A losing formula

THE heir apparent to the world's largest mobile phone company was not in a terribly comfortable position on Tuesday when he attempted to explain the Spanish downturn that prompted the biggest one-day fall in the history of Vodafone share trading.

Vittorio Colao, who takes over from chief executive Arun Sarin this week, is currently head of Vodafone's European operations. Unfortunately for him, one of his last acts in that post was to justify what many regarded as a shocking 2.5% decline in revenues from Spain, previously one of Vodafone's best-performing operations.

Colao indicated that Vodafone first became aware of problems in late May, with detailed evidence emerging in June. Operations were particularly hard hit by the collapse of the housing market in Spain, where many of Vodafone's customers are migrant and construction workers.

"It has happened quite sharply," Colao said.

Investors were not appeased, marking the shares down by nearly 14% and wiping almost £11bn off Vodafone's market value by the end of the day. The response was so savage that Vodafone announced plans for a £1bn share buy-back just 24 hours later in an effort to counteract this sharp decline.

Though the plunge was precipitous, many analysts say it was not over-done. For starters, the warning that slowing economic growth is crimping revenues in markets like Spain came a mere eight weeks after Vodafone issued its most recent revenue guidance. Although macro-economic conditions may have deteriorated during that period, executives would have been fully aware of the turbulent global business climate when they made the original forecast.

In a note issued after the guidance was published, Citi telecoms analysts Terence Sinclair and Andrew Lee said Vodafone's management had "to take the rap" for not drawing special attention to the pressures in Spain.

"The share price move reflects confusion about whether visibility has worsened since the roadshow, or whether there has been a control slip as well," they wrote. "This leaves the stock open to a period of particular uncertainty given the increased risk of another guidance change (in the first half of the financial year)."

There are also concerns about how far the Spanish flu may spread. Vodafone's European operations generated three-quarters of all its revenues last year and there is ample evidence to suggest that other countries in the region will begin to seriously struggle as the credit crunch grinds on.

Fewer people are visiting Vodafone shops in the UK. The situation looks unlikely to improve in the near-term, as Government figures earlier last week showed a massive 3.9% slump in retail sales for June, the largest decrease since records began in January 1986. Like Spain, Vodafone's home market in the UK accounts for about 13% of its overall revenues.

"There's a big macro-economic picture that's playing through, and, frankly, as a company, we're not immune to it," outgoing chief executive Sarin told commentators who were digesting the fact that Vodafone had trimmed its full-year revenue forecast to the bottom end of the £39.8bn to £40.7bn range given in May.

Some analysts say that will not be enough, and believe Vodafone will further pare back its forecast as the year progresses. "Consensus expectations are still too optimistic," said one.

Looking ahead, Colao and company might take some cold comfort from the fact that the global economic downturn has created an identical predicament for nearly all of Vodafone's competitors in western Europe.

"Clearly, Vodafone is starting to feel the pinch in a number of areas," said Windsor Holden, telecoms analysts with Juniper Research. "I think we will see similar results from the other big players."

Though telecoms has traditionally been regarded as near-immune to economic slowdown, Vodafone's sober outlook has now shattered that perception, leaving sector investors far more circumspect. As Vodafone's shares were hammered on Tuesday, others such as Spain's Telefonica, Deutsche Telecom and Telenor of Norway were also hit, bringing an end to four days of advances by European equity markets.

Mobile operators in these countries are facing the dual problem of working in saturated markets during a period of cautious consumer spending. For those who can't or won't buy their way into higher-growth emerging markets, the question now is how to get more out of the existing client base.

According to the latest figures from industry researchers Gartner, 35.9 million mobile phones were sold in western Europe in the first quarter of this year, a decline of 16.4% on the same period in 2007. This is compared with increases of 26.6% in the Asia-Pacific region, 25.8% in eastern Europe, the Middle East and Africa, and a 28.4% surge in Latin America.

