Should you invest in Vodafone?

There is one company which has been held by almost all British companies since 2000: Vodafone. But with the outlook for the sector as a whole looking poor, should you?

Warren Buffet once famously opined that when the automobile was invented, the sensible investment decision was not to buy shares in automobile companies, but to short' horses, i.e. that sometimes it is wise to pass on buying into major technological changes. When the car was invented, clearly the future for the horse as a form of mass transport was less than rosy; but this did not mean automatic profits by investing in this new technology. In the last fifty years, the auto industry worldwide has only managed to produce a profit one year in five. The consolidated profit

and loss account for the world's automobile manufacturing business shows chasmic losses since the car was invented.

Since 2000, one British company has been consistently held by all investment institutions save, we believe, six. Its name is Vodafone. The mobile has become so useful that it is difficult to remember the sheer horror of telephone boxes, let alone the tortuous experience of making a simple 26 mile call from Dover to Calais, and the phenomenal cost. That mobile telephones have an enormous utility is beyond doubt. Yet as with horses and automobiles, the correct investment decision since 2000 has been to hold neither Vodafone nor most mobile shares; for although the new technology has been life-transforming, the underlying business models have always been dubious and on a long term view, look weak.

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As one of the tiny number of firms never to have held the share for clients, Vodafone is of especial interest, for it represents both a risk (we could be wrong) and a conundrum. It is one of the few businesses we find impossible to model on a long term view and worse, when we try, its future looks as unusual as a coal fired aeroplane. We have hesitated in confessing to this before, if only because some investors whose intelligence we respect have recently become large shareholders; moreover, those who bought craftily in 2006 have made a useful 25% or more. Yet we continue to believe that apart from trading or for tracker funds, Vodafone is inappropriate for long term or value investors at its current price, and for anyone who believes that the age of the telephone with wires is over.

Little potential in the UK mobile phone market

In the UK, a core market for Vodafone, the typical price of a one minute mobile call can be three times that of a landline. Whilst a mobile allows the use of a telephone when a landline is unavailable, it is thus a complimentary tool, not core. Such a huge price differential means that

most of us use our landlines in the office and at home. Then consider developments by fixed line telephone companies both in the UK and elsewhere.

The great majority were once government owned, so were slow to react to mobile telephony. Now after years of idiocy, they have caught up; some such as BT have improved aspects of their technology or service, including the development of telephones without wires that can be used further and further from the home or office base. There is no technology barrier to prevent home phones shortly being used as mobiles. Whether people will then choose to use their mobile phone at three times the price per minute remains a moot point. Moreover, the future price of a telephone call is zero. An obvious threat to all telephone companies, fixed line or mobile, is Skype and its look-alikes. Already the cost of an international call is zero. True, it requires a PC which you have already if you are reading this and a gizmo attachment, the price of which will soon tumble to a few dollars. Thus not only are the old technology' companies like BT charging less than mobiles, but competition has developed intending to charge nothing at all. By any lights, mobile telephony does not seem a great business model.

The managers at Vodafone are not thick. Certainly, they have stumbled on many occasions the failure to rationalise their activities in North America, once vastly over-paying for 3G licences, or Germany's Mannesmann Group spring to mind but they know the underlying dynamics. However, they have arrived at a solution which we believe will fail: to buy growth in third world countries. This is predicated on the belief that fixed line telephone systems there are so crumbly and incompetent that a mobile is manna from heaven. Hence Vodafone is spending $11 billion in cash buying out an operation in India.

Vodafone's board appears not to have noticed that buying into rapidly growing third world economies' (at the top?) is the same policy adopted by other mobile companies, so perhaps they should question the logic. However, as with oil shares, logic often has little to do with investment decisions, particularly when a company seemingly has no choice. We are very pushed to see how a good return can be made.

Despite prices falling every year, a handset is out of reach for the majority of the population in India. Even though usage will grow, the rates of illiteracy and innumeracy are still so high that mobiles are of little value to many. Saturation levels too may be well below that of industrial nations, and achieved in perhaps as little as four years. Thus there will be some good growth, but not for long. Highly priced expansion into the third world seems certain to result in another round of write-offs and -downs, just when the previous huge cycle had ended.

