Vodafone was one of the first companies to join the UK Value Investor model portfolio way back in 2011.
At the time, Vodafone was a steady dividend growth stock with an attractive 5.5% dividend yield; but much has changed since then.
The company itself has changed, following the 2013 sale of its 45% stake in Verizon Wireless. This produced a windfall of $130 billion, much of which was returned to shareholders.
Note: This sale was largely responsible for the 55% decline in the value of the Vodafone’s shares, but that decline was effectively offset by a related return of cash and shares.
The company’s track record has also changed, with Vodafone’s revenues, profits, dividends and capital assets all stalling or going into decline over the last few years, while its borrowings continue to go up.
And my investment strategy has changed, or more accurately it has evolved considerably since 2011. Over the years I’ve added investment rules for profitability, capex intensity, indebtedness and other factors, and Vodafone now struggles to pass any of these ‘quality company’ standards.
In fact, Vodafone is no longer a good fit with my investment strategy, primarily because of its weak growth, weak profitability, high debt levels and high capex requirements. And that’s why I’ve finally decided to sell.
Buying Vodafone: The world’s largest mobile communications company
Vodafone started out in the early 1980s as a joint venture with the aim of commercialising military mobile communications technology. The UK government had just started to sell mobile phone network licences and Racal Telecom (as Vodafone was then known) was the second company to acquire one.
The company joined the UK stock market in 1988 and spent much of the 1990s growing both organically and through a series of acquisitions. The peak of this era was marked by Vodafone’s £112 billion acquisition of Mannesmann, which turned Vodafone into the world’s fourth largest company with a market cap of £224 billion (or about £320 billion, adjusted for inflation).
Interestingly, that (inflation adjusted) £320 billion price tag came at the peak of the dot-com tech bubble, when investors everywhere were buying anything vaguely internet or tech-related. Today, almost 20 years later, Vodafone’s market cap is barely a tenth of its year 2000 peak. So if ever you need an example of the madness of crowds, just look at Vodafone’s dot-com share price.
Inevitably Vodafone’s share price tanked during the dot-com bust, but the company continued to expand. It did this through ‘partner networks’, which allowed it to offer telecoms services overseas without having to invest in expensive infrastructure.
By the time Vodafone crossed my radar in 2011, it had an impressive track record of growth, which you can see in the chart below:
The company also had what appeared to be reasonable debts, with a net debt to operating profit ratio of less than three (£30 billion net debt and £12 billion operating profit, to be precise).
This picture of steady growth and low debts was exactly what I was looking for. I wanted to invest in large, successful and well-known companies with long histories of progressive dividend growth, and Vodafone offered all of that and more.
However, fast forward to today and this investment in Vodafone has not exactly set the world alight. Annualised returns have been okay at just over 8%, but much of that was down to luck with special dividends and the large return of capital following Vodafone’s sale of its 45% stake in Verizon Wireless.
Without the special dividend and Verizon Wireless windfalls the results would have been much worse. That would have more accurately reflected Vodafone’s financial performance since 2011, which has been weak at best and shareholder value destroying at worst.
Given Vodafone’s weak performance and recent dividend cut, the rest of this post-investment review will focus on why, with the benefit of experience and hindsight, Vodafone should never have entered the portfolio in the first place.
Mistake 1) Ignoring Vodafone’s weak profitability
Back in 2011, I didn’t pay much attention to profitability. I did look at Vodafone’s return on equity (ROE) and return on capital employed (ROCE), but according to the somewhat messy spreadsheet and notes I created at the time, neither of those ratios affected my decision to invest.
I eventually decided to add profitability (specifically the ten-year average return on capital employed) into my investment process in 2014, after seeing Tesco struggle and hearing some sound arguments for ROCE as a measure of quality and competitive strength.
More recently, I’ve added net return on sales (or net profit margin, i.e. net profits as a percentage of revenues) as a second profitability metric. The idea was to put in place an additional barrier against weak companies, as well as companies where small movements in revenues have a dramatic impact on profits.
