Foresight Capital Partners

Last week, we detailed how a dividend investing strategy provides a generous “margin of safety”. Here we detail a worked example of ‘dividend investing’ using the example of an investment in BT Group I recently exited.

Dividend investing candidates within the FTSE 100, display some or all of the following characteristics:

1. Dividend yield is at least 150 per cent of the average.
2. PE ratio at least 20 per cent less, than the average.
3. Dividend payout ratio less than 50 per cent of earnings.
4. Investment grade debt, with cash growth on the balance sheet.
5. Stable dividends going forward, backed by a predictable and sustainable business.

By systematically sifting through the FTSE 100 using, the objective criteria (1-3), will provide a manageable list. The more subjective criteria of (4) will require further detailed study of the companies through their annual reports, announcements and investor presentations. Criteria 5 demands research into not only the company but also the business environment.

In spring 2005, such analysis identified BT Group with a PE under 10, and yielding 5 per cent. Though the headline growth figures where not inspiring from 2000 to 2005, the firm had undergone a transformation at the balance sheet, valuation and shop-floor level. In 2000, BT traded on a PE of over 40, had no dividend to speak of and had debts of £30 billion. By 2005, the debt had been reduced to £10 billion, the speculative growth stock valuation requiring many “ifs” to justify had be replaced with a utility like valuation, and the firm took the bold move to turn itself into a ‘platform business’.

In 2002, the firm re-organized itself around the belief that revenue from calls where going to zero and future growth would come from services (media, broadband, corporate data service) offered over its platform. Resulting in BT building its 21st Century Network platform.

Such developments though enhancing BT’s position where not reflected in its share price until they started to feed through to the bottom line. On 26 April 2006, when this feed through was imminent I purchasing BT at 220.62p (including costs/tax), under 10 times historical earnings and 9 times my estimate of future earnings.

This position went against the consensus with City firms Bear Stearns (14 Nov 05), and Goldman Sachs (13 July 05) both subsequently downgrading BT. As Ben Graham would say, “it is the quality of your analysis that makes you right as a stock picker, not whether the market happens to agree with you”. On 8 May 2007, I sold BT at a price of 318.75p, at which point the earnings had moved forward 20 per cent, paid 6 per cent in dividends and the rating had moved forward to 13 times earnings, provided a return over the year of over 50 per cent.

It is good to see many of the themes with regard to the BT Group which I detailed last year becoming a reality within their business and also being more accurately reflected within BTs stock price (up 47.85% year-to-date plus (approx) 5% dividend). For those who wish to catch up on the activities of BT for which voice services now only make up about 15% of the business, I refer to interested reader to an interview of Ben Verwaayen CEO of BT Group made by FT.com:

FT.com Interview (7min 27sec in duration)

Moving forward though BT is not the screaming bargain it was a year ago it still is a good business at a reasonable price. The technology back-drop (i.e. move the VoIP and data centric services) really works in BTs favor since its business is already positioned for this technology shift within the industry. Many of BTs competitors are not as well positioned and hence I can see BT taking market share at least within its core European market. Further the increasing influence of globalization in the provision of business services puts BT in a strong position due to their existing global IP network infrastructure.

BT has just opened it first customer lines on its 21st Century Network (21CN) at Wick near Cardiff. The 21CN will eventually be rolled out nationwide and be a complete upgrade of BTs infrastructure. Allowing BT going forward note only to offer more value added digital products and services but also to reduce its fixed ongoing costs associated with maintaining its network. After pouring 10B GBP into this project (over several years) which has had a natural drag on the earnings this long term investment will soon start to pay-off. It will also reduce BTs operational risks since the 16 existing networks will ultimately be reduced by just 1 integrated technology platform which naturally will significantly simplify BTs operational position.

As was widely reported BT also launched its BT Vision service which is a home TV service. The offering is not really news since it has been in the pipeline for at least two years and for those for are interested to learn more I refer the interested parties to either the front page of today’s Companies and Markets section of the FT, or the numerous company reports of the matter which are available from BT’s corporate site at:

http://www.btplc.com/

If you are primarily interested in producing income for the long term then buying into a closed-end fund may not be the right approach since:

• A fund will typically pay-out less than the full dividend stream from the underlying investments. Moreover in a typical case the costs incurred from running the fund will be split 50/50 between the capital and income accounts of the funds. That is, half the funds management fee and management costs will come from the income steam (which is mostly dividends) further lowering the amount which can be paid out.
• Dividends are historically much more predictable than capital growth since a companies management will generally eer of the side of caution when deciding on the dividend level to ensure that they can be reliably paid and reliably increased. The most likely reason for this is that any cut in a companies dividend in most cases results in many of the senior management being relieved of their posts. Where as capital growth depends on the behavior of other market participants which is much less predictable.

