Mobile Telephony in the UK: Vodafone and O2 Financial Analysis

Introduction to UK Mobile Telephony

Cellular service was launched in the UK in 1985. Cantel and affiliates of Mobility UK were licensed to operate at 800 MHz. Personal Communications Services (PCS) operating at 1.8 GHz were licensed in the UK in December 1995, with two new players — Clearnet and Microcell — each receiving 30 MHz of spectrum. Mobility UK affiliates and Cantel each received 10 MHz of new spectrum. PCS service was launched in late 1997.

Today, a wide variety of national and regional licensed wireless carriers, along with numerous resale partners, provide wireless voice and data services covering more than 99 per cent of the UK population. Major carriers and resale partners include:

O2, Petro UK Mobility, Chatr Wireless, Primus, Cityfone, Public Mobile, CityWest, Rogers, Dryden Mobility, SaskTel, EastLink, Sears Connect, Fido, 7-Eleven Speak Out Wireless, Ice Wireless, Sogetel, KMTS Mobility, Solo Mobile, Koodo Mobile, TBayTel, Lynx Mobility, Telebec, MTS, Vodafone, Mobilicity, Videotron, Nexicom Mobility, Virgin Mobile, NorthernTel, Wightman Telecom, NMI Mobility, Wind Mobile, and PC Mobile.

Vodafone Corporation provides telecommunications products and services in the UK. It operates in two segments: Wireline and Wireless.

The Wireline segment provides voice solutions — including local, long-distance, and call management services — as well as high-speed and dial-up access with a suite of security services, digital entertainment services (high-definition TV, personal video recorder, video on demand, and pay-per-view), converged voice, video, data, and Internet services on a multi-protocol label switching-based network, and managed contact centre solutions in North America, Central America, and Asia. This segment also offers a range of equipment and application solutions to support meetings using phone, video, and the web; hosting and managed IT infrastructure solutions; and health solutions such as claims management, hospital-to-home technology, patient records at the point of care, and access to drug and medical information through information communication technology.

The Wireless segment provides digital voice services — including postpaid, Pay & Talk prepaid, and Mike all-in-one services — as well as Internet and data solutions such as web browsing, social networking, instant messaging, text messaging, picture and video messaging, images, ringtones, Vodafone Mobile TV, video on demand, Vodafone Mobile Radio, downloadable music, and wireless mobile applications. The company was founded in 1993 and is based in London, UK.

Company Overviews: Vodafone and O2

Vodafone Group PLC (NASDAQ: VOD) — Market Capitalisation: £14.90 Billion

BCE Inc. provides a suite of communication services to residential and business customers primarily in the UK. Its services include O2 Home Phone local and long-distance services, O2 Mobility and Solo Mobile wireless, high-speed O2 Internet, O2 TV direct-to-home satellite and VDSL television, IP-broadband services, and information and communications technology services such as voice, data, Internet, video, and value-added solutions.

Solutions for small and medium-sized business customers comprise Internet access, web hosting, business applications that automate business processes, enhance online presence, secure networks, and support employees, wireless voice and data solutions, various WAN/LAN and cabling solutions, and local and long-distance telephone services and systems. BCE Inc. also delivers security, call centre, storage, and vertical industry solutions through CPE and infrastructure solutions, IT consulting, and outsourcing and managed services to enterprise customers.

In addition, the company provides wireless voice and data communications products and services, value-added services such as call display and voicemail, email and video streaming, music downloads, ringtones, and games, as well as roaming services with other wireless providers. The company also offers IT professional services in the UK and the United States, engages in renting, selling, and maintaining business terminal equipment, sells video set-top boxes, and provides network installation and maintenance services for third parties. BCE Inc. was founded in 1880 and is headquartered in Montreal.

LSE: OOM — Market Capitalisation: £26.00 Billion

Financial statement analysis helps managers identify deficiencies and take actions to improve performance, and helps investors make investment decisions. Financial analysis is conducted using financial ratios. The ratios calculated here are those most relevant to revealing the financial situation of firms in the wireless services industry.

