The Vodafone Group (LSE: VOD) share price is trading at levels not seen since the financial crisis, 10 years ago. Is this a clear signal to buy, or a sign of possible distress?
The big risk for investors is the firm’s rising level of debt. I’ve previously been bullish about this stock, but new developments last week have prompted me to take a fresh look. Here’s what I think.
Between a rock and a hard place?
If a profitable company needs cash to fund an acquisition, the first choice is usually debt. But if the company already has too much debt, then sometimes it will choose to raise the cash by issuing new shares.
Vodafone is in this situation at the moment. It needs to come up with €10.8bn in cash to finance last year’s €18.4bn deal to buy European cable operator Liberty Global.
Unfortunately, the group’s net debt is already high, at €32bn. That represents roughly 2.2 times the group’s earnings before interest, tax, depreciation and amortisation (EBITDA). As a general rule, I prefer to see debt below 2x EBITDA.
Should VOD issue new shares?
One option for chief executive Nick Read would be to issue new shares to raise cash. This would help to manage the group’s debt levels and protect its investment-grade credit rating. Losing this rating would be bad news, as Vodafone’s borrowing costs would rise sharply.
However, there are two problems with issuing new shares.
The first is that with the stock at a 10-year low of c.136p, Vodafone shares aren’t a very valuable currency. I estimate that to raise a given amount of cash, the firm would need to issue 45% more shares today than it would have done one year ago, when the stock traded over 200p. This would increase the level of dilution suffered by shareholders.
The second problem with issuing new shares is that it would increase the annual cost of paying the dividend. This would make a dividend cut almost certain — something Mr Read is trying to avoid.
A cunning plan
The solution chosen by Mr Read is to issue £3.4bn of mandatory convertible bonds. These are basically bonds that are repaid with new shares, instead of cash. The company hopes that because no cash is due to be repaid, these bonds won’t affect its credit rating.
If you’re thinking that this is just a delayed way to issue new shares, you’re right. But Mr Read has a cunning plan. When these bonds mature in 2021 and 2022, he plans to buy back the new shares he’ll have to issue. To fund this buyback, Vodafone plans to issue more debt.
Should I buy, sell or hold?
My view is that Vodafone’s new bonds should provide some breathing room and allow the dividend to be maintained for another year or two.
However, I can see no plans to reduce borrowing. It turns out that this is deliberate — Mr Read believes that his plans for the firm will enable it to support higher debt levels on a permanent basis.
He may be correct, in which case the shares could perform strongly. But this seems a risky strategy to me.
I wouldn’t buy the shares at their current levels, and am thinking about selling my own stock.