My current minimum standards for these ratios is 5% for return on sales and 10% for return on capital employed, both averaged over a ten-year period.
With the benefit of hindsight we can go back to Vodafone and calculate its return on sales and capital employed to see how it would have faired against those standards way back in 2011.
Let’s start with the good news. Vodafone’s average return on sales to 2011 was 19%, which is comfortably above my 5% standard. However, the company’s return on capital employed averaged a far less attractive 6%, which is below my 10% standard.
Vodafone’s weak returns on capital employed highlight an unpleasant truth about this and many similar telecoms companies: They need lots of expensive tangible and intangible assets (e.g. mobile phone masts and licences to use various parts of the electromagnetic spectrum) to provide telecoms and other services to customers.
In Vodafone’s case, this situation was made even worse when it acquired the assets of other companies at extortionately high prices. This ‘acquisition premium’ ends up on the balance sheet as intangible ‘goodwill’ (totalling an incredible £106 billion in 2002), but be in doubt that the cost to investors is all too tangible.
Having been around the block a few times since 2011, I now also realise that companies with low returns on capital employed often have high levels of debt. This situation usually occurs because the company’s thin profits are not enough, on their own, to fund the necessary investment in capital assets to drive growth. And being too lenient with Vodafone’s debts was my second mistake.
Mistake 2) Failing to spot Vodafone’s large debts
As I’ve already mentioned, in 2011 I did look at Vodafone’s net debts. These came to £30 billion, which is a lot. But compared to its adjusted operating profits of £12 billion it isn’t all that much.
However, a few years ago I realised that my debt rules, as they were in 2011, were woefully inadequate and far too lenient. After several iterations, my current approach is to look at total debts rather than net debts (i.e. debt offset by cash), and to compare those total debts against the company’s ten-year average net profit (i.e. profit after interest and tax) rather than operating profit (profit before interest and tax).
These small adjustments in focus make a big difference to the amount of debt a company can have and still be called ‘prudent’.
In Vodafone’s case, its total borrowings in 2011 were £38.3 billion compared to net debts of £30 billion. On the profit side, Vodafone had ten-year average net profits of £6.7 billion, compared to 2011 operating profits of £12 billion.
So with total borrowings of £38.3 billion and average net profits of £6.7 billion, Vodafone had a debt-to-profit ratio of 5.7, which is materially higher than my current limit of five.
With the benefit of hindsight, it’s clear that by this stage of the analysis Vodafone wouldn’t have made it into the model portfolio. It’s profitability was too weak and its debts were too high. However, there was an even bigger mistake which stopped me from seeing Vodafone as a loss-making basket case, rather than the steady growth company I thought it was.
Mistake 3) Looking at Vodafone’s adjusted earnings
Many companies calculate adjusted earnings because it allows management to show the ‘underlying’ performance of the company, without the skewing effect of non-recurring items such as acquisition-related costs or profits on the sale of fixed assets (e.g. buildings, phone masts, etc.)
Back in 2011 I based my calculations on adjusted earnings because they tend to be smoother year-to-year than reported earnings, and smooth earnings was what I was after.
But the flaw in that plan is that many unpleasant expenses fall into the ‘one-off’ or ‘non-recurring’ bucket, and those expenses can be conveniently ignored by management through the use of ‘adjusted’ earnings.
In Vodafone’s case, some very large differences between its adjusted and reported figures occurred between 2002 (which is as far back as I would have looked in 2011) and 2007. On an adjusted basis the company produced adjusted net profits of almost £34 billion during that period, but on a reported basis the company made a loss of almost £52 billion over those six years.
That colossal £86 billion difference was, as is so often the case with highly acquisitive companies, due primarily to a mixture of goodwill amortisation and impairments. These are non-cash charges, so management were able to say with a straight face that the company was performing well on an operational basis. That may have been true, but I wouldn’t trust a company, its culture or management where they could lose £86 billion of shareholder’s money and still be upbeat.
