Vodafone and the Verizon anomaly

“The remarkable story of colossal hidden value discovered in one of the most in-depth analyst covered FT100 stocks!”

Spotting a pricing anomaly in the market is essentially what all stock market investors are hoping to find. However, when that anomaly is circa £80bn in magnitude and found hidden in one of the most widely covered FT100 stocks it is truly astonishing. Well, that’s what happened in 2013 with Vodafone, and its lucky shareholders will be receiving over £50bn of this value early in 2014.

That a mis-pricing of this enormity could have occurred is both surprizing and difficult to comprehend. I first spotted that there may be hidden in Vodafone in July 2011 when its long held investment in Verizon Wireless (VZW) paid a ‘one-off’ dividend of which Vodafone received a cool $4.5bn.

At this time Mr Market looked to be valuing Vodafone (LON:VOD) solely on its attractive dividend yield of 5.45% with a share price of circa 155p and market capitalisation of £75bn. This was clearly anomalous; Mr Market appeared not to be putting any value on Vodafone’s 45% ownership of VZW – and yet it had just promised a huge windfall dividend. Vodafone’s market value was completely justified by its already generous dividend yield.

One’s first reaction is that this couldn’t be true, there must be a mistake or something missed, but it was very intriguing and certainly worth a closer look.

How could Mr Market miss Vodafone’s hidden £84bn stake?

Well it’s still difficult to fathom, but the reason appeared to be twofold:
? Firstly Vodafone’s VZW investment was not consolidated into its P&L accounts – it was simply not reported. Thus, anyone scanning Vodafone’s figures in late 2011 would see that its dividend yield was circa 5% - ignoring the additional special dividend of 4p giving a true yield of 8.34% for 2012.
? Secondly, VZW was also a non-performing asset in that it hadn’t paid a dividend for many years (2005 – 2011).

For these two reasons Mr Market had completely discounted Vodafone’s investment in VZW to being essentially worthless.

So what was Verizon Wireless worth to Vodafone?

This again was not easy to assess in 2011, VZW as 55% owned by Verizon Communications (VZ), was fully consolidated into its Balance Sheet and P&L. This meant that VZW figures were not visible in the combined balance sheet. However, the Profit & Loss did at least show the business units separately. What was crystal clear in the P&L was that whilst VZ’s wholly owned fixed line business was stagnating, the 55% owned wireless business was growing rapidly; widening margins, and throwing off cash. A back of the envelope calculation suggested VZW business might be worth a cool £80 billion and Vodafone’s 45% share would be worth ~ £36 billion. It’s now apparent that it’s actually worth a great deal more to VZ but back in 2011 they were very keen to down play this value.

Verizon Communication’s subterfuge

With the good news of the $4.5bn dividend payment it was reasonable for shareholders to expect that VZW might start paying dividends regularly. However, this notion was quickly dispelled. ‘Verizon Wireless dividend hopes dashed’ reported the FT as Lowell McAdams told their journalists there would be no policy for annual dividends (FT 11th Sept 2011). Yet McAdam’s statement did not tell the whole story.

Whilst VZW might not wish to pay dividends annually its parent VZ had a progressive dividend policy and other financial pressures, including an expensive investment programme and a pension deficit. It seemed clear that VZ would need VZW dividends to meet its own obligations. This point was completely missed by the FT and most other analysts and journalists covering Vodafone.

So it was a surprize when only eleven months after paying out $10bn, VZW declared on the 12th November 2012 a further $8.5bn dividend. And it was astonishing that only seven days after Lowell McAdam (Telegraph 4th May 2013) again warned Vodafone’s shareholders of a "lean" year, another $7bn dividend was declared. This flow of cash from VZ could not go un-noticed.
Throughout the summer of 2013 there was a gradual realisation that Vodafone did in fact have a hugely valuable 45% stake in what was VZ’s key asset. This was accompanied by a great deal of press speculation, presumably orchestrated by VZ’s advisors, suggesting that now was the time for Vodafone to sell its stake.

'Vodafone to realise $130BN for 45%interest in VZW’

 Yet, it wasn’t until 2nd September 2013 that the truly remarkable price that VZ was prepared to pay was revealed. Vodafone was to receive the equivalent of £85bn for its 45% stake in VZW. This was equivalent to 85% of Vodafone then market capitalisation of circa £100bn. So this put a value of only HBC 12/25/15 MTN (LON:15BN) on the whole of the rest of its operations – operations that has been generating between £5 – 7.2bn in free cash flow each year over the previous four years. However, the euphoria was short-lived as there was a nasty revelation in the small print of the press release.

The Sting in the tail and the illusive 8% dividend increase

Whilst the press release made great play of the return of value to shareholders and an 8% increase in the final dividend, it was positively misleading on the full implications for shareholders. Not until page three is there mention of a share consolidation. Also, it’s far from obvious that what’s actually intended is a near halving of existing shareholdings. In effect, this is also a near halving of the dividend payment to shareholders. So whilst, there is a celebrated 8% increase of the final dividend to 7.47p per share – it will only be paid-out on half the number of shares (i.e. paid post-consolidation).

To receive the full 11p per share pay-out a shareholder would thus need to take the returned value and re-invest it back into Vodafone shares. It’s clear that many shareholders will not have appreciated these implications and it’s of no credit to Vodafone that this was not made crystal clear. Thankfully, the recent Vodafone Circular is more explicit if not a light-read.

Vodafone’s prospects post-consolidation

The effect of Vodafone’s share consolidation is to drastically reduce the cost of its dividend pay-out. Without the consolidation, Vodafone was already committed to pay-out £3.57bn as a 2014 final dividend, but only £1.9bn as a result of the share consolidation; that including the supposed ‘8% increase’. This is a 47% reduction – so the obvious question is – is it necessary?

Clearly, the economic problems in Europe are having effect but its magnitude has been off-set by growth in other markets and increased efficiency. Vodafone was able to pay a healthy yield over the period 2005 to 2011 when it received no VZW dividends. In fact, its dividend had increased by 7% p.a. from 2010 – 2012 without VZW’s assistance. Looking forward Vodafone is forecasting free cash flow of £4.5 – 5bn once VZW has been sold. So whilst dividend cover was getting tight, the share consolidation restores plenty of headroom with projected dividend cover at 1.7x for 2015.

Future prospects and projections

Vodafone has stated in their Circular a re-commitment to a progressive (i.e. increasing) dividend policy. The proposed share consolidation provides the fire-power for Vodafone to drive forward the share price. In near halving the number of shares the cash earnings per share will near double.

Even without a recovery in Europe there is sufficient headroom to grow the dividend between 50% and 75% with a similar effect on the share price – assuming a consistent yield. Add-in the benefits of their recent acquisitions, the Project Spring investment programme and a recovery in Europe a doubling of the share price looks achievable.

Another key question is where will all the cash be going that Vodafone’s shareholders will receive? With good potential for future growth in the share price an attractive 4.62% yield (on current 237p share price); a lot of that cash just might go back into Vodafone shares.

Disclosure of interest: Maddox is long Vodafone

MaddoxUK2@gmail.com