"While sales in emerging markets continued to be driven by strong net new subscribers' growth, mature markets felt the pressure of an uncertain economic environment," said Carolina Milanesi, research director for mobile devices at Gartner.

Although a number of mobile operators – including Vodafone, which most recently took a 70% stake in Ghana Telecommunications for £452m – have been investing in emerging markets there are some risks to this strategy. While emerging markets have been outpacing growth in established ones, many of these countries have inflation rates running into the double digits. Analysts point out that such rises in the cost of living could hamper consumers' ability to buy into new technologies in the medium term.

In addition, acquisitions in emerging markets are increasingly viewed as expensive, as future growth potential is already priced into the takeover cost. European buyers were absent from the recent battle for South Africa's MTN Group, which was seeking a hefty premium from would-be partner Reliance Communications of India. That deal collapsed last weekend at the 11th hour following a dispute between family members in control of Reliance.

The growing cost of acquisitions in emerging markets was one of the main reasons cited by France Telecom chief executive Didier Lombard when asked why he chose to pursue Nordic operator TeliaSonera, rather then looking for takeover targets outside Europe.

Before the offer for TeliaSonera was abandoned on June 30, Lombard highlighted the Nordic firm's ability to develop lucrative new services in its home markets of Sweden and Finland, while also expanding into relatively wealthy emerging economies. That view was at least partially born out on Thursday, when TeliaSonera reported solid increases in second quarter profits as growth in Russia and Turkey made up for sluggish demand in the Nordic region.

Others also reported positive results last week, as Dutch telecoms group KPN and smaller Swedish operator Tele2 beat expectations for the second quarter. Both feature among Morgan Stanley's top picks for the sector, along with France Telecom and Deutsche Telecom, owner of T-Mobile.

The French operator, which owns the Orange brand, will report its second-quarter results this Thursday, followed by Deutsche Telecom on August 7. Analysts will be keen to see whether either of these larger rivals reports problems similar to Vodafone's.

Others, however, have already flagged up the difficulties within the sector. Telenor, a local competitor to TeliaSonera, saw its shares fall last week when it was forced to cut its growth targets after a surprise 1.5% drop in core profits during the second quarter. While Telefonica's Czech subsidiary reported strong results, the Spanish firm's operations in Chile posted a 53% drop in net income during the second quarter. Telefonica, which last year became the largest shareholder in smaller operator Telecom Italia, will report its group results on Thursday.

While the picture remains mixed, analysts have no doubt that the sector is headed for tougher times. "You have to be a little bit nervous about the outlook for telecoms as a whole," said Jonathan Groocock, an analyst with Investec.

Juniper's Holden reckons although there is demand from some quarters for consolidation among European operators, such activity will be limited in the short to medium-term. Cross-border European deals have in the past been difficult to complete, either for political reasons or because of shareholder wariness. Now, added to that is the credit crunch.

For the moment, industry observers say mobile network operators will have to focus on cutting their costs in line with revenue projections. Cost control was one factor mentioned by Vodafone in its results last week, although there were no details as to what might be done, or when.

Holden said other, more fundamental factors would also have to come into play.

"Stagnant growth in a saturated market – there is no way around it," he said.

"You can't go out and create new customers. You have really got to build up the relationships with the customers you already have."

While mobile phone advertising remains a nascent market, Holden said it would provide a useful source of revenue further down the line. More immediately, operators such as Vodafone will need to concentrate on minimising churn, signing customers to longer term contracts, and getting users on board for additional higher margin services.

The latter, however, will require a careful approach to avoid scaring off consumers who are increasingly cautious about how they spend their restricted amounts of disposable income.

"It will undoubtedly be very tough," Holden said. "It will really be a case of making the offer to the customer as enticing as possible, but without pricing it out of their budget."

A tough balancing act, to be sure, but one which Colao, Vodafone and the rest of the industry will have to perform until the return of fairer economic conditions.