Analysts Debate: Is Vodafone a Top Stock?

The Motley Fool has been making successful stock picks for many years, but we don't always agree on what a great stock looks like. That's what makes us "motley," and it's one of our core values. We can disagree respectfully, as we often do. Investors do better when they share their knowledge.

In that spirit, we three Fools have banded together to find the market's best and worst stocks, which we'll rate on The Motley Fool's CAPS system as outperformers or underperformers. We'll be accountable for every pick based on the sum of our knowledge and the balance of our decisions. Today, we'll be discussing Vodafone (Nasdaq: VOD  ) , the international wireless provider.

Vodafone by the numbers
Here's a quick snapshot of the company's most important numbers:

Statistic	Result -- Fiscal 2012
Revenue	$74.2 billion
Net Income	$11.2 billion
Market Cap	$142.5 billion
P/E Ratio	13.1 trailing, 11.0 forward
Dividend Yield	6.8%
Mobile Customers	446.5 million
Key Competitors	AT&T (NYSE: T  ) , T-Mobile, �Airtel�

Sources: Company filings.

Travis' take
Vodafone is an international mobile network operator with access to some of the most desirable locations in the world. Vodafone and Verizon (NYSE: VZ  ) are equity partners in Verizon Wireless, with Vodafone owning 45% of the wireless giant. The company also owns the second largest network (by subscribers) in India, the largest network in Germany, and the largest network in Egypt.

European business has been hurt by the financial crisis playing out there, but emerging markets are continuing to grow. If Europe's economy stabilizes and returns to "normal," the company should grow along with it. But I want to focus on Verizon Wireless, which generated 42.2% of the company's adjusted operating profit last quarter�.

When Apple (Nasdaq: AAPL  ) released the iPhone 5, I took a step back to consider who the big winners were. The more I thought about it, the more I thought that Verizon Wireless was a clear winner in the U.S. because of its superior network and ability to charge a premium as a result.

Over the past two years I've personally tested every major wireless network by accident. I'm an AT&T user for my current iPhone and have never been impressed by the network. I also bought a MiFi device from Virgin Mobile over a year ago, which works on Sprint's network. It was OK, but when I lost the device I went in search of a better experience. For some reason I chose a 4G device from T-Mobile, the biggest mistake I've ever made in electronic devices. Since I use my MiFi for work, I can justify spending a few extra dollars for something that's going to work when I need it, so I sucked it up and spent the money on a Verizon Wireless MiFi. They're expensive, but the performance puts the other networks to shame.

I think many consumers will go through the same thought process when picking their next smartphone devices for a few reasons. First, coverage has always been important and Verizon Wireless has the best network in the U.S. But the big change in newer devices is the ability to use them as hot spots. This is a huge bonus for the average user, and if you're connecting multiple devices it will be worth considering the network, more so than when phone calls were the most important thing.

For carriers, this has a few implications. 4G will increase data usage and so will the ability to connect other devices. As a 3G user, I may have used 250 MB of my mobile plan, but 4G will likely push that closer to 1 GB. Add in the hot spot ability and I may push 3 GB to 4 GB. The tiered pricing plan will make this usage more lucrative for carriers.

Vodafone is in prime position to benefit from emerging markets, a European comeback, and Verizon Wireless' dominance in the U.S. The stock is reasonably valued at 13.1 times trailing earnings and while the high dividend may fluctuate with Verizon Wireless' special dividend, I think it will still be a strong payout. I'm comfortable with an outperform call at the current price.

Sean's take
As should come as no shock to anyone who has followed my mode of thinking before, I'm not exactly in agreement with Travis or my cohorts. I know, I know... it's hard to believe, but compose yourselves!

Let's start with the highly touted Verizon Wireless. Speaking not as a loyal AT&T customer, but as an unbiased and objective investor, while the iPhone 5 will undoubtedly bring in numerous new customers since its 4G LTE is light-years ahead of its peers, the iPhone 5 is also a margin killer and could actually have an even larger negative impact on both Verizon's and Vodafone's bottom lines than previous versions did. Here's a quick glance at what gross margins have done over the past seven years at Vodafone -- and it isn't pretty!

Year	2006	2007	2008	2009	2010	2011	2012
Gross Margin	41.8%	39.8%	38.3%	37%	33.8%	32.8%	32%

Source: Morningstar.�

With consumer spending growth slowing dramatically in recent months, I'm expecting data upgrades, where Verizon Wireless makes its bread-and-butter profits, to be moot at best.

Then there's the case for European growth -- or should I say the lack thereof. In previous quarters, growth from emerging markets has been strong enough to cancel out weakness in its European operations, but that finally caught up with the company when it reported its results in July. India is showing signs of promise, but looking at things realistically, the EU's extraordinarily high levels of unemployment and its debt issues are years, perhaps even a decade, from being fully addressed. It's going to be a long time before spending picks up, and a good chunk of Vodafone's business is still tied to Europe.

On a valuation call I can't say that I'm overly excited about Vodafone either. Let's be clear that I'm not ready to bet against Vodafone right here, right now, but I feel there are certainly better alternatives. I would personally avoid the EU altogether, but if I were forced to choose, I'd prefer to own France Telecom (NYSE: FTE  ) . Even knowing that France Telecom is planning a dividend cut, it should ultimately still be yielding more than Vodafone, and has more upside to offer at seven times forward earnings as opposed to Vodafone at 11.

To me this appears to be an easy stock to avoid. I understand it's difficult to pass up a high yield and the lucrative Verizon Wireless-Apple pact, but the gross margin figures and weakness in Europe spell out a scenario that I'd rather not have any part of.

Alex's take
Sean's table of compressing gross margins got me thinking about Vodafone's free cash flow, which should be a better way to depict the company's progress over time than its highly variable (and more easily gamed) net income line. Vodafone was tremendously unprofitable for several years last decade, but its free cash flow held up. How has its free cash flow margin (free cash flow as a percent of revenue) held up as Vodafone's expanded its reach? Not particularly well. Its dividend payments have become larger than seems prudent as a percentage of cash flow in the past two years:

Year	Free Cash Flow	FCF Margin	FCF Dividend Payout Ratio
2006	$6.69 billion	22.7%	41.2%
2007	$5.82 billion	18.6%	118.1%
2008	$5.76 billion	16.3%	63.3%
2009	$5.25 billion	12.8%	79.6%
2010	$6.09 billion	13.7%	68.9%
2011	$3.36 billion	7.3%	142.7%
2012	$4.90 billion	10.6%	141.6%

Source: Morningstar.

When you look at Vodafone's dividend payments over the last few years, you'll notice that this period of high payout ratios corresponds to the point when management decided to keep payments consistently high. Rather than goose the stock, all it's done is keep it tracking the S&P 500:

VOD Dividend data by YCharts.

And this is happening during a time of moderate declines in free cash flow and marked declines in the company's free cash flow as a percentage of its revenue. Investing in Vodafone with the expectation that its dividend will stay this high would be short-sighted, to say the least.

According to Vodafone's own filings, its customer base has expanded from 171 million customers�in 2006 to 404 million in 2012, with 150 million of those in India. Each customer contributed $39 to Vodafone's free cash flow in 2006, but only $12 in 2012. This seems like a great strategy if your goal is to become a less-efficient company. As an investment, it's less appealing. I'm going to pass on this one. I wouldn't short Vodafone, but I don't see it as a long-term outperformer based on these numbers.

The final call
Outside of a bullish view from Travis, we have a very apathetic view of Vodafone right now. The potential value and high dividend are enough to keep us from making an underperform call, so we'll stick on the sidelines on this one.

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