Moreover, despite the chief executive being Indian born, he appears to have forgotten the golden rule of third world investing: too much success, and the government will always squeeze the foreigner' (on behalf of the domestic incumbent). Ask Cable & Wireless, now a pathetic shadow of itself, when a mere decade ago it dominated Hong Kong's telephone system. (Even worse, after being squeezed, the board then opted to take useless lumps of share paper, not money). The history of the Indian gvernment putting up barriers against successful foreigners (Coca Cola several times) is lengthy.Sould Vodafone's market share rise to a third, the easy bet is the company will be squeezed bylegislation.

Where next for mobile phone companies?

One option for mobile telephony is to become not-for-profit-trusts and to distribute any surpluses to long-suffering shareholders. An alternative is to acquire those competitors gradually stealing their businesses, such as fixed line (!) or to go for free calls and bolt on other services. Each option has drawbacks. One reason why fixed line companies are successfully fighting back is price; another is that they can offer a whole range of services currently unavailable to mobile companies.

Fixed line companies are already streaming videos, TV, entertainment, computing power and instructions for your toaster down existing wires; and the most important service they will soon offer is the largest single revenue source of the internet - pornography. Estimates vary, but of all

payments across the internet, between a quarter and a half are for porn. Whilst in Japan, watching pornography on a mobile screen measuring three centimetres by two has taken off. This has to be a) sad and b) a strange Japanese quirk. The great technological success of wireless free calls with

easy portability and great utility now looks so last century: the lack of wires bars them from many mainstream human activities.

We have tried to analyse the Vodafone syndrome. If our competitors are right, we will applaud; no point in being curmudgeonly. But we believe these mainstream investors are in serious denial. They will highlight the good yield this year and next; consensus estimates suggest a yield of 4-

5%. They will also highlight that most of the losses have been taken (the five years to March 2006, Vodafone's accumulated losses under GAAP were £64 billion, equivalent to 5.5% of one year's UK GDP). We have also tried to analyse what the board means by profitable. One of our tests is how much tax is paid the more the better in our view.

In India the ten-year bond yield is 8%. A sensible risk premium would be to add 350 basis points, so a realistic cost of capital would be 12% p.a. Thus an Indian business should produce a return on capital of not less than 18% to be worth the risks and returns. Is this Vodafone's forecast? Hardly. As in the technology boom, they are using EV/EBITDA, Enterprise, ARPU and various other acronymic formulae; these may have their place in the sun, but we still consider them to be all the revenue except the nasty bits', an unusual accounting convention.

Why are investors still optimistic about Vodafone?

Vodafone was bought by many investors in 2000 at between £3 and £4 a share (now £1.47). Some did so because certain consultants would not approve a fund management firm unless Vodafone was held; many also believed (and being wrong is no crime) that it could only rise further; others fell into the horses/auto trap. Today, their optimism arises from the potential of the strongly rising cash flow and the decent dividend, yet we still believe the five year outlook for mobile telephony profits is poor. The only reasons we can find for investors holding Vodafone at current prices are the same as for commodities. These are: because it has risen, it will carry on rising; because people use their services, they will continue to do so and profits will magically follow; and because it has been held for a long time (normally bought at a higher price) and crystallising a loss would require an explanation, whereas running with the herd requires none.

Perhaps the new Chairman, Sir John Bond, recently ex of The Hong Kong and Shanghai Banking Corporation (we so much prefer and love that old name vs. HSBC') will shake things down. And there does appear to be a sub-plot, to use mobile phones as a swipe credit card and for banking; but

the window, and profits provided by using mobiles as payment machines, will be temporary. Not only will competitors immediately copy and price-cut, but banks will certainly fight back with their own gizmos. Making good money from mobile telephone shares was an exciting late 20th Century phenomenon. We will be amazed if it is repeated in the 21st.

Written by Richard Benson and published in Benson's Economic and Market Trends 31/7/2006,