Why Vodafone Will Regret Selling Verizon Wireless

Vodafone received a mountain of cash in exchange for its 45% stake in Verizon Wireless. But it's using the cash for costly and time-consuming growth initiatives that make Verizon the clear winner from the deal.

Jun 18, 2014 at 10:30AM

It's been a rough several months for European telecom giant Vodafone (NASDAQ:VOD), to say the least. After the high-profile deal to sell its Verizon Wireless stake to Verizon Communications (NYSE:VZ), Vodafone was awash in cash.

But the market isn't so convinced that the rush to unload Verizon Wireless was the best move. Shares of Vodafone have lost approximately 16% of their value just since the beginning of the year. It looks like investors are having a classic case of seller's remorse.

The impetus for the deal was to reinvest in the emerging markets, where management believes the true growth potential is for the future. Indeed, since the sale, Vodafone has gone on a bit of a spending spree, acquiring companies and building out its technology in under-developed countries.

But all this has come at a steep cost. Expenses are rising, which is dragging down Vodafone's profits. In addition, it gave up a gold mine of an asset that is hugely profitable. Vodafone just wrapped up an ugly fiscal year, and management forecasts another ugly year ahead.

While the potential of the emerging markets sounds tantalizing at first, it's useful to remember there are two sides to every trade. Verizon looks like the clear winner from the deal. Unless Vodafone's strategic growth plan materializes soon, management is going to have some serious explaining to do.

The siren song of the emerging markets
As you likely recall, Verizon forked over $130 billion to acquire the remaining 45% stake in Verizon Wireless that it didn't already own. At the time, it seemed like an unimaginable amount of money that Vodafone apparently couldn't pass up. Afterwards, Vodafone management assured investors that with that much cash in the company's coffers, they were on the verge of a global expansion campaign that would send future earnings soaring.

Indeed, aside from the $85 billion returned to shareholders, Vodafone is in the process of investing 19 billion euros -- about $25.7 million -- over the next two years. The goal is to build out its reach in several areas, including wider 4G coverage in Europe and 3G coverage in the emerging markets.

However, this will take time and cost a lot of money. Vodafone projects fiscal 2015 earnings before interest, taxes, depreciation, and amortization -- EBITDA -- to decline 9%. This is a concern, since Vodafone was performing poorly as it was. To that end, EBITDA fell 7% last year.

It's true that Vodafone is being boosted by the emerging markets. Its Africa, Middle East, and Asia-Pacific segment generated 6% revenue growth last year. But Vodafone is still being hurt on its home turf. Europe is a major problem. Revenue there fell 9%. Giving up its prized U.S. asset in exchange for a boat load of cash isn't going to change that.

Meanwhile, it's smooth sailing for Verizon. Thanks in large part to Verizon Wireless, the company just posted its fifth-consecutive quarter of double-digit earnings growth. Wireless service revenue rose 7%, which outperformed the wireline business.

In addition, margins in wireless are much higher than on the wireline side. Consider that Verizon generated a 52% EBITDA margin in wireless, compared with just a 22% EBITDA margin in wireline.

Put simply, Verizon Wireless is a cash cow with wide and expanding margins, and it should continue to pump out prodigious cash flow for years to come.

Vodafone's turnaround can't come soon enough
For Vodafone investors who thought the $130 billion windfall from selling Verizon Wireless would result in a cascade of returns, the past several months haven't worked out as hoped. Management's dreams of emerging-market domination are within reach, but it's going to take time and cost a lot of money. Vodafone will need at least two years to build out its infrastructure across new markets.

During that time, Verizon will continue to make a fortune from Verizon Wireless, which is the largest and most profitable wireless carrier in the United States. If Vodafone investors are willing to wait it out, there's a light at the end of the tunnel. But it's going to take a lot of patience, especially since Verizon shareholders -- such as Warren Buffett -- are laughing all the way to the bank.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Vodafone. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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