Financial Analysis

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It is impossible to imagine modern society without mobile telecommunications given that three billion calls are made each day in the US alone (Romano, 2013), there are more than 6.8 billion mobile telecommunications subscribers worldwide, and today, 96.2 out of every 100 people are expected to have a mobile device (Mobi-thinking, 2013). If these figures are not astonishing enough, the number of mobile subscribers is likely to surpass the world’s population in 2014 (Pramis, 2013). A total of 1.9 billion cell phones were sold in 2012, and the number does not seem as though it will fall anytime soon; in fact, the number is likely to grow to 2.6 billion by 2016 (Mobi-thinking, 2013). In 2011 in the UK, the number of mobile calls surpassed landline calls (Lee, 2013). Vodafone Group is the second largest service provider in the world, with a 2013 revenue of more than £44 billion (Mobi-thinking, 2013). However, assessing the financial state of a telecommunications company involves more than just assessing its revenue. This high technology oriented industry has continuous technical development, requiring shorter spans of return on investment and complex depreciation adjustments.

The telecommunications industry is in itself diversified to various product offerings. Usually, cellular telecommunications (mobile and satellite) and fixed line telecommunications (landline and internet) are the two identified categories. China Mobile is the world’s largest service provider, with over £43 billion in revenue in 2010, and Vodafone being second largest with £43 billion. China Mobile had 594.2 million subscribers in 2010, and Vodafone had 338.9 million subscribers in the same period (Mobi-thinking, 2013).

Vodafone is a UK based company operating in 30 countries with strategic network of 50 partners. Its standard cellular services now include instant messaging and mobile data services, along with products like cloud sharing, cellular plans, and offering of cellular and fixed line services as bundles (Vodafone, 2014).

Zain Telecom (Zain), on the other hand, is a Kuwait based mobile telecommunications provider operating with foreign subsidiaries in seven other Middle Eastern and North African countries (the African subsidiaries being sold in 2010). With 46.1 million customers in these countries, it is the largest operator in Kuwait, with an overall revenue of £2.6 billion. The company is 100% free floated, with all the shares publically sold; with 24.4% of the holding, Kuwait Investment Authority holds the largest share in the company (Zain, 2014). SWOT analysis of both companies is attached as appendix.

1.2 Financial Background

Vodafone PLC has shown promising market growth over the last five years. Its share price has risen from £125.8 per share in the first quarter of 2009 to £242.9 per share at the end of 2013, which is a 93.1% overall increase over twenty quarters. While its revenue has shown growth potentials, it has experienced a slight fall in year 2013, rising from £41 billion in 2009 to £44 billion in 2010, to £46 billion in 2012, and then back to £44 billion by 2013.

In comparison to Vodafone, Zain has limited operations, and in the last five years, its performance was somewhat similar to Vodafone, with growth between 2009 and 2010 amounting to a 12.5% increase and then revenue decreasing in 2012, falling in 2013 to its the lowest level in five years (2.65).

Being located and reporting in UK, Vodafone follows UK GAAP and the Companies Act 2006 for its reporting purposes. The company uses historical costs for accounting purposes, and other disclosures are appropriately supported as per the accounting standards.

Investments are impaired based on IFRS 11 principles. The analysis of the company’s investments in joint ventures and associates reveals impairment losses of more than £2 billion. The company’s policies regarding impairment tests rely upon sufficient market evidence and appropriate conditions, leading to lower estimated recoverable amounts than the book cost. The available for sale investments are rightly attributed as per the rules of IAS 39 and are measured at fair value, with any adjustment being attributed to equity.

Another important consideration for Vodafone as an international business is the translation of foreign currency into reporting currency. Vodafone initially records the transaction of monetary items at the current rate and then revises it to the rate at closing date at the end of the financial year. This practice is in compliance with IAS 21, and all profit or loss is appropriately treated in the profit and loss account.

