(*Underlying. All figures exclude goodwill amortisation)

Something worth highlighting with Vodafone's profits is goodwill amortisation. To recap, goodwill is technically defined as 'the difference between the costs of an acquired entity and the aggregate of the fair value of the entity's identifiable assets and liabilities.'

As noted last week, Vodafone has been very acquisitive and the resultant goodwill amortisation -- essentially the cost of the goodwill associated with purchases spread over several years -- affects the reporting of progress significantly. For instance, during the year to March 2004, Vodafone reported a statutory (i.e. including goodwill amortisation) loss of £9.0b, while excluding goodwill amortisation, an after-tax profit of £6.2b was registered.

What's important to remember is goodwill amortisation is a pure bookkeeping item and not a cash charge (the cash was expensed at the time of the acquisition). Prospective investors therefore should look at profits excluding goodwill, but (as shown below) include goodwill when assessing how efficient the company's has invested its money in the past. Read more on goodwill.

Margins

Backing up last week's coverage of Vodafone's competitive strengths is a high operating margin. Over the past five years, an operating margin of at least 30% has been recorded.

However, accounting nuances in respect of joint ventures and associates seriously distort the margin calculations. The most glaring example is how Vodafone's stake in US operator Verizon Wireless is reported. The bookkeeping reasons are complex, but the upshot is Vodafone's 2003/4 books show the US operation contributing zero to group revenues but £1.4b to operating profits.

Vodafone thankfully provides 'proportionate' figures, which represent the company's aggregate share of revenues and profits from all of its subsidiaries and equity interests. For 2003/4, proportionate revenues were £39.4b and EBITDA was £15.1b. A bit of guesswork to determine a proportionate depreciation charge subsequently gives a proportionate operating margin of around 25%. Save for the loss making 'other Americas' region, the proportionate margin at Vodafone's other geographical divisions ranges from 16% in Japan to 40% in Italy

Vodafone has not been without its exceptional items. One of the largest in British corporate history was levied during the 2001/2 financial year, when the firm wrote off a bevy of investments totalling £6b. That aside, the other one-off charges have been minimal when set against overall profitability.

Cash flow

This table shows Vodafone's cash flow profile:

Vodafone enjoys superb working capital traits. The net change in stocks, debtors and creditors has traditionally been minute compared to operating profits.

With the network rollout continuing, capital expenditure is a different story. In the past five years, net cash spent on fixed tangible assets has on average exceeded the depreciation charge by 58% and represented a sizeable 50% of operating profits.

Capex in the year to March 2005 will continue to be heavy -- Vodafone forecasts £5b. That said, £1.75b of it will be 3G-related, which could be deemed 'expansion' rather than 'maintenance' expenditure.

Interestingly, deep within the 2003/4 accounting notes a statement declares: 'Capital expenditure is heaviest in the early years... but in most countries is expected to fall below 10% of revenues by the year ended 31 March 2008'. With 2003/4 tangible capex at £4.4b and revenues at £33.6b, either the former is set to fall dramatically or the latter improve dramatically in the years ahead. Sounds quite promising either way.

A good sign of reliable cash generation, sensible management and perhaps a cheap share price was the introduction last year of a share buyback programme. Just over £1b was spent between December 2003 and March 2004, with another £3b earmarked for the year to March 2005. Some pundits suggest this programme could be enhanced significantly.

Balance sheet

Another plus within the accounts is the relatively low level of debt. Net borrowings at March 2004 were £8.5b (versus operating profits of £10.7b) and net interest payments of £714m in the preceding twelve months were covered a very manageable fifteen times. No worries either with the group pension scheme. The FRS17 position at the end of March 2004 showed a pre-tax shortfall of just £165m.

Where the books fail to inspire is return on equity. Adding back the goodwill written off and amortised over the years, Vodafone's shareholders' equity base averaged about £176b during 2003/4. Underlying earnings last year were £6.2b, thus giving a paltry return on equity of 3.5%.

By far the dominant balance sheet items as at March 2004 were intangible assets. They comprised of £79b of goodwill and £15b of 'licence and spectrum fees'. It's clear Airtouch, Mannesmann and all the other corporate deal doing have provided sub-standard returns. That's not too surprising after, for example, £101b was spent on Mannesmann in 2000, when in 1999 the German operator recorded earnings of only £326m.

Management

Responsibility for Vodafone's poor reinvestment returns of late rests with former boss Sir Chris Gent. But long-time shareholders probably hold Sir Chris in high esteem, given he transformed an obscure Racal subsidiary into the mobile phone giant seen today. For prospective investors such as the Qualiport however, it's replacement Arun Sarin that counts.

Having only been appointed chief exec last year, the jury remains out on Sarin's talent. Certainly his prompt implementation of the buyback strategy is a welcome move. But this year's attempt to buy AT&T Wireless for £19b indicates old company habits die hard. It's also worth pointing out that Vodafone's whole management team was nurtured under Gent -- the six executives (there are nine non-execs) have served an average of seven years on the board in one way or another.

The boardroom also holds enough shares to matter. At March 2004 it owned 10.7m shares (about 0.02% of Vodafone's share capital), which at today's 118p share price equals a not insignificant £12.6m. The board's options though totalled 89.5m in number. Interestingly, options relating to five of the six executives (some 83.7m) all had a weighted exercise price of 150p or above. Representing a small 1.6% of the company's share capital, a total of 1.1b outstanding options shouldn't dilute future profits too much.

Summary and valuation

This review confirms Vodafone as watch list material. The operational predictability and barriers to entry referred to last week are supported by high margins, a lack of debt, no pension issues, minor working capital movements and an ongoing share buyback operation.

However, Vodafone is not a perfect company. A lot rests on the firm's corporate strategy. The style of Sir Chris could well live on in the boardroom and more big deals on terms similar to those seen in 1999 and 2000 will destroy yet more shareholder value. In addition, it's anyone's guess to the extent and timing of any 3G payback. Nevertheless, the 3G expenditure should lay the foundations for further long-term growth.

Assuming for the year to March 2005:

* Operating profits (£10.7b), interest payments (£714m) and minority interests (£814m) remain at 2003/4 levels;
* The £4.4b deprecation charge is replaced with capital expenditure of £5.0b;
* Corporation tax is 31%, and;
* 66,759m shares in issue

... free cash flow of 8.49p per share is produced. Demanding a free cash yield of 7.5% therefore requires an 113p buy price. Although Vodafone has indicated high single digit customer growth for 2004/5 and some of the capex is clearly expansion related, the assumptions help factor in some of the aforementioned investment risks.

Where next? Evaluating Vodafone's Quality | The Ideal Qualiport Company