In fact, the money Vodafone lost following its period of acquisition madness was so large that the company made a net loss of £25 billion for the entire 2002-2011 period. If that isn’t a horrendous performance then I don’t know what is. But if you only looked at the company’s adjusted results (as I did) then you would have been completely unaware of (or at least unappreciative of) just how bad Vodafone’s reported results were.
If I’d looked at reported earnings rather than adjusted earnings then Vodafone, with its negative ten-year reported earnings, would have had negative ten-year profit margins and returns on capital in 2011, and an infinite debt-to-profit ratio because it hadn’t made any profits.
If I’d carried out this analysis in 2011 then at this point Vodafone would definitely have found itself entering my dustbin rather than my portfolio. But having bought Vodafone, there was still one final mistake to make.
Mistake 4) Holding Vodafone when I should have sold long ago
As my investment strategy evolved and as Vodafone’s growth stalled, it became increasingly clear that Vodafone was not the sort of company I wanted in the model portfolio.
By mid-2018, Vodafone was the lowest-ranked holding in the portfolio, according to the UK Value Investor stock screen. On top of that, it’s growth rate, profitability and debt ratio had all been ‘too low’ since mid-2017. Despite all this, I continued to hold on until a few days ago. Why?
This is actually quite difficult to answer, because you have to tease out the underlying drivers of a complex and subjective decision, and that isn’t easy.
There are several reasons why I didn’t sell Vodafone a year or two ago and, yes, a desire to avoid selling the company at depressed valuations was one of them. However, the main reason is that there was a disconnect between Vodafone’s consistently weak performance and the consistently upbeat statements from the company’s now ex-CEO.
For example, the company’s per share capital employed (the value of productive assets funded by shareholders and debtholders) and revenues (the amount of money coming into the company from customers) declined between 2010 and 2019. As for profits, Vodafone continued to produce huge reported losses every few years. Over the same period, the company’s debt ratio continued to go up, until today its debts are 19-times its average profits. None of this is good, and yet the ex-CEO continued to talk about “sustained momentum” and “confidence in the outlook”.
I couldn’t understand why the now ex-CEO would be so upbeat when the company’s results were so patently terrible. So while Vodafone’s share price declined from 230p in early 2017 to 120p in May of this year, I waited because I wanted to see how things would pan out. Either the ex-CEO was right and Vodafone’s performance would eventually improve, its dividend would be sustainable and the 9% dividend yield would drive a major increase in the share price. Or, the ex-CEO was wrong to be so upbeat, the dividend would prove to be unsustainable and the share price would remain, perhaps correctly, at very depressed levels.
Well, now we know the answer to that conundrum. Following Vodafone’s recent dividend cut, it seems clear that the ex-CEO was wrong to be so upbeat. The company’s performance over many years has been terrible, its rising debts were probably unsustainable and its weak returns on capital suggest the need for a major efficiency-driven transformation, funded in part by a dividend cut.
A few paragraphs ago I said that holding on to Vodafone for too long was a mistake. But I don’t actually think it was.
My investment strategy and stock screen have gone through quite a few changes since Vodafone was purchased in 2011, and I wanted to see if Vodafone’s low rank on the stock screen was correctly ‘predicting’ that the company was now a low quality value trap. In this context I think holding on to a weak company was, in this very specific case, the right thing to do.
Having now seen that the stock screen was a better predictor of Vodafone’s future than the ex-CEO’s upbeat statements, I’m more willing to trust the stock screen any my own gut feelings as to whether a company is above average, or not.
In future, if one of the portfolio’s holdings has a very low stock screen rank, very weak fundamentals and my gut tells me it’s unlikely to do well without a major turnaround effort, I’ll jettison the company much more quickly than I did with Vodafone, regardless of how upbeat its CEO continues to be.
As for Vodafone, I’ve removed it from the model portfolio and my personal portfolio and the proceeds will be reinvested into a new investment next month.
John you are in good company. I meant to sell Vodafone at 240p and held on hoping in would make it back to 300p. Big mistake, I ended up selling where you did. In future I think if I realise I am holding a bad company I will just sell immediately and buy something better.