The company uses lower of cost or net realisable value to record the inventories. To calculate the cost, the company uses the weighted average cost method, which includes the any associated or already incurred direct material or labour costs. Net realisable value is an estimate developed after careful analysis of market conditions. Obsolescence has been netted off the inventory cost, which is determined on the basis of net realisable value of the inventory.

According to the auditor’s report, the company has not disclosed all the information necessary regarding the directors remuneration. Moreover, the company has itself disclosed that it has taken the leverage of IFRS 8 and has not disclosed various transactions within the group. This could be a time-saving tactic, or management may have opted to not disclose future plans, which may be reflected in the nature of transactions carried out.

Zain, being an international group, uses IFRS to report its financial statements, along with International Accounting Standard Board (IASB) requirements. Historical costs has been used for accounting, and instances have been disclosed wherever fair value evaluation is being used.

Zain management has disclosed all its estimates based upon appropriate judgements and supported by the relevant IFRS. For instance, investments have been a widely used instrument to invest extra cash into some profit generating activities. Based on the intention of investment, the company recognises the investment on cost or fair value, and appropriately apportions any impairment or changes in profit or loss or equity accounts. Likewise, impairments are recorded as per IAS 36 and contingent liabilities are recognised as per IAS 37.

The group has also disclosed its estimation techniques for dealing with uncertainty, including estimating future cash flows, appropriate discount factors, and associated risks. Doubtful debts are another estimate for which historical analysis are used to make estimates of future rates; intangible assets are amortised based on definite useful life.

Calculation of goodwill impairment is another important judgement management has to make. For this purpose, the value of all the cash generating units is calculated and compared with the fair value of the business with the adjustment of expenses incurred to sell. These expenses are determined using market rates, and estimates are based on units’ profitability before settling any depreciation, interest and tax payments.

The auditors’ report confirmed Zain compliance with the IFRS, which was carried out in accordance with international standards on auditing. The inventory count is reliable since it was duly carried out in accordance with company’s law (Defined by Zain).

Over the period of last two years, Vodafone has shown tremendous growth in cash balances, resulting in a more than 500% increase from the base year of 2009. In 2013, accounts receivable also decreased, resulting in a better cash position. Income tax payable figures have also considerably declined, resulting in an 11% overall decline in net operating assets compared to the 2009 base year. Overall, management is more focused on investing in medium-term loans than on long-term debts, resulting in an overall stable position over the past five years.

Over the last five years, Zain showed promising liquidity improvements, with about a 233% increase in cash balances compared to the 2009 base year. However, the subsequent increase in accounts payable show that the company is leveraging relaxed credit policies, although this also indicates that business/sales have increased. Overall, the growth in operating assets was declining over the years, before a slight recovery in 2013. Likewise, the net operating assets have been declining as well. Zain has completely abstained from short-term investments, and its long-term debt has been reduced. The impact of the African subsidiaries being sold is evident in the overall disposition of the balance sheet.

Vodafone, on the other hand, showed consistent revenues over the same five year period, with about an 8% variation over the years. The cost of the sales has increased in a higher proportion than the increase in revenue, resulting in a somewhat consistent gross profit margin over the period. However, due to an increase in impairment losses, the operating income has declined by a margin of 127%. For this reason, the comprehensive income to common shareholders has declined to 14% of the income in the base year.

Overall, the income level of Zain showed stability over the period, but their cost of sales increased tremendously. Against the benchmark year of 2009, the major increase was in the cost of sales, increasing over 450% with its net margin registered a decline to 74% against the benchmark. Likewise, the overall operating income also declined over the period, reaching 72% against the benchmark. There was a considerable decline in the net interest expense as it reached a low of 6.5%.

As the name suggest, return on capital employed is the ultimate measure of understanding whether an investment is profitable or not overall. However, this can be further decomposed by determining the profitability at the operational level, calculating the financial leverage, and identifying the operational spread.