The Verizon state of Vodaphone really makes no sense since at present in terms of earnings they only receive the dividend and have no (and our unlikely to get) strategic control over the company. Moreover, Verizon is not using GSM technologies (unlike Europe, Japan) hence there are no ecconomies of scale in terms of technology even if they did get strategic control. Hence, an exit seems the only sensible path. Which begs the question, what price should Vodaphnoe expect for its 45% state in Verizon?

There are some tax implications for Vodaphone on a cash sale but even the worst case senario the tax bill would be 25%. As a high end estimate, analysts have estimated that using the Cingular/AT&T Wireless and Sprint-Nextel deals as the yardstick, Vodafone could get as much as $66 billion for its 45% stake. The management of Vodaphone have also bounded around a range of $40-50B. But my query to all these estimates is simply who would (or even could) pay such a price for a minority stake in a mobile phone company.

Verizon sole market is the US which has a 70%+ mobile penetration and hence the growth is terms of Verizon’s users is limited and personally I would only be a buyer (or holder) of Verizon at value stock valuation levels (ie low PE, high yield). Vodaphone on a PE of 10.8, yielding over 5% (source http://uk.finance.yahoo.com/q/ae?s=VOD.L), is certainly on a value stock valuation, but Verizon with its PE 14.8, Yield 4.6% (source: http://seekingalpha.com/by/symbol/vz) which is not really what I would call a value stock. Moreover, the GSM Vodaphone spread of businesses (see: http://en.wikipedia.org/wiki/Vodafone); certainly contains at least some growth where as Verizons US business is essential ex-growth.

Just doing the sums we can see that a valuation of $66B works out at 51.45p per vodaphone share, a valuation of $50B works out at 34.75p per share, and $40B works out 31.92p per share since:

51.45p = (($66B - 25% tax) / 1.85 USDGBP Exchange rate) / 52B Vodaphone shares
38.98p = (($50B - 25% tax) / 1.85 USDGBP Exchange rate) / 52B Vodaphone shares
31.19p = (($40B - 25% tax) / 1.85 USDGBP Exchange rate) / 52B Vodaphone shares

Now any bid over $40B would certainly enhance Vodaphone’s valuation since even if a $40B offer was paid out as a special dividend, would imply valuation of the remaining business at 83p a share, where the earnings would only drop by:

($35.38 (today closing price) / 1.85 USDGBP exchange rate) * 0.046 (dividend yield) * 0.45 (stake) * 2.90b shares = 1.148B GBP

That is, Vodaphones 2006 average estimated earnings would drop from 10.64 * 52B shares = 5.53B GBP to 4.382B GBP, on a market capitalisation of 83p * 52B shares = 43.16B GBP. That is, Vodaphone would be move from a PE of 10.8, to a PE of 9.85, and new capital structure would most likely pay out a slightly higher level of dividend at around the 6% level.

Hence, if anything like the $40B mark could be acheived on the Verizon stake sale then even after a 25% tax cut, shareholder value would be enhanced by 10%. Moreover, with a Verizon closing price of $35.38 per share, if Vodaphone where to sell its 45% stake at market prices then the price would come to $46B (= $35.38 per share * 45% stake + 2.9B shares), hence a value of at least $40B is more than reasonable.

What will happen next?

However, saying all this at present any moves by Vodaphone to sell its Verizon stake seem rather unlikely in light of the noises eminating from Vodaphone. Quoting from the Press conference of Verizon on the 1st August 2006 available at: http://seekingalpha.com/article/14768
(scroll down about 665 of the conference text).

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The operating agreement between the two of us is strong, is sustainable, it has stood the test of time over these five or six years, and their view is that the creation of value available to them over the next several years is far greater than any strategy that they might have to exit the partnership.

He reiterated that was exactly the position of Sir John Bond, his new chairman, and for all practical purposes I had the chance to meet John Bond also within the last month or so, and that is exactly the situation.

