AT&T Inc. (Market Capitalization as of 24/05/2013: $197.6bn)
Verizon Communications Inc. (Market Capitalization as of 24/05/2013: $147.0bn)
Vodafone Group PLC (Market Capitalization as of 24/05/2013: $144.7bn)
Vodafone: M&A since 1985
The strong winds of market activity in the US telecom landscape have recently reignited a dormant flame in the relationship between Vodafone and Verizon Communications. The past weeks have seen increased speculation that Verizon will soon bid to buy out Vodafone’s $120.0bn minority stake (45%) in their widely profitable joint venture, Verizon Wireless (henceforth “VW”), the largest US mobile carrier by subscriptions (with more than 115mln subscribers as of Q4 2012).
The $7bn dividend announced by VW on May 14th, of which $3.15bn will go to Vodafone, and the need for the latter to refocus its strategy on its struggling European operations (sales decreased by 4.2% to $67.3bn in the year to date, March 31st) may increase the likelihood of a bid sooner rather than later.
Vodafone Group Plc., headquartered and listed in the UK, is the largest mobile telecom company in the western world, with more than $67.0bn in revenues and 447 million customers (44 million of which are due to its stake in VW) in 2012. The history of the company has been one of bold expansion worldwide, often through blockbuster acquisitions.
The company originated as Racal Vodafone, a subsidiary of Racal Electronics plc, a manufacturer of military radio equipment. On January 1st 1985 at midnight Vodafone made the first mobile call in the UK, and in 1988 it was listed on the London Stock Exchange (LSE) as Racal Telecom. The increase in the value of the firm led to its demerger from parent Racal Telecom and its standalone listing as Vodafone Group in 1991.
The aggressive strategy of organic and inorganic growth pursued by CEO Christopher Gent escalated to a peak in 1999. In June of that year, following regulatory approval, Vodafone acquired American wireless provider AirTouch Communications, Inc. for $62.0bn. A few months later its US wireless assets were merged with those of Bell Atlantic Corp to form VW, North America’s largest mobile carrier.
In the same period, Vodafone responded to the homeland attack of German conglomerate Mannesmann (who had acquired Orange, a UK mobile operator) by launching a mammoth cross-border hostile takeover of Mannesmann itself. CEO Christopher Gent and Scott Mead of Goldman Sachs finally overcame unprecedented resistance from both the target and the German government by striking a last minute deal with a sweetened offer ($8bn more in consideration) and concluded the $183.0bn all-share deal, then the largest corporate merger in history.
The last decade has seen further expansion of Vodafone across Europe, in developing countries and in the enterprise services sector.
The Problem with Verizon Wireless: Diversification discount?
In the past few years however, the firm has been caught in a tough spot, suffering from structural shifts in its customer base, away from voice usage and towards data, together with possibly temporary but nonetheless significant squeezes in margins caused by regulatory changes at EU level and the prolonged economic downturn in southern Europe. This situation is reflected in both a decrease in sales and by impairment losses on south European assets totalling over $17.0bn for 2012 and 2013 combined, a whopping 42.3% of EBITDA for the relevant period.
In this difficult scenario, VW has become somewhat of a thorny rose for Vodafone: although very desirable for its profitability and for the cash flows provided by its dividends, its management, together with its payout policy, is firmly in control of Verizon Communications, through its 55% stake. These adverse dynamics have arguably created a geographic diversification discount to Vodafone, which at $144.7bn market cap is trading at just 1.25x times the estimated after tax value of its stake in VW. The discount also materializes in relative valuation: Vodafone’s forward P/E is 12.00x, while Verizon Communications’ is 18.66x. This puts Vodafone in the neighbourhood of mature, intrinsically less valued fixed/mobile telecoms conglomerates such as Deutsche Telekom (forward P/E 13.30) and British Telecom (forward P/E 12.51x).
Vodafone’s current CEO Vittorio Colao, a Bocconi graduate, has repeatedly asserted the importance of increased strategic focus, namely on emerging markets and improved infrastructure in the EU. At the same time, he has reiterated that he has “an open mind on everything” with respect to Vodafone’s future ownership of VW.
The report will now analyze the two different strategic options that the Vodafone management team could adopt to deliver the hidden value of the Verizon stake to the shareholders. That is: 1) Verizon buys out Vodafone’s 45% stake in Verizon wireless. 2) Verizon and AT&T team up to acquire Vodafone in its entirety, in what would be the largest corporate takeover in history, valued at around $245.0bn.
