Wireless Phone Services Provider Vodafone - Case Study Example

Company Background Vodafone Group PLC is a wireless phone services provider. The company provides a range of mobile telecommunication services, including voice and data communications. The company is the second world largest provider by a number of subscribers (Yahoo! Finance, 2005). At March 31, 2005 the company had 431.8 million registered venture customers (Reuters, 2005). The company has significant presence in Europe, United States and Asia Pacific regions through subsidiary undertakings, associated undertakings and investments. It has equity interests in 26 countries and partner agreements extended to 14 countries. According to Reuters (2005) analysts' opinion, the company is outperforming currently (financial ratios provided can be seen in Appendix 1). Profitability The group turnover was 34,133 m on the year ended March 31, 2005, which was 33,559 in 2004 and 30,375 in 2003 (Vodafone Annual Report, 2005, p. 78). Presented in percentage, the growth of turnover in 2003/04 was 10.4% and in 2004/05 it was 1.7%. The rise of the group turnover represents the addition of new customers and the increase of revenue from value added services. Looking at the five-year annual growth of turnover given on the diagram 1 it can be easily seen that the company's rate of expansion is decreasing. During previous years the company was rapidly expanding due attraction of new customers; now the customer audience of Vodafone is stable. The interim results of six months ended September 30, 2005 show that the group turnover has increased 9% to 18,250 m (Reuters, 2005). Diagram 1: Annual growth of group turnover of Vodafone Group PLC Reasonably the cost of sales in 2005 has increased along with the group turnover, leading to the gross profit of 13,380 m. In 2004 gross profit was 14,098 m and in 2003 it was 12,479 m (Vodafone Annual Report, 2005, p. 88). This gives us the ability to evaluate gross profit margin providing us with the information on how much of the group turnover can cover the non-operational costs by dividing gross profit on group turnover. The following diagram shows the three-year perspective. As can be seen there is hardly a trend can be outlined, but it can be concluded that the gross profit margin has fallen to 39.19%, indicating the rise of operating costs. Diagram 2: Gross profit margin (%) The group's operating loss was 5,304 m, 4,842 m, 5,052 m in 2005, 2004, and 2003 respectively (Vodafone Annual Report, 2005, p. 78). Thus we can calculate the net profit margin, showing us basically the percentage of profit earned on sales, or in this case the percentage of losses lost on sales. Basically, net profit margin shows the profitability of the company. It is found by dividing operating profit (loss) on group turnover. The next diagram shows the net profit margin of three years. As can be seen the previous year 2004 was more profitable for Vodafone than 2005. Additionally Reuters (2005) report of net income 23% decrease to 2,780 m in the first half of 2006. The reasons of the decreasing profitability are increased operating costs, administrative expenses and a decrease of non-operating income. Diagram 3: Net profit margin (%) Liquidity Liquidity is important for the company as it reflects the ability of meeting its liabilities. High liquidity can detract from profits, because liquid assets are low returning investments. Low liquidity stunts company's growth and eventually leads to bankruptcy. Liquidity ratio is measured with dividing the current assets of the company by the its current liabilities. Current assets of Vodafone were 11,794 m and 13,149 m in 2005 and 2004 respectively (Vodafone Annual Report, 2005, p. 79). Current liabilities to creditors were 14,837 m in 2005 and 15,026 m in 2004 (Vodafone Annual Report, 2005, p. 79). The comparison of liquidity ratios for 2004-2005 can be found in the following table. Along with current ratio there is a quick ratio, which shows the ability of a company to repay its liabilities with cash only excluding inventory assets (sales of inventory are often difficult), which were 1,246 m (2005) and 4,839 m (2004) including stocks and investments (note the large change in investments: 816 in 2005 and 4,381 in 2004). Quick ratio is measured by subtracting inventory assets from current assets and then dividing them by current liabilities. Table 1: Liquidity ratios of Vodafone Group in 2004-05 Year Current assets Inventory assets Current liabilities Current ratio Quick ratio 2004 13,149 4,839 15,026 0.875 0.553 2005 11,794 816 14,837 0.795 0.74 Despite the ability of Vodafone to repay its debts quickly without selling assets and returning investments has significantly increased, the company's liquidity ratio is still below 1 and decreasing, which means the company will not be able to repay its current liabilities without using its fixed assets. Cash Flow and