The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations. It gives an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, and receivables). The higher the current ratio, the more capable the company is of meeting its obligations.

Vodafone: 0.380  |  O2: 0.686

A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due immediately. From the ratio analysis, it is seen that the current ratios of both Vodafone and O2 are less than 1. This does not necessarily mean they will go bankrupt, but it does indicate that these companies are not in optimal short-term financial health.

The asset turnover ratio measures a firm's efficiency at using its assets to generate sales or revenue — specifically, the amount of sales generated for every pound's worth of assets. The higher the asset turnover ratio, the better the company is at utilizing its resources.

Vodafone: 0.376  |  O2: 0.500

The debt ratio indicates what proportion of debt a company has relative to its assets. It gives an idea of the company's leverage along with the potential risks it faces in terms of its debt load, and can help investors determine a company's level of risk.

Financial Ratio Analysis

Vodafone: 81.00%  |  O2: 29.00%

A debt ratio greater than 1 indicates that a company has more debt than assets. The debt ratio of O2 is well below 1, while Vodafone carries a comparatively high debt ratio of 81.00%.

The P/E ratio is a market valuation ratio comparing a company's current share price to its per-share earnings.

Vodafone: 14.9  |  O2: 12.64

A high P/E suggests that investors expect higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio does not tell the whole story on its own; it is most useful when comparing companies within the same industry. The technology sector has an average P/E ratio of approximately 17.38, and the domestic telecoms industry average is approximately 18.2. The average market P/E varies in relation to expected earnings growth, expected earnings stability, expected inflation, and yields on competing investments. For example, when treasuries yield high returns, investors pay less for a given level of earnings per share, and P/E ratios tend to fall.

The market-to-book (M/B) ratio — also called the price-to-book ratio — is a way of measuring the relative value of a company compared to its stock price or market value.

Vodafone: 1.78  |  O2: 1.80

A lower P/B ratio could mean that the stock is undervalued, but it could also indicate that something is fundamentally wrong with the company. The industry average price/book ratio is 3.73.

DuPont analysis is a method of performance measurement in which assets are measured at their gross book value rather than net book value in order to produce a higher return on equity (ROE). ROE is calculated in a three-step process: Return on Assets (ROA) is calculated and then multiplied by the equity multiplier to find ROE. DuPont analysis captures:

Operating efficiency — measured by profit margin; Asset use efficiency — measured by total asset turnover; Financial leverage — measured by the equity multiplier.

The formulas are:

ROA = Profit Margin × Total Asset Turnover
Equity Multiplier = Total Assets / Common Equity
ROE = ROA × Equity Multiplier

The industry average ROE is 10.10%.

Vodafone ROE: 8.66%  |  O2 ROE: 16.36%

Supporting figures (from Appendix 2):

Required Return, Risk, and CAPM

Where: r is the expected return rate on a security; R_f is the rate of a risk-free investment (i.e., cash); and R_M is the return rate of the appropriate asset class.

Beta represents the overall risk of investing in a large market such as the New York Stock Exchange — by definition, the market beta equals exactly 1.00000. Each individual company also has its own beta, representing that company's risk relative to the overall market. Beta measures the volatility of a security relative to its asset class.

Beta was calculated using market return and individual stock returns. Stock return was calculated as:

Return on Stock (%) = ((Ending Price − Beginning Price) / Beginning Price) × 100

Market risk was calculated using S&P/TSX data over a five-year period. The standard deviation of S&P/TSX returns over the period represents the market risk (σ_m). The covariance of the market return and each individual stock's return was computed, and beta was derived using the formula:

β_i = COV_i,M / σ_m²

Vodafone Beta: 0.389  |  O2 Beta: 0.469  |  Rogers Beta: 0.53

The required rate of return for each stock was calculated using CAPM. The risk-free rate used was the 5-Year Treasury Note rate. The market return was the average S&P/TSX return from 2005 to 2010.

Risk-free rate: 3.07%  |  Market return: 8.40%

Vodafone Required Return: 5.15%  |  O2 Required Return: 5.57%  |  Rogers Required Return: 5.91%