Option 1: Pro and cons of the Verizon 45% buyout Verizon Wireless
If the British company decides to sell its 45% participation in the joint venture, many new opportunities could be created. Vodafone’s share of Verizon Wireless was estimated to be worth $115.0bn after-tax by Goldman Sachs analysts. This price is about 6.0x Verizon’s adjusted operating profit of $18.5bn (and also 6.0x Vodafone’s adjusted operating profit of $17.9bn). However, poor performance on the EU market and an increase in the US wireless competition may weaken Vodafone’s negotiating power.
People close to the matter stated that the tax impact of the transaction would be very low if Verizon bought 100% of a unit called Vodafone Americas Holdings, which now contains the Vodafone stake in Verizon Wireless. By buying the holding company, Verizon could spare Vodafone as much as $35.0bn in taxes.
Vittorio Colao, Vodafone’s CEO has repeatedly stated that the multinational firm is not correctly valued because its valuation suffers from a geographic diversification discount. The company’s current market capitalization on LSE is equivalent to $144.7bn (Enterprise Value is $180.0bn), which is quite low if we consider that we are talking about a firm that is leader in Western Europe and is growing in all five continents, besides owning the joint venture in Verizon Wireless.
On the other side, selling the participation would mean giving up a business that has more than 98 million retail users and $76.0bn in annual revenues and has had a steep growth in recent years, with an average revenue per user that has grown annually by 7% and is now at $150/customer per year.
Moreover, if the transaction goes through, Vodafone will be smaller in terms of number of users and global footprint, but with a stake in Verizon and some billions in cash.
To be more precise, Verizon Communications has declared that it already has capacity to borrow $50.0bn from banks. This figure can increase up to $62.0bn if the deal is completed as 50% in cash and 50% in Verizon’s stocks (the most likely cash-stock split) and the buyer accepts to pay $115.0bn in total consideration
One of the uses for this cash would be to strengthen the overall business offering, either through internal product expansion or through M&A activity.
The European wireless market is the one with the highest mobile penetration rate in the world, and so Vodafone can invest to strengthen its offer of “converged services”, the increasingly popular bundled package of voice, TV and Internet to attract new revenue. Buying Kabel Deutschland, the German cable operator with a market value of $8.1bn, would give Vodafone the ability to offer such packages to customers in Vodafone’s biggest market, according Bernstein’s Bienenstock.
The company also could use some of the money to purchase a cable operator and bolster its European operations. The cable business is still a growth business, so it would definitely add to EBITDA and revenue growth. Two candidate targets are CWW and Liberty Global, the $14.1 bn cable company that has recently purchased Virgin Media.
However, the European market is a mature one, and it has not performed well in recent years. Emerging markets on the contrary are currently the main drivers of Vodafone’s growth. Markets like India, Africa and Turkey have already been cited as areas in which having an important share of customers will be key in the future. Investing in these countries is an opportunity worth of attention.
If the cited investment opportunities do not offer a satisfactory level of returns, or simply, if Vodafone doesn’t plan to invest all the cash that it will receive from the sale of its share in Verizon, the company would likely opt for a special dividend payment to its shareholders, a strategy that has been pursued recently also by Apple Inc.
Option 2: Is an acquisition of Vodafone by AT&T and Verizon impossible?
Another possible resolution of this case would lead to the largest M&A deal ever. Telecom giants Verizon Communications and AT&T reportedly were putting together a bid to buy Vodafone. According to Financial Times’ Alphaville blog, Verizon would acquire Vodafone’s 45% stake in Verizon wireless and AT&T would take control of Vodafone’s extensive business outside of the United States. The price that the two American companies could pay would range between $3.78 per share, with a 30% premium on the current price of Vodafone, and $4.08 per share, with a 40% premium. In this way, the final value of Vodafone would end up to be approximately $245.0bn.
Apart from its complexity, this deal would be an excellent opportunity for both sides. First of all, according to John Hempton, chief investment officer at hedge fund Bronte, a total buyout would be much more efficient from a fiscal point of view than the simple 45% stake acquisition. The saving on the final tax bill would be of around 10 up to 20 billion dollars, implying a higher value creation for Vodafone and Verizon shareholders.
Second, this transaction would be a great boon for AT&T to enter into the European market, getting global scale and cash flows accretion. In the previous months, there were rumours about AT&T looking for a possible acquisition abroad in order to overcome constraints on growth that the company was facing.
Third, a “joint acquisition” would allow AT&T and Verizon to share the risk that a deal of this size would imply.