Capital Structure Cash flow is simply cash received minus cash distributed. It is important to analyze cash flow on the matter of company's financial needs. Positive cash flow makes the company able to fund future investments. Cash inflow from operating activities of Vodafone continues to increase from 11,142 m, 12,127 m in 2003, 2004 respectively to 12,713 m in 2005 (Vodafone Annual Report, 2005, p.80). The closing net debt of the company has slightly decreased: 13,839 m, 8,488 m, and 8,339 m in 2003, 2004, and 2005 respectively (Vodafone Annual Report, 2005, p.80). The increase of cash in 2005 was the largest among 2003, 2004, and 2005 as can be seen in the following table. Table 2: Excerpts from cash flow of Vodafone Group Year Increase of cash, m Cash flow from managing liquid resources, m Cash flow from managing debt, m Changes in debt in the year, m 2003 393 (1,384) 165 (1,805) 2004 1,069 4,286 (280) 5,351 2005 1,405 (3,563) 2,170 149 As can be seen from the data given above Vodafone tries to decrease the use of debt in its capital structure, which is important for the company, as the low liquidity with extensive use of debt makes the financial health of the firm very weak. The capital structure of Vodafone, which is basically the proportion of using debts and equities in financing, can be analyzed through the long-term debt-to-equity ratio. It is equal to long-term debt of the company divided by the total shareholder's equity. The data used for the analysis of cash flow is presented in the following table. Table 3: Capital structure of Vodafone Group Year Shareholder's equity, m Long-term debt, m Debt-to-equity ratio 2004 111,924 12,100 0.108 2005 99,317 11,500 0.116 As can be seen the company's debt-to-equity ratio is very low, indicating small use of debt in financing. Vodafone simply cannot use debt extensively due to liquidity Recommendations The Vodafone company is low leveraged. However financing business through debt is cheaper than through equity, therefore the Vodafone capital structure is far from optimal. To enhance the capital structure of a company Vodafone should use its debt more aggressively. However, this cannot be done without the improvement of liquidity. The only way for the company to increase liquidity is to improve its net profit. Improving net profit implies lowering the expenditures, both operating and non-operating (e.g. administrative expenses). Reducing expenditures will positively affect liquidity, and will open loan opportunities for Vodafone. Dividends as Residual A company applies 'dividends as residual' policy when it pays dividends only in case of no other way of using its revenues.(ADVFN, 2005) Investments come on the first place, dividends come on the last. Along with the data given if the company operates on the residual dividend policy, and the dividends still continue to increase then a company is performing well, because it has already used the needed funds for investment and pays the funds left as dividends. Quoting on the AIM means it is a small and developing company. Singalling A signaling theory looks on the dividends given by a company as a sign of its performance. Under this theory a company pays dividends only when it is convinced of the profitable future. When the future promises losses or simply no revenues, then a company reduces or holds dividends on the same level. "According to the dividend information content hypothesis, dividend changes trigger stock returns because they reflect changes in management's announcement of a firm's future profitability." (Ibrahim and Ragab, 2004). Under this theory the constant increase of dividends shows the confidence of a company in its prosperity. Clientele Preferences The theory of clientele preferences implies that investors do in fact have preferences between dividends and capital gains. That is why companies adjust their dividend policies to have the appeal for a certain group of possible shareholders: "the dividend policies adopted by the firms would match the dividend preferences of investor groups" (Oaktree Research, 2003). Therefore we can conclude from the data given that a company quoted on the AIM and paying stable increasing dividends is attractive to investors interested in long-term ownership of shares, as the AIM provides incentives each year for shareholders. Dividend Valuation Model To evaluate whether a company's shares are good for buying we should calculate the expected price per share the next year. This is performed through a formula: Value=Dividend per share x dividend growth rate / (required rate of return - (dividend growth rate - 1)). The required rate of return=risk-free rate of return +risk premium x beta=6.5%+5%*0.9=11%. The dividend growth rate this year was 1.097 Value=5.4*1.097/(0.11-0.097)=5.924/0.013=456p. The current value per share is calculated by dividing total value of shares (190 m) on the total number of shares (100,000,000). It