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Should I Invest In Vodafone Group Plc Now?

VodafoneToday, at the current valuation, mobile phone and communication specialist Vodafone Group (LSE: VOD) (NASDAQ: VOD.US) strikes me as something of a ‘jam tomorrow’ investment proposition, with much optimism built in to the price.

Since selling its stake in US operation Verizon Wireless, rump Vodafone seems puffed up by takeover speculation, a consequence of its status as one of the world’s big-hitting dealmakers.

As we wait for some big merger or takeover deal to materialise, Vodafone looks like one of those clowns on stilts with big flapping trousers: it cuts a dash striding along towering above others, but can’t stay up there forever. Unless something happens, that clown is coming down.

So what could happen to resolve the over-valuation issue?

Emerging-market hopes

Vodafone’s recent full-year results show Europe delivering around 64% of Vodafone’s earnings, down 10%. The rest came from the fast-growing emerging markets of Africa, the Middle East and the Asia Pacific, where earnings increased 10% on the year-ago figure.

Growth of 10%, if sustainable, means we can project that emerging markets could make up more than 50% of Vodafone’s business within five years. After that, emerging markets will be the main profit driver for the firm, which seems a good thing when we consider recent lacklustre performance in Europe.

So, in theory, Vodafone has potential to change into a faster-growing beast than it is now. Maybe that’s why the firm’s forward price-to-earnings (P/E) ratio is running at just under 27 for 2016. However, city analysts expect earnings to grow just 6% that year, so maybe not.

Turnaround potential in Europe

Europe isn’t a complete dead loss according to Vodafone’s CEO who reckons headwinds there include competition and regulatory and macroeconomic factors. The firm’s investment programme, Project Spring, aims to pump £6 billion over three years into the company’s networks. By increasing network and service differentiation, Vodafone hopes to become the provider of choice for customers’ increasing data requirements.

The firm assumes that economic environment in Europe will recover and regulation is unlikely to kill off the industry as frictions bite and common sense eventually rises to the surface. So, recovery in Europe, with better forward profitability, could also be a factor that helps Vodafone’s business catch up with its share price.

Dividend delight?

Investing in infrastructure and rolling out wider 4G coverage in Europe and 3D coverage in emerging markets takes cash warns the CEO, whilst promising to maintain the firm’s dividend payment. However, the dividend looks vulnerable. True, the forward dividend yield at a share price of 198p is running at almost 6% for 2016, but forward adjusted earnings only cover the payout about 0.6 times. What we really want is earnings to cover the dividend payment about twice. If we notionally adjust the forward dividend payment to raise the cover to two, the forward yield would be about 1.9%, which I think is a much better indicator of Vodafone’s current valuation.

Going forward, Vodafone expects its cash flow to improve. Let’s hope so, investors at today’s share-price level badly need that to happen. Perhaps the best hope for investor salvation is a takeover offer after all – let’s keep everything crossed.

What now?

Vodafone looks expensive and that means it carries risk.

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Kevin does not own shares in Vodafone.