Questor share tip: Vodafone a hold for income

Vodafone
219.05p+11.2p
Questor says HOLD

Vodafone [LON:VOD] investors are holding shares in a lower profit, lower dividend and higher risk investment proposition.

However, Questor believes long-term shareholders would do well to follow our previous recommendation of “Keep calm and hold” during the telecom giant’s period of change.

Operating mobile networks is a nice business to be in. Once a company has invested in its infrastructure of masts and wires it can generate plenty of cash from a stable customer base. However, Europe is proving to be a very tough market.

Vodafone has the opportunity to consolidate its position in the European telecoms market by buying rivals on the cheap with the cash it received from selling US business Verizon Wireless in February.

The challenges facing Vodafone after the sale of its US business are big. It has to buy or die. The company needs to use the spare cash from the Verizon deal to expand its operations in Europe and emerging markets, or risk becoming a takeover target itself.

Vodafone has already completed a deal to acquire Spanish operator Ono for about £6bn, but this won’t improve its fortunes overnight. Europe remains an incredibly tough place to do business. Second-quarter revenues fell 3.4pc in Germany, 9.7pc in Italy, 3pc in the UK and 9.3pc in Spain, Vodafone said yesterday in its results for the six months ended September 30. Total revenues for the first half were down 8.9pc to £20.8bn.

Long-term investors should look past the falling revenues to the company’s customers, who will regularly pay for the service. Vodafone should be able to reduce costs and improve profits over the coming years in the businesses it acquires.

The other strategy Vodafone has is to spend large amounts on speeding up its service, the logic being to charge higher prices for a premium service. This would in effect create a two-tier mobile network, one with superfast speeds capable of streaming videos and television, and another that runs much slower. The company is spending £19bn upgrading its network through a venture it calls “Project Spring”.

Vodafone said its superfast 4G coverage in Europe is now 59pc, or 10.5m customers across the group, up from 32pc previously. The company is also expanding its broadband and TV offering to the European market.

Investors are exposed at the moment because there is so much uncertainty around Vodafone’s future profit levels. The shares are trading on about 34 times forecast earnings per share of 6.14p, which is highly overvalued for a company forecast to increase earnings per share by about 1pc during the coming 18 months. Part of that premium is down to the potential of a bid, the other reason is Vodafone can still boost revenue and earnings from future acquisitions.

The company tentatively hinted at its confidence in its future performance by increasing the interim dividend by 2pc to 3.6p; and with the market expecting the full-year dividend to be 11.3p, that offers a prospective yield of 5.2pc.

Vodafone is on course to become a lower-growth Europe and emerging markets focused mobile company. That is no bad thing if it can achieve scale, a strong market position and drive higher prices through its premium service. With such an acquisition strategy there is always the risk of overpaying and this will prove extremely painful for investors.

Given the mixed outlook on trading in the core business, the high valuation and the risk around transaction, we can’t recommend buying.

Questor recommends holding until we get a clearer idea of future profits.