is 1.9 or 190p. The value of a share is projected to rise 2.4 times. It is a good buying opportunity. Historic Price Earnings Ratio Historic PER=Known price/last year earnings=205/14=14.6. Future Growth Rate of Dividends and Earnings As the future growth rates shown in the past will be the same in the future then the future growth rate of earnings (dividends) can be found by dividing earnings (dividends) this year on the earnings (dividends) last year and subtracting 1. Dividends are 50% of earnings. However for different years of the five given we will receive different rates. Let us take the average. Last reported/1 year ago=14/13-1=0.08 1 year ago/2 years ago=13/12-1=0.08 2 years ago/3 years ago=12/11-1=0.09 3 years ago/4 years ago=11/10-1=0.1 4 years ago/5 years ago=10/9-1=0.1 Therefore the average will be 0.09. As the percentage of dividends is the same (50%) then, future growth rate for dividends is the same Required Rate of Return Using the formula from above required rate of return=6.5%+5%*1.2=12.5% Complete PER model Using the above formula for the calculation of share value=7*1.09/(0.125-0.09)=7.63/0.035=218p. Therefore, shares of 205p are underpriced. Implications of Using the Historic PER As can be seen from the previous calculations the historic price earnings ratio can sometimes lead to mistakes as it uses the historical data which can be wrong in future. Additional Factors for Valuing Unquoted Shares If the shares valued are unquoted, than the valuation is dependant on the structure of the company. For example, the proportion of capital needed in the production process, which in turn may be closely linked with the branch of activity, may be different in quoted and unquoted companies. Therefore to estimate the value of unquoted share one should use quoted shares as a benchmark, but to take into account business sector of the company and its liquidity. Forward Market Hedge Strategy When this strategy is used the contract is signed beforehand to pay funds in the foreign currency on the current exchange rate. Thus the risk of loss due to negative change of exchange rate is avoided. In the given case, a company signs a contract with Malaysian seller on paying 600,000 M$ on the exchange rate of 5.4165 M$ per 1 . That is a company will pay 600,000/5.4165=110,772 . If the future spot rate is equal to three-month forward prognosis then the company will lost 110,772-600,000/5.425=110,772-110,600=172 .This can be perceived as the price of hedging. Money Market Hedge Strategy This is a similar technique allowing to avoid the risk of change of exchange rate. However in this case our company will borrow 107,546 , exchange it into Malaysian dollars: 107,546*5.4165=582,524 M$. After three month the inflation rate of 3% will bring this sum to 582,524*1.03=600,000 M$. However, a company will need to pay additional 3,226 to cover the interest of borrowing. Therefore the sum will be 107,546+3,226=110,772 - the same as in the forward market hedge. Option Hedge Strategy This strategy is about using the option put proposed. The company takes the loan of 600,000 M$ and instantly repays premium price of 15,000 M$. The leftover 585,000 M$ will inflate to 602,550 M$ in three months. After paying out the liability to Malaysian seller the company can repay the rest of the loan on the strike rate of 5.425 M$ per 1 , as agreed (585,000/5.425=107,834 ), or in the case if the spot rate is better it can exercise by paying on the spot rate. For instance, if the spot rate is 5.5 M$ per 1 , the company pays 585,000/5.5=106,363 . Bibliography ADVFN. (2005). Residual Dividend Approach. Retrieved December 25, 2005 from http://www.advfn.com/money-words_term_8967_Residual_dividend_approach.html Ibrahim, A.N. and Ragab, A.A. (2004). The Signaling Effect of Dividends on Future Earnings: Empirical Evidence from the Egyptian Stock Markets. Proceeding paper for The Prospects of Arab Economic Cooperation Conference, Alexandria, Egypt, July 22-24. Retrieved December 25, 2005 from http://www.irti.org/alexConf/papers/S2P3.pdf. Oaktree Research. (2003). Dividend - Relevance or Reverence. Retrieved December 25, 2005 from http://www.oaktree-research.com/content/view/30/58/ Reuters. (2005). Vodafone Group Profile. Retrieved December 25, 2005 from http://investing.reuters.co.uk/Stocks/CompanyProfile.aspxsymbol=VOD.L Vodafone. (2005). Annual Report. Retrieved December 25, 2005 from http://www.vodafone.com/assets/files/en/VOD_annual_report_2005_3.pdf Yahoo! Finance. (2005). Vodafone: Company Profile. Retrieved December 25, 2005 from http://biz.yahoo.com/ic/47/47982.html Appendix 1: Excerpts from Financial Ratios of Vodafone (Reuters, 2005) Price/Earnings Gross Margin (%) Net Profit Margin (%) Current ratio Quick ratio 12.85 37.01 19.13 0.67 0.64 Long-term debt-to-equity Total debt-to-equity Earnings per share, Return on equity (%) Return on investments (%) 0.116 0.134 0.10 5.68 4.98 Read More