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Saying this, the capital structural between Vodaphone and Verizon is rather inefficiant and obstructive to the smooth functioning of both businesses. Hence, I would not imagine the present situation being sustained in-definately. What will happen at present is not that clear but as always there is a number of possibilities including Verizon buying out Vodaphone, or even Vodaphone being brought-out by a private equity firm. These and other  possibilities we will consider in a follow up post.

Vodaphone as expected will enter the broadband arena to extend the range of channels which its platform can deliver services over. Interestingly a deal has been worked out where Vodaphone will enter the market by buying capacity from the BT network via the BT Wholesale division. This approach fundamentally differs from other parties who have entered the UK Broadband market such as BSkyB, O2 (of Telefonica), Orange (of France Telecom), who have all installed their own hardware within BT exchanges via the local loop unbundling program. This deal in some sense is not that surprising since BT Group’s mobile service at present just reselling Vodaphone mobile network capacity and hence the broadband deal is just a reciprocal of this existing arrangement.

Broadband as a service is a commodity and hence long term the margins are going to zero, hence the value to BT, Vodaphone and all the other players long term it not the broadband itself but the services which they can distribute over this customer service delivery platform. With this in mind with Vodaphone and BT Group both using the same infrastructure any broadband services they develop will be able to be distributed to both parties customer bases. Hence, the partnership should also been seen as a means by which to combine their development and marketing efforts. What I imagine will happen in practice is that they will delegate between themselves the development of differing services and cross license and cross sell the service offerings. Where BT will concentrate of broadband and Vodaphone will concentrate of GSM mobile services.

This strategy will be self reinforcing with BT/Vodaphone re-presenting by far the largest (UK and Global) development budget for broadband services, by far the largest UK broadband customer base, and once the services have been ported to the GSM mobile platform the largest global customer base to which any services can be distributed. This will create a dominant 600lbs gorilla, which unless unchecked will lead to a virtual monopoly in the UK broadband space, as the BT\Vodaphone services pull away in term of technology, range of services and content from the other (much smaller) providers.

Investment View

Personally, I own stock in BT and for a third party fund I run own stock in both BT and Vodaphone. Both stocks at the present prices, cash generation levels and yields represent great stocks for income purposes. I also liked BT for its capital growth potential, but now at 250p with a fair value as I see it around 300p the growth potential is much lower than when the stock was trading at just over 200p earlier in the year.

On Friday Vodaphone Plc sold its 25% interest in Proximus, the mobile telephone market leader in Belgium, for £1.4 bn, continuing its strategy of releasing capital in either markets where it has a minority position or in companies where it only holds a minority position. As mentioned in the press release available at:

http://www.investegate.co.uk/Article.aspx?id=200608250700031022I

the proceeds from this sale will go down to paying off debt, i.e. a re-allocation of capital within the group. However, Vodaphone will still preserve its position with regard to access of Proximus customer base through a revised long-term Partner Network Agreement which will run for an initial five year term. This means that the Vodaphone will still preserve the Proximus platform for the distribution of its global products and services such as Vodafone live!, Vodafone Mobile Connect Card, Blackberry from Vodafone and international roaming services.

The strategy which Vodaphone is implementing (with Proximus above as an example) is so effective because it allows Vodaphone to invest capital in high growth areas while still preserving access to its huge customer base. Vodaphone’s key business attribute is that it can develop a service or product which is a capital intensive activity (as is the case with all high tech research and development). Then deploy this new service or product to a single market (for example, Japan or Korea) in order to refine the technology and the associated business model of the new service or product. After this initial refinement Vodaphone can instantly get huge economies of scale by re-deploying this new service or product to all markets where it has access via either Vodaphone holding companies or partnership arrangements (as in the case of Proximus).

By applying this model Vodaphone can spread the initial cost of developing the new product or service over its entire customer base which is in fact the largest customer base of any global mobile phone company. These economies of scale which result from the large scale deployment of its key GSM technologies through various holding companies and long-term partnerships are the key long-term competitive advantage which will ensure that Vodaphone will continue to be a dominant force within the mobile telephony industry.

With the shares trading on an average estimated PE of 10.64 for 2006 (see analyst estimates), a highly cash generative business which pays out a 4%+ dividend, and the new strategy of core holdings and partnership being enacting upon we see Vodaphone as a Good Buy for its income or growth potential.