Market is pricing Vodafone like a utility stock

Investor - An insider's guide to the market: Over three months ago Vodafone disclosed to the market that its tax bill would be £5 billion (€7.3 billion) higher than previously thought.

Then just over a month ago Vodafone told investors that its profit margins would be at the lower end of expectations. This, combined with the earlier bad news, knocked the shares by 11 per cent in one day.

Earlier this week Vodafone was back in the news when it announced a goodwill writedown of £23-£28 billion, one of the biggest post-acquisition write-downs on record.

The write-down is primarily related to the acquisition of Mannesmann of Germany, which was bought for £101 billion in 2000 at the height of the dotcom bubble.

Not surprisingly, Vodafone's shares fell further on this news and are currently trading around 110p, which is a far cry from the 52-week high of 155p.

While the scale of this write-down is eye-catching, in theory it should not have a significant adverse impact on the share price. Cashflows are not affected and it really reflects acknowledgement of the sins of the past. Indeed it could be argued that the Mannesmann deal was not such a bad deal because Vodafone paid for it by issuing its own shares, which were just as overpriced as Mannesmann's at the time. Many of the original post-privatisation Eircom shareholders will be aware of this as a result of their experience in receiving highly priced Vodafone shares as payment for the Eircell mobile phone business. Such shareholders have watched the value of their shareholding decline over the years.

As well as the writedown announcement, Vodafone management acknowledged that the company had entered an era of slower growth. Consequently management reduced guidance for sales and earnings growth and this in fact was the real reason for the adverse market reaction. The group lowered its long-term growth assumptions, saying that competition in its mature markets of Britain, Italy and Germany was likely to erode profit margins. Other threats include the emergence of new technologies such as internet telephony. For 2007, Vodafone now expects revenue growth of 5-6.5 per cent, which is below its guidance only last month of organic growth of 7.5 per cent.

Not so long ago Vodafone was viewed as a growth company by its own management and stock market analysts. The sharp decline in the share price over the past year indicates that the market is coming to terms with the fact that Vodafone is no longer a growth stock.

Rather it is a large international utility operating mainly in mature markets subject to intense competition. To be attractive to investors utilities need to pay high dividends to compensate shareholders for pedestrian growth prospects.

The stock market is now pricing Vodafone more as a utility than a growth stock, as indicated by its price-earnings ratio (p/e) of 10.8 and divided yield of 3.8 per cent.

A utility such as National Grid trades on a p/e ratio of 12.1 and a yield of 4.2 per cent, while BT is currently trading on a p/e ratio of 11.3 and a dividend yield of 5.2 per cent.

If the hallmark of growth companies is a dash for growth by management, then the hallmark of utilities is typically cost-cutting and the sale of underperforming and/or non-core assets. There are signs that Vodafone management has begun to move in this direction. Vodafone's chief executive, Arun Sarin, admitted that the group is looking more closely at a higher dividend policy, further cost cuts and asset disposals.

For the many Irish investors who still hold Vodafone shares as a legacy of the Eircom privatisation, developments this week are clearly disappointing.

Of course more active investors may well see the recent share price weakness as a buying opportunity. Many large companies go through difficult phases, but most have sufficient resources to enable them to change direction and engineer an eventual recovery.

Unfortunately, there are a number of reasons for taking the view that an early turnaround is unlikely.

There seems to be little or no prospect of any improvement in industry-wide profit margins. Evidence of this comes from the fact that over the past six months profit warnings have been announced by several of Vodafone's peers, including Deutsche Telekom and France Telecom. In the medium term the threat posed by internet telephony from companies such as Skype could be devastating.

A substantial recovery is still some way off.

Investor says: To be attractive to investors utilities need to pay high dividends to compensate for pedestrian growth prospects