Vodafone Group Plc (ADR) (VOD): Income Stock or Value Play?

LONDON — Vodafone Group Plc (ADR) (NASDAQ:VOD) is a popular stock with income investors, but some shareholders have become concerned at the increasing fragility of its cash flow.

Free cash flow
It’s worse than you think. Analysts look at free cash flow — operating cash flows less capital expenditure — to assess a company’s ability to keep funding its dividend. But the free cash flow figure that Vodafone Group Plc (ADR) (NASDAQ:VOD) reports is an idiosyncratic measure including income from associates it doesn’t control, mainly U.S. joint-venture Verizon Wireless, but excluding license and spectrum payments it’s obliged to make. Reverse those items and the picture looks like this:

Metric 2010/11 2011/12 2012/13
Vodafone’s own free cash flow 2.6 3.5 1.1
Income from associates 1.5 4.0 4.8
Dividends paid 4.5 6.6* 4.8

Numbers in billions of pounds. *Excludes 2 billion pound special dividend.

Vodafone Group Plc (ADR) (NASDAQ:VOD)Problem
Newbury, we have a problem. The cash from operations controlled by Vodafone Group Plc (ADR) (NASDAQ:VOD) falls woefully short of supporting the dividend. No wonder income investors such as Invesco Perpetual’s Neil Woodford have bailed out.

Vodafone Group Plc (ADR) (NASDAQ:VOD)’s Southern European businesses are suffering from deep recession, while the firm has strategic weaknesses as consumers devour more data and incline toward services that bundle mobile with Internet and TV. Vodafone Group Plc (ADR) (NASDAQ:VOD) CEO Vittorio Colao sees a fix in buying European cable operators like Kabel Deutschland and Fastweb, but a bidding war for Kabel could be expensive. It’s a shame Vodafone Group Plc (ADR) (NASDAQ:VOD) doesn’t have a better track record in acquisitions.

One purchase has proved a spectacular success. Verizon Wireless’ majority shareholder has reportedly offered $100 billion to buy out Vodafone’s 45% interest, and some analysts have put a figure of $130 billion or more on the stake. It’s impossible to value Vodafone without taking into account VZW’s value, which is in Vodafone’s books at just $38 billion.

$100 billion equates to about 130 pence per share. $130 billion would be 170 pence. Estimates of the tax on a sale have varied wildly, but it’s fair to assume the company would net something in this range if a deal were struck.

That begs the question, what is Vodafone’s value without VZW? Despite a history of big impairment charges, it’s reasonable to start with its adjusted EPS. My back-of-an-envelope calculation, assuming a 20% tax rate on dividends Vodafone receives from associates, splits adjusted earnings thus:

Metric 2010/11 2011/12 2012/13
Adjusted EPS 16.7 14.9 15.6
Less: EPS due to associates 7.8 7.8 10.5
Vodafone’s own EPS 8.9 7.1 5.1

All figures in pence.

Applying Vodafone’s 11.5 projected P/E ratio to earnings of 5.1 pence suggests a value excluding VZW of around 60 pence, or 80 pence if you take the 7 pence three-year average EPS. Adding 130 pence to 170 pence for the VZW stake values Vodafone in the range of 190 pence to 250 pence, compared to its current market price of 185 pence.

A different person on a different day would come up with different figures, but the message is clear: Vodafone may no longer be a reliable income stock, but it could be a value play.

The article Vodafone Group: Income Stock or Value Play? originally appeared on Fool.com.

Fool contributor Tony Reading owns shares of Vodafone. The Motley Fool recommends Vodafone.

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