Vodafone gets thumbs up from tipsters but Asia is key to future

Serious Money: Out of 35 global investment banks, 25 rate Vodafone as a "buy". Eight give the stock a "hold" and two say "sell". These rating schemes are like mobile phone tariffs: not designed to be easily understood. But it seems safe to say that most stockbrokers like Vodafone; indeed, it is easy to point out the good stuff.

The company generates prodigious amounts of cash: on one measure, its profit margin is 40 per cent. Gross operating profits could reach £15 billion (€22.2 billion) this year. Yet Vodafone is likely to report large losses for at least the next three years (blame the effects of past acquisitions). Are the stockbrokers right?

Start with the company's valuation. "Valuation" sounds precise. It isn't. There are lots of bright analysts who think Vodafone is cheap, and a couple who think it is expensive. So no real help there - but it is always like this. Valuation is not the purely objective game that many assume it to be. Also, there might, occasionally, be good reasons for buying or selling that have nothing to do with valuation.

Always ask how much are you being charged for growth. Most forecasters expect around 8 per cent profits growth over the next few years for Vodafone (but any major acquisition purchase could alter that). In the bubble years, many people adopted an old Chinese counting system: one, two, three or lots.

The projected earnings growth that they paid for was simply "lots". When Vodafone was nudging £4, (currently around £1.35), somebody must have thought that "lots" was a very large number indeed, certainly orders of magnitude greater than 8 per cent.

The most basic valuation measure, the price-earnings (PE) ratio, shows Vodafone priced at around 14 times 2004 earnings. This is almost the same as the PE ratio for the UK market; this is what we are paying for 8 per cent growth.

Now, there is an expanding universe of valuation measures of varying degrees of complexity. But, like the humble PE ratio, they are always the equivalent of the workhorse of finance, the discounted cash flow model. For those unfamiliar with the jargon, this means working out today's value of all future profits.

We can see how this might throw up a problem: how can we guess at Vodafone's future earnings? That's what the analysts get paid the big bucks for. And on their guesses about earnings, Vodafone's valuation, on most measures, looks just about OK. But achieving those growth forecasts will be vital.

Fixed-line operators - the Eircoms of this world - are likely to die without a new business model (hence the probably futile rush to broadband). But this is good news for Vodafone: the switch to mobile phones is a key driver of the demise of the fixed-line dinosaurs. In some countries, people are giving up fixed lines altogether. But this only happens as the cost of mobile calls falls; margins are under pressure. Mobile operators need take-up of the new data services (pictures, news, etc), or simply more voice calls. Unfortunately, for Vodafone, large amounts of voice telephony could, finally, be about to migrate to the internet (Voice over Internet Protocol or VoIP).

Vodafone's margins probably last for as long as a "disruptive" technology doesn't emerge. It's small-scale stuff, but there is a lot of excitement about something called Flash-OFDM which, some argue, is superior to 3G, the technology that everyone overpaid for and is yet to be rolled out. At the moment, OFDM offers genuinely mobile, wireless broadband internet access.

One suggestion is that the integration of VoIP with OFDM might mean that all voice calls will be via the internet within a decade. If true, that's the end of traditional fixed-line calls and must mean a whole new world for mobile operators, if not the end of the world. I want to be invested in companies that are involved in this new technology. Nextel in the US is already rolling out trials, Cisco and Nortel make some of the kit and SK Telecom in Korea is also involved.

For now, Vodafone looks like an unexciting bet. Before the bubble years, telecoms used to be classified as "utilities" - stock market shorthand for boring companies with stable cash flows. My guess is that the stock will go up broadly in line with the UK market this year, which, in my view, means a rise of around 5-10 per cent.

Looking further out, I am worried; those margins must be under competitive or regulatory threat. New technologies might also hurt longer term growth prospects. If I wanted to own a boring stock, I would probably choose one of the Irish banks, say AIB, which is on a PE of around 10-11, is forecast to have a similar growth rate to Vodafone, at least for 2004, and, unlike Vodafone, pays a half-decent dividend. In addition, I don't have to worry about sterling.

Could there be an upside? The growth opportunity seems to be in Asia. Vodafone's 100 per cent owned Irish subsidiary has 1.8 million subscribers. Its 3 per cent stake in China Mobile gives it access to over 4 million subscribers where, relatively speaking, hardly anyone owns a phone. If you hang on to your Vodafone shares, you are essentially betting that Arun Sarin can realise the vision of a global brand that can withstand ferocious competition and successfully ride the waves of technological change.