Table 1: 5 Return on Capital Employed - Vodafone vs. Zain

Current inter-company analysis of Vodafone and Zain reveals completely different results for both companies. Vodafone had a much lower ROCE compared to Zain in all the years analysed. Vodafone experienced depleting returns, rising from 4% to 9% for three years, before falling as low as 1% in 2013. On the other hand, Zain showed promising growth over the last five years, from 12% in 2009 to 14% in 2010/11, 18% in 2012, and about 16% in 2013. The percentage of ROCE reveals the efficiency with which the capital invested by shareholders has been used to generate the value for them. The results reveal that Zain management is generating more value for its investors than Vodafone. The following analysis will determine what is triggering the increase or decrease.

Profitability at the operational level is determined with the return on net assets earned. This is calculated using the operating income and comparing its ratio to the net operating income. The figures state that Vodafone has a very low return on net assets; starting at about 4%, it rose to 10% in 2010 and stayed stable before it fell to 1% in 2013. This could be attributed to a large amount ‘other operating expenses’, which included the impairment of goodwill and other investments that the company had made. Zain, on the other hand, nearly doubled its return from 2009 (8.5%) to 2010 (16.7%); followed by a decline return of around 13.5% in 2011, 2012, to about 11% by 2013. This may be attributed to the decline in the revenue over that period, along with relatively higher impairment losses.

Table 1:6 Return on Net Operating Assets - Vodafone vs. Zain

Financial leverage is the measure of determining how much of the borrowed money is being used by a business to operate. This ratio is essential not just for investors to understand but also for the institutions lending money to the business. The right limit of financial leverage is subjective in nature and depends on industry norms. Vodafone has a relatively high financial leverage, witnessing a continuous increase since 2011, from 36% to 51% in 2013. This could be attributed to the decline in net operating assets, along with an increase in net financial liabilities.

Zain, on the other hand, had a bell shaped financial leverage trend over the period. From 90% in 2009, it fell below 0% (having net financial assets) before it rose again to 46.5% by 2013. The particular pattern is due to the disposal of the African stream of business in 2010, after which Zain began to focus primarily on its GCC business.

Table 1:7 Financial Leverage: Vodafone vs. Zain

Operating spread is the difference between return on net assets and net borrowing cost. Net borrowing cost is calculated by determining how much of the net financial obligations are actually due to the long-term debt. The operating spread then contributes towards covering the financial leverage. Vodafone had a negative spread in 2013, suggesting that its return on net assets was less than the net borrowing cost of the company. Similarly, Zain had a declining spread as well, but this is understandable due to the selling off the business operations and the restructuring of the business.

Table 1: 8 Operating Spread - Vodafone vs. Zain

Vodafone had a steep increase from 2009 to 2010, before it started declining with a sharp fall from 17% to 3% in 2012 to 2013. This could be attributed to the increase in operating expenses against the sales figure, and it can also be attributed to the decline in revenue. Zain, on the other hand, has a much more stable position comparatively, as they continued to maintain a good margin of its sales. However, the decline is evident, from 31% to 23% over the five years.

Table 1:9 Profit Margin - Vodafone vs. Zain

The indication of how much revenue the business is making for every pound invested is essential to understanding the efficiency of the management. Results for Vodafone reveal that its asset turnover is increasing, going from 33% in 2009 to about 41% in 2013. This indicates that the capability of the business generating more revenue is increasing, which is a good indication for the future. More importantly, the overall cash figures have increased for the business, along with a considerable decline in accounts receivable, showing that it has strong credit policies and is promptly following its debtors to make early payments.

Zain, on the other hand, is also maintaining a higher level of asset turnover ratio due to the reduction in net assets (since African operations were sold out), and it focused towards more revenue oriented operation areas (Gulf countries). Its asset turnover stayed around 50% after selling the African businesses.

Table 1: 10 Asset Turnover - Vodafone vs. Zain

Vodafone PLC is a UK based telecom giant, while other operators in the country operate as foreign subsidiaries. For this reason, the scope of the telecom industry is extended to include European operators who have been operating in somewhat similar circumstances. The portfolio consists of Sonaecom SGPS (Portugal), Tele2 (Sweden), TIM Participacoes (Italia), VimpelCom Limited (Netherlands) and Vodafone Group (UK).

