The Vodafone (LSE:VOD) share price has fallen 53% in five years. But despite the stock now yielding 11.5%, investors still appear reluctant to buy.
In my view, this won’t change until the company has successfully addressed what I believe are its two principal problems.
First, its return on capital employed (ROCE) isn’t high enough, and second, it has massive debts. Fortunately, improving the former will help with the latter.
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What does this mean?
ROCE is a measure of how efficiently a company uses it resources. For the year ended 31 March 2023 (FY23), it was 5.1%.
Part of Vodafone’s problem is industry-specific.
The telecoms sector requires enormous investment in infrastructure but, due to intense competition, the scope to make exceptional profits is limited.
Other industries do better. For example, BP‘s ROCE was 18.1%, in 2023.
But I think it’s not a good sign given Vodafone’s previous management team ran a business where the return in three of its key markets was lower than the cost of financing its operations.
The company’s business model in the UK, Italy and Spain is clearly flawed, although I accept rising interest rates and post-pandemic inflation have contributed to the problem.
Can it be fixed?
The company’s addressing the issue by seeking to dispose of its businesses in Spain and Italy. In FY23, these contributed 19% of revenue and 16% of earnings.
Although exiting these territories will make the company smaller, it should increase the group’s ROCE.
Also, it plans to use the sales proceeds to pay off some of its huge borrowings.
Excluding leases, its net debt was €36.2bn at 30 September 2023. This is approximately 2.7 times its forecast FY24 profit as measured by adjusted EBITDA (earnings before interest, tax, depreciation and amortisation). Vodafone has a target of 2.5 times earnings.
The company could receive up to €15bn from leaving Spain and Italy.
Assuming all proceeds are used to reduce its borrowings — and removing the FY23 contribution of these markets from its forecast FY24 profit — its gearing could fall below 2 times.
At this level, I don’t think Vodafone would be viewed as highly indebted.
Deutsche Telekom, Europe’s most valuable telecoms company, says its “comfort zone” is 2.25-2.75 times.
What happens then?
As the restructuring nears completion, I think Vodafone’s share price could start climbing again. That’s because investors will look more favourably on a company that’s using its assets more efficiently. And one that’s less highly geared.
Deutsche Telekom trades on a price-to-earnings multiple of 12. Post-reorganisation, Vodafone will have a higher ROCE with less debt, than its larger rival.
Applying a 16% drop in earnings to its consensus FY25 forecast of €2.57bn, would give a figure of €2.16bn (£1.85bn).
If it achieved a similar valuation to Deutsche Telekom, its market cap would be £22.1bn. That’s a 23% premium to today’s share price.
Time to buy?
Due to this potential, if I didn’t already own some, I’d be tempted to buy the company’s shares.
But I think it will take a while before the benefits of the restructuring flow to its bottom line. That’s assuming, of course, that the planned deals are successfully concluded.
However, I’m going to stick with the company. I take comfort from the fact that it now has a management team that recognises the company needs to change.