On the other side, the feasibility of the largest M&A deal in history could be limited by several factors. The first problem for the two American companies would be related to the financing of the buyout. From the Financial Statements of 2012, the combined cash of Verizon and AT&T was approximately $8.0bn. For the consideration that we did above, the best solution would seem to execute the transaction in a share by share payment. However, assuming that Vodafone would accept such solution (which seems very unlikely), the ownership dilution for the current shareholders would be extremely high. On the opposite side, a 100% cash payment, financed with a debt issuance, seems still too far from reality if we look at the current capital structure of the two firms (AT&T D/E=0.70x, Verizon D/E=0.56x).
Another possible roadblock to the conclusion of the deal would probably come from regulatory authorities. The colossus that would rise from the buyout of Vodafone would almost be a monopolist in the sector that antitrust authorities would hardly take into consideration. A recent example was the AT&T $39.0bn bid to acquire T-Mobile USA from Deutsche Telekom that was shut down by US antitrust authorities in 2011. However, this would not be an easy task for the authorities. The cross-border structure of the deal would make computation of market shares for the dominant position relatively complex. Basically Verizon would have the possibility to demonstrate that its market shares would be insignificant compared to the size of the market in which it operates. And the situation for AT&T would be even tougher; it would require a coordination between the US and the European regulators that, as it had already happened in the past, could miserably fail.
Concluding remarks and the likely scenario of the following months
As the title of the analysis suggests, the problems of the Vodafone’s management team are not only confined to the trade-off between doing something or not with respect to the stake in the JV with Verizon, but they concern also the form that the transaction might take.
Vittorio Colao has stated now numerous times that he is open to many options, among which keeping the stake in Verizon. This course of action seems highly unlikely and is more a facade that Mr. Colao is keeping both with respect to Shareholders and to their long-term American business partner Verizon.
The first reason why a transaction should not occur is that Verizon Wireless is a huge cash generator, still enjoying an emerging market-like growth. Every CEO, not only those with empire-like preferences, would be worried of disposing such a well-functioning business. The loss of Verizon would probably leave to Mr. Colao less discretion on cash flows and, consequently, on any long-term projects that he has in mind.
There is also a second reason why Vodafone might not want to sell its stake in Verizon Wireless. There is a need to remember that the ownership is at 45% and this has some accounting implications on Vodafone’s financials. When Vodafone accounts for the stake it doesn’t use the equity method, nor do they consolidate line-by-line the financial statements. In a more simple way, the share of Verizon’s wireless Net Income is added. This means that ceteris paribus, Net Income margins might look better through the joint venture. Therefore papers have written with certainty that Vodafone, despite being a highly efficient company, trades at a discount. This claim might be overstated for the above explained reasons. Evidence of this is very hard to find, as Vodafone has booked huge impairments for projects in Southern Europe and it is not yet clear whether these will be recurring charges or not. Other competitors had the same problem so only time will tell.
One last reason, which could harm the rationale of a deal happening soon is that shareholders and investors in the Telecom space are very focused on Cash-flow generation, as the business is now mature. For this reason, Mr. Colao probably wants to assess whether the loss in Free-Cash-Flow from the stake in the JV is more than compensated by the value created through the elimination of the diversification discount.
Nevertheless in all likelihood something will happen in the next 6-12 months, as Vodafone is rumoured to have already hired bankers and consultants to discuss about strategic options. The public market outlook seems to concur that this is the case. As it is shown in the graph below, reporting Vodafone’s last 3 months share price time series, the stock has been rallying from just above 1.60£/share (2.42$/share) to 2.0£/share (3.02$/share), a 25% increase, meaning that also event-driven funds believe that a transaction is likely to occur.
Talking about the relative likelihood of the two options, it is possible to say with relative certainty, that a total buyout of Vodafone by AT&T and Verizon is very unlikely to happen. The complexity and huge dimension of the required financing and premium would make the deal very difficult to execute. A consideration in shares would probably give Vodafone too much influence in the board of the two American companies.
Verizon has stated that no debt would be used in the transaction, which seems strange given how cheap this financing option is at the moment and the fact that the company is not leveraged, but the growth of Verizon Wireless allows also for a half cash, half shares consideration for the 45% stake, which seems to be the most plausible option. The reason is that Vodafone would this way see its hidden value unlocked and would also retain an equity stake in Verizon Inc., for which the shareholders would also enjoy the up-side of a well delivered transaction.
The success of a corporation boils down to few defining moments of strategic reasoning and this is one of those. We will see whether Mr. Colao will keep up to his name and deliver to Vodafone’s shareholders the best possible value and position for the years to come.