The industry offers about a 20% of the return on capital employed, with Vodafone averaging only 6%. All the big operators are actually on the lower side of the average, which seems to be common in the European market. Further decomposition will highlight the performance of the companies in their respective markets.

The first level decomposition provides a return on net operating assets analysis, which averages at 8.5%. However, Vodafone is on the lower side at 4.5%, with Tele2 averaging about 14%. Vodafone also has a strong and large base and is the second largest operator in the world. In 2013, the RONA for Vodafone was even less than 0.5%, as its overall profitability declined as well. For the year, its profit margin was about 3%, whereas the industry average is more than 10.5%.

Overall, the financial leverage of Vodafone (42%) is consistent with the industry (39%), but was on the higher end in 2013 (51%). Following continuous investment in relatively volatile technology, high financial leverage can create credibility problems in the near future. Due to the lower return on net operating assets, Vodafone’s operating spread is negative for 2013, but it is still higher than the industry average of 1%.

Vodafone has a higher profitability margin than the industry, for the last five years average, but its 2013 profit margin was only 3% compared to the 6.6% industry average for the year. Its asset turnover is also the lowest in the region, while other companies are generating a revenue of minimum 60% per pound spent, Vodafone only makes about 40%. Thus Vodafone needs to find efficient ways of generating revenue against the amount of assets they have acquired.

Zain operates in a comparatively less saturated and smaller market than Vodafone. Since there are only three mobile service providers in the Kuwaiti market, Zain was analysed against GCC companies. Companies included in the portfolio are Zain, Vodafone Qatar, BahrainTelecom, Etisalat, and Wataniya (operating as a national mobile telecommunications company).

The analysis shows that on average, the industry’s return on capital employed was around 25%. Compared to the industry average, Zain had the highest average at about 43%. Of the four other companies, Etisalat had somewhat similar operating assets to Zain, but its ROCE was only 18.6%. Wataniya (NMTC) had the second best return of 27% over the five years. This signifies Zain’s importance as the market leader, given that it had the highest return on capital employed.

At the first level of ROCE decomposition, the industry average of return on net operating assets was about 5.5% in 2013, with Zain being the highest at 11% return. However, the industry average is actually distorted due to the early operations of Vodafone in Qatar, resulting in negative figures. But taking into account the return of the last five years, NMTC had the highest average return of about 19%, when the industry’s return was 11.8% and Zain had the second lowest at 12.7%.

Average financial leverage in the industry was 18.7% and Zain had the highest of all the companies at 37%. This signifies that Zain has much higher levels of debt compared to other companies in the same sector. Etisalat had about 11% debt; the difference between the debt levels of Zain and Etisalat can be thought as a potential opportunity for Etisalat to raise finance (through debt) and expand without much impacting its credit rating. However, if Zain raises finance through debt, creditors will be concerned about business’ ability to pay off their debts.

Against the 11% average operating spread, Zain has an operating spread of 15% on average, with the 2013 spread equalling the industry average. Overall, the profit margins were highest at Zain (27%), with most of the market nearing an average of 23%. These results do not include Vodafone Qatar since it was operating at higher losses due to its early stages of establishment. Overall, the asset turnover ratio for the industry was more than 54%, but Zain was only operating at 47%, and Vodafone Qatar operated at 13% on average. Zain had the second largest net operating asset base so it needs to improve its asset turnover ratio by increasing its efficiency; Etisalat had the highest asset base and a 62% ATO ratio.

Based on the analysis of the two groups operating in different markets, it is not difficult to determine that there is a great deal of competition in the fast paced telecom industry and that the continuous development in the technologies is somewhat limiting the profitability of the companies. Vodafone, being the second largest telecommunications company in the world, is experiencing a declining ROCE, which may be a temporary concern for its investors. However, since Vodafone is expanding into the developing markets, its long-term position is secure, and it will continue to provide investors with long-term returns due to its strong market holdings. On the other hand, Zain has separated itself from its underperforming African subsidiaries and is focusing on developing into the biggest telecom service provider in the Gulf region. Its major competitor in the region is Etisalat and Wataniya in Kuwait. Against both of these companies, Zain is performing competitively, and it is focusing on expanding in the profitable markets within the Gulf region.