John Kingham says
Hi Andrew, great minds think alike (or not, in this case!)
Historically I’ve had a tendency to hang on ‘hoping’ for some sort of turnaround, but as Buffett has said, turnarounds seldom turn.
I’m gradually becoming less accepting of weak companies, and like you I now think the best approach is to just jettison them if you really think they’re not a very good company (and not just because the share price has gone down).
Obviously this is a judgement call more than anything else, but after almost ten years of doing this I think I’m starting to get the hang of it.
Recently I’ve come to the conclusion that good corporate governance of a company should be given the same degree of attention as the consolidated accounts of a company.
Good corporate governance ensures that remuneration is fair and square so that talented management is retained but only rewarded when they sustain the profitability of a company i.e. free cash flow. Note I say profitability because any fool can grow revenue but generating copious amount of cash is another affair.
The other thing management should be able to do is to maintain; market share, increase the price of product/service and lower the cost. When a company fails to mention any of these points to me it indicates that the management is not acting in the best interest of the company and its shareholder.
The board structure should be given equal consideration after all NED of a company should be acting in the interest of the shareholder but if the nomination structure is skewed chances are good old nepotism is at play.
Interestingly if you look at the corporate governance of M&S and Wal-Mart in mid-90s you can see a clear difference in behaviour. Ultimately the shareholders paid the price for M&S egotistical behaviour. I also think companies like Vodafone have similar issues.
John Kingham says
The incentives are what really matter, and there’s no consensus on what the best approach is. If you pay the CEO millions then they get that money regardless of performance.
If you base CEO pay on performance metrics (EPS, profit, total shareholder return, etc.) then that can skew their decisions, and not necessarily in the direction of added shareholder value.
What you really want is a CEO who works because they want to see the company succeed, and not just because they want to maximise the size of their pay packet. But exactly how you do that is not clear (at least it isn’t to me). And making them hold massive positions in the company’s shares isn’t the way to go either (I think), because you might make them excessively risk averse.
Personally I’d go with some maximum multiple of the median UK wage (say 10x) and if they want more than that they can take a long walk off a short plank. But I’m not sure that idea would go down well with those who believe in hiring the ‘best’ (i.e. most expensive) talent.
IMHO those who expect to be paid the best turn out to be best only at trousering the cash.
Those who are good at working at a company are those who do so quietly and without fuss and massive reward. So I always look at CEO remuneration after noticing all the biggest company collapses tended to have “the best” CEOs – what are they in it for? Themselves or the work?
John Kingham says
Hi Andy, yes that’s been my experience too. There’s also a lot of evidence to show that if you incentive people primarily with target-driven bonuses they’ll do whatever it takes to achieve those targets, regardless of the collateral damage.
Bob Barnacle says
Vodafone has been on this investor’s radar for several years, not least because of the Dividend Yield; but the lousy profitability mentioned in the article, prevented a purchase.
Prompted by discussions on the CityWire Forum around a disheartened VOD investor, and by an article in The Times; took a fresh look at the numbers.
The profitability remains lousy, but was struck by the Price to Book, which suggests if the assets are priced anywhere accurately, then Vodafone is currently on offer at a substantial discount to assets.
Being keen to build Infrastructure exposure against a backdrop of the popular Infrastructure ITs being way over-priced, and having recently lost MANX and KCOM, to infrastructure predators, we took a small initial low conviction stake in VOD on 04/07/19, with a view to add on renewed price weakness.
Now hasten to add that this investor’s analysis pales in comparison to your own; but it will be interesting to see how matters progress.
Certainly am not confident am will now be taking extreme caution.
Thanks as always.
Bob Barnacle says
P.S. It was good to see that you came our well ahead due to those dividends.
John Kingham says
Hi Bob, as you say it will be interesting, mostly around how VOD will try to increase ROCE by leasing out towers and other infrastructure.
If that works then perhaps a reasonable price to book ratio is due, but if not then I think the company should focus on returning cash to investors so they can reinvest it at higher rates of return than VOD is capable of.