increasingly central to modern living. As well, 4G offers a sharp improvement in users’ mobile internet experience.

Outlook

Project Spring is set to re-define VOD’s brand, boost LTE and add revenues. For those who are unaware, this project is being funded from the sale of the company’s stake in Verizon and will be used to dramatically upgrade the company’s wireless coverage through 90% of the company’s network in its five biggest European markets.

The project will redefine the company’s brand as higher quality through faster and more diverse coverage. This change is expected to drive greater net contract adds, LTE adds/upgrades, enterprise market share and ultimately higher revenues. Additionally, this expansion is expected to boots data traffic/volumes on the network with are a high margin product for the company.

Project Spring places VOD Europe in the “sweet spot” during the LTE growth phase. The company will strive to be synonymous with 4G. Other European operators with lower LTE coverage could miss out on much of the highly profitable growth phase. As precedent, the early and best LTE network built by Verizon was key to securing its high LTE market share in the US.

Economic Moat Trend

With just 6% of European subscriptions paying for 4G services, LTE penetration is expected to provide significant upside in Europe. In comparison to the US, Verizon Wireless has 60% penetrations in LTE services, indicating huge growth potential for the current market. This is likely to be further compounded by the massive infrastructure upgrade related to Project Spring.

VOD claims that it will add 1.5 percentage points of penetration (ppts) each quarter in the next years, which is likely quite a conservative estimate. Analysts are predicting a rise of 35 ppts in the next three years. The release of the Iphone 6 will be a catalyst for the company as the new feature have heightened demand and increased data usage.

European wireless EBITDA margins (35% of service revenues) are considerably lower than those of Verizon. Incremental data revenues have generated an EBITDA margin of about 75% for the US market leader. Assuming a similar ratio margin for data in Europe would imply operating leverage of 2.1x that gives an EBITDA growth rate that is more than double that of revenue increases. All in all, the EBITDA margins in Europe have plenty of upside.

Margins have been highly erratic over the past 10 years (as shown above), but the positive momentum gained in recent years will likely continue in the medium to long-term.

Major Risks

  1. Incumbents in the market (TI, DT, BT) could replicate the success of Telefonica’s Fusion (quad play) in other VOD markets (Italy, Germany, UK), leading to the company’s share loss and deflation to average revenue per user.
  2. The high level of competition in this industry leads to heavy price competition. Forced price competitions to compete will likely have a negative affect on the company’s earnings
  3. The company is still highly exposed to macroeconomic trends in Europe and any further downturns could lead to reduction in the number of new wireless devices and subscriptions being sold.

Investment Rationale

Top line growth is likely to dramatically improve from (-4.2% 1Q14) to (2.8% 4Q15) driven from Project Spring, LTE, easy comps and an improved macro setting. Furthermore, turnover from developing markets will deliver better network and profitability as seen in previous companies.

Vodafone currently trades at $35.88 (price as of Jan 28th) and looks attractive with potential upside in the medium term on the basis of growth opportunities and dividend yield (5% March 2016e).