7.0 References

SWOT Analysis:

Vodafone

Being the market leader in UK market provides Vodafone with a wide customer base and allows it to penetrate globally: not just in the European market, but also in the Asian market. However, since Vodafone expanded by acquisition, service level cannot be guaranteed across all its networks, resulting in a high churn rate (Dudovskiy, 2012). As Vodafone continues to expand, it has developed a strong base in many countries, and is in a position to provide good rates in the markets it operates. However, it needs to maintain its level of service at a competitive cost since increasing local competition can actually threaten growth in the European and Asian markets.

Zain

Zain has been the market leader in Kuwaiti market, and its presence in other Gulf countries allows it to diversify its investment into many different profit generating business units. Being a 100% free floated company, Zain’s decisions are not biased but are directed towards the maximisation of shareholder wealth. Its presence in the international level allows it economies of scale due to duplication of services across the market. It can take strategic expansions in the region and become the top mobile services provider across the Gulf region. However, there is the threat that rapid telecommunications technological expansion will be capitalized by competing firms. Moreover, the absence of any strong majority holding in the company is also a weakness, as this can allow management to take over decision making solely to its own benefit.

Return on Net Operating Assets

Profit Margin

Vodafone 2013 2012 2011 2010 2009 6.0019306909915027E-3 9.0426983817508286E-2 9.1005653589172508E-2 9.5650634536019741E-2 3.5723404749193381E-2 Zain 2013 2012 2011 2010 2009 0.15586518307081634 0.17836816319499649 0.14332248652961568 0.13646368138904941 0.12054287159899711 Vodafone 2013 2012 2011 2010 2009 9.2353883860427279E-3 8.9843787501620281E-2 8.8975882576779047E-2 9.3911890770582873E-2 3.6334236045235974E-2 Zain 2013 2012 2011 2010 2009 0.11328297138025686 0.13558924491225754 0.13334384955037604 0.1672783098774101 8.5386058220769057E-2 Vodafone 2013 2012 2011 2010 2009 0.50996824153224118 0.43712224605186195 0.35889440922848498 0.38157356081477301 0.42363222766416747 Zain 2013 2012 2011 2010 2009 0.46511445666788226 0.4080748781777363 0.15678277713423278 -6.6508751449759901E-2 0.89136210801871629 Vodafone 2013 2012 2011 2010 2009 1.9618085486837602E-2 3.0255724055902468E-2 8.9631800738104762E-3 3.5890625453069272E-2 3.1334240667622151E-2 Zain 2013 2012 2011 2010 2009 6.6761821026078451E-3 1.2640115566232655E-2 2.0683632954386334E-2 -0.19514507149246219 3.6839656478060964E-2 Vodafone 2013 2012 2011 2010 2009 -6.8761029637676527E-3 4.1463461865837291E-2 5.8880735662453679E-2 4.1996508157912324E-2 3.5121397791180869E-3 Zain 2013 2012 2011 2010 2009 0.10660678927764902 0.12294912934602489 0.11266021659598971 0.36242338136987229 4.8546401742708092E-2 Vodafone 2013 2012 2011 2010 2009 3.1231833368899023E-2 0.17279229592606157 0.17765778937013657 0.22161719733765067 0.10426728231242842 Zain 2013 2012 2011 2010 2009 0.22993903073970243 0.24960600480217754 0.25537811322705867 0.31828360356186475 0.30594590359827722 Vodafone 2013 2012 2011 2010 2009 0.40798061300360755 0.41506009013520279 0.3818797699599677 0.35144896039956058 0.33420244274062788 Zain 2013 2012 2011 2010 2009 0.49266525572379422 0.54321307301768362 0.52214282526168942 0.52556370483877668 0.27908874482884194

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