Shares in telecoms giant Vodafone Group (LSE: VOD) popped nearly 10% higher last week, after new boss Nick Read told investors he had no plans to cut the dividend.
According to Mr Read, this year’s dividend should be level with last year’s payout. At current levels, that gives the shares a yield of about 8%. If this payout is sustainable, the shares could be a serious bargain for income investors.
When I last looked at Vodafone’s results in June, I concluded that the dividend was sustainable because it was covered by the group’s free cash flow.
Today I want to revisit these numbers in the light of last week’s half-year results. Is the payout still affordable, despite high levels of debt and big spending commitments?
Turning towers into cash
Last week’s figures showed that net debt had risen to €32bn at the end of September. That’s roughly 2.3 times the group’s adjusted earnings before interest, tax, depreciation and amortisation (EBITDA).
This level of borrowing is proving quite costly, with interest payments approaching €1bn each year.
As a shareholder, I’d be more comfortable if the group’s net debt-to-EBITDA ratio dropped below two. Based on current earnings guidance, this would mean reducing net debt by about €5bn.
One way to do this would be for the firm to sell and lease back some of its radio towers. Mr Read has already said this is an option he’s considering. I expect selective sales over the next year or so.
Is the dividend still covered by free cash flow?
Critics of Vodafone have pointed out repeatedly that the firm’s dividend isn’t covered by earnings. That’s true. But the reality is that free cash flow is often a better test of affordability than accounting profits. After all, dividends must be paid with real cash.
Its dividend costs about €4bn each year. This week’s financial guidance is for free cash flow of €5.4bn in 2018/19, excluding spending on new spectrum. The problem is that spectrum costs appear to be running at about €1.5bn per year.
These figures suggest to me that free cash flow will be very tight indeed over the next year or two.
Cost savings could help
As things stand, I’d say a dividend cut might be necessary. But in addition to potential tower sales, Mr Read also plans to cut the group’s European operating expenses by at least €1.2bn by March 2021.
If these savings can be achieved without sacrificing sales, then free cash flow could improve significantly. This would make the dividend look a lot more affordable.
I’d keep buying
I think it’s worth remembering that Vodafone has been through several years of major change under former boss Vittorio Colao. The firm has spent billions on network upgrades and acquisitions in Europe.
Mr Read has been hired to bed down these changes and make sure that costs are under control. Although a dividend cut remains a possibility, I think this risk is already reflected in the price.
In my view, Vodafone remains an attractive option for investors looking for long-term FTSE 100 income stocks.