What Vodafone must do to top 300p

Vodafone is rarely short of friends. The mobile telecoms colossus has an army of supporters in the City. In return for that support, they've been rewarded with substantial share price gains over the years and regular fat dividends. Now, Berenberg has joined the fan club and produced a weighty 78-page tome to explain why.

"We think improving European operating trends will continue, underpinned by mobile data growth, an improving customer mix shift, and ARPU [average revenue per user] stabilisation," writes the broker. "Returns and cash flow should bounce back, sustaining the attractive dividend yield."

However, Vodafone shares have not impressed since the Verizon distribution in March 2014 (see chart), largely due to currency weakness, spectrum costs and fears of a Liberty Global deal.

That means headline operating free cash flow (FCF) multiples look only fair value, and the shares look cheap on an enterprise value-to-cash profits basis and against the domestic operations of major peers like Deutsche Telekom on 9 times and Telefónica on 8.8 times.

"The 5% dividend yield decides it for us, being better than all of its major peers except Telefónica, whose dividend we think is more risky."

Fears that Vodafone may spend heavily on Liberty Global are overdone, too, Berenberg says. Of course, there is a risk that a deal could result either in material earnings dilution, or the assumption of too much debt. But most accept the industrial logic of a deal, and Berenberg believes the sale of Vodafone's Africa, Middle East and Asia-Pacific (AMAP) assets would enable "an appealing and realistic possible deal structure".

"Assuming that Vodafone was able to sell AMAP for our target valuation of c£31 billion (7.8x FY16 EBITDA), and then paid a 20% premium for Liberty Global, funded with equity of between 38% and 57%, the deal would materially enhance FCF per share and EPS from year two post-close."

That would keep gearing at a manageable level and leave dividend cover unaffected.

Berenberg upgrades its rating on Vodafone to 'buy' from 'hold' and raised its target price to 270p. That implies "a modest 0.3% pa European customer growth, 67% smartphone and 44% 4G penetration by FY20, 0.5% pa growth in European service revenues through FY20 (compared to a 0.4% decline in Q3 FY15)."

However, if Vodafone manages "modest" customer base growth, an increase in smartphone data plan take-up from 37% to 75% by 2020, with 4G take-up rising from 10% to 60% at stable ARPU, it would justify a share price of 311p. But Berenberg admits this is a long-shot.

"This scenario implies continued strong momentum in smartphone take-up, which is maybe optimistic, and accelerating momentum in 4G take-up over the next five years, which also feels optimistic to us."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.