Uncertainty surrounds Vodafone's cashflow

Serious Money: One of the very first companies to be analysed in this column was Vodafone: thanks to certain, er, legacy effects, there are still plenty of Irish shareholders of the UK phone giant and, as one of the largest companies in the world, it still serves as a bellwether for the stock market as a whole.

As a very visible brand, we all know what the company does and how it makes its money. Vodafone is big. Love it or loathe it, the company's share price performance affects an awful lot of people. Even if you don't own Vodafone directly, I'll be willing to bet that your pension fund or other equity-linked investment has bought a lot of shares.

At the very least, every citizen of Ireland has an interest in Vodafone thanks to the holdings of the National Pensions Reserve Fund: thanks to its commitment to "passive" investing, large holdings of Vodafone are guaranteed. Is Vodafone a good investment?

Vodafone is a case study in how to think about equities. First, start with a standard analysis of the financials. Standard (and therefore subject to all the caveats and criticisms discussed in previous columns) ratios make the company look quite attractive. The stock is on a p/e of just over 11, an enterprise value (EV)/sales ratio of just over 2 and an EV/EBITDA ratio of around 4.3. A gross dividend yield of nearly 4 .5 per cent isn't the best the market has to offer, but is more than reasonable. The effective yield is actually higher than this: shareholders get money back via an extensive share buyback programme.

For those of us interested in how much pure cash the company is generating (we look at this in order to get around some of the accounting issues associated with other measures) it is striking that the free cashflow yield is around 12 per cent. On the face of it, anyone who can borrow money at less than 12 per cent would be making money if they did so to buy Vodafone outright. In the current environment where private equity houses are looking to make exactly these sorts of leveraged investments, we might wonder why they are not queuing up to take out the company.

Vodafone generates mountains of cash. An EBITDA margin around 45 per cent helps generate gross cashflow of close to £14 billion (€20.5 billion) annually. You can buy Vodafone for around £83 billion, taking into account net debt of around £8 billion. Assuming that the cashflow can be maintained, you wouldn't have to wait too long before you got your money back - pocketing those cashflows - if you bought the company outright, even allowing for financing costs of borrowing the money.

The issue, of course, is one of sustainability. If we were absolutely sure that Vodafone is going to throw off cash at its current rate forever, we should be buying as many of the shares as we possibly could. In fact, we should ape the activities of the currently fashionable private equity institutions and borrow large sums of money to do so.

Why is the market so obviously concerned about Vodafone's ability to continue to generate cash at current levels? Put another way, why are investors so convinced that Vodafone's profitability is likely to fall through the floor, and quickly?

The list of suspects is a long one and contains some familiar - and not so familiar - items. Vodafone faces the same problems facing the whole telecommunications industry. Increased competition, the emergence of all kinds of disruptive technologies (most obviously voice over the internet, but there are plenty of other contenders) and tough regulatory environments are common to most telcos and it is why they have all been having a tough time, at least in terms of share price performance. To be fair to Vodafone, plenty of other telcos have actually been doing worse. All telcos are subject to doubts about the sustainability of their cashflows.

Vodafone does have specific issues. Doubts about management strategy, focused particularly on the Japanese and US businesses have led some commentators to speculate about the future of the chief executive. Managing a telco these days is not a lot different to managing a premiership football club, particularly one that isn't Chelsea. Many investors want the company to sell its share of Verizon, the US telco giant, and return the cash to shareholders.

Given that the sums raised by such a move could amount to £25 billion (that's the top end of estimates I have seen) and that Vodafone's market capitalisation is currently around only three times that figure, the impact on the share price could be enormous. Indeed, if Verizon is worth that much, it throws into even sharper relief the very low value being placed on Vodafone's core franchise, European mobile telephony.

At this point it would be very easy to conclude that the market has got itself tied up in knots about Vodafone and is clearly over-discounting the rate at which the company's profitability is going to fall.

Yes, cashflow generation is going to erode, but it won't fall to zero and the implied value of those fading cashflows is actually ludicrously low. As it happens, I suspect that plenty of commentators will be making these points in the months ahead and will receive plenty of encouragement should the company change tack - a new chairman is taking up his seat - and pull back from the US and/or Japan. In these circumstances, Vodafone will have a good - perhaps very good - run.

But for those holders of Vodafone out there, I would use any such occurrence as an opportunity to sell. My own view is that the market is more than aware of the issues and knows how to value the US and Japanese businesses. The market is concerned about management strategy - and would welcome a change - but is actually worried about something far deeper.

Vodafone has bet the farm on one product - mobile telephony - and one technology - 3G. In its darkest moments, the market is concerned that 3G is going to be obsolete before it is fully rolled out and is not going to make anything like a decent return on the capital invested in it. Mobile telephony is rapidly becoming a commodity product. In which case, we have no sure way of knowing anything about those future cashflows.

In other words, the risk premium attached to those future cashflows is going to stay high - a fancy way of saying that the share price will remain under pressure and that any rallies will be very short lived indeed.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.