Investors like growth and they like dividends. So why isn't Vodafone on a premium rating?
The global mobile phone operator hasn't just forecast high single-digit growth in sales next year. It also expects to hold its profit margins and to freeze its capital expenditure. That should allow it to increase an already attractive dividend.
Yet its shares trade on a forward P/E ratio of just 13. That's about the same rating as the broad UK stock market.
A fear of falling
Investors seem to be preoccupied with two risks. One is that Vodafone won't be able to sustain its growth for long. The other is that its profit margins will actually fall.
Vodafone's growth forecasts depend on its winning new customers, rather than squeezing more revenue out of existing ones. So far, this has worked surprisingly well. The company has expanded in emerging markets while bolstering market share elsewhere.
But there are limits. Vodafone's market share gains, particularly in Germany and Spain, are likely to provoke a fight-back. Its main competitors in these markets, T-Mobile and Telefónica respectively, are now growing so slowly that they are likely to respond sooner or later.
Moreover, new customers spend less on average than existing ones, diluting average revenue per user (Arpu). Vodafone was able to offset last year by introducing bundles that offer lots more minutes for a small increase in price. But there are signs that consumers might balk at buying these if it tries to repeat this trick.
Take the example of the UK. Vodafone's subscribers there can now get 500 minutes a month for £40. At these levels, some users won't be tempted to spend more for extra talk time. And the risk is that rivals could offer the same number of minutes at a lower price. If this happened Vodafone would have to respond. Worryingly, its Arpu has already fallen in Germany; and it barely rose in Italy at the last count.
Hits to margins
Increased competition doesn't just hit growth. It also hurts profit margins. Vodafone's ebitda margin fell by nearly a percentage point in the first half of the year.
The main driver of lower margins has been higher spending on acquiring subscribers. This was felt most acutely in the UK, where 3 – a new entrant to the market using third-generation (3G) technology – has amassed 2.5 million customers. But the pinch has also been felt in other territories.
Regulators have also done their bit, cutting the payments mobile operators receive from other carriers for inter-network calls.
Vodafone is taking action to defend its margins. It is seeking £1.4 billion ($2.7 billion) of annual cost cuts within a few years under a new restructuring programme. Its new 3G tariffs are also designed to balance competing needs – capturing growth and avoiding a price war across the industry.
But there is a catch. Vodafone cannot control all the risks. Its sales target is all about chasing demand. And its margins depend, in part, on how rivals react to slower growth. A 3G price war is still possible.
Investors have certainly factored risk into Vodafone's share rating, judging by the lack of a premium.
There could be several reasons for this. One is trust. Investors were unnerved earlier this year when Vodafone launched what looked like a highly priced offer for AT&T Wireless, a US mobile operator. They were especially upset because the company didn't spell out the full terms of its offer.
Shareholders might also have doubts about cost cuts. Sure, there is fat to trim. But cutting it means getting to grips with a sprawling empire. Then there is the question of whether Vodafone can cut costs fast enough to offset the competitive pressure on its margins. One percentage point of margin is equivalent to £300 million a year.
Investors might be overestimating risks. But they don't seem to be willing to give the company much benefit of the doubt. It will have to prove its doubters wrong if it wants to restore its premium.