Income investors: this is why I’m interested in Vodafone shares

Many investors are increasingly looking to generate safe income from dividend-paying stocks. If that sounds like you, then you may want to read on.

For income-centric portfolios, I generally consider stocks with dividend yields over 4%. In such a portfolio, my secondary goal is to achieve some capital appreciation over the long term, between four to six years.

A stock I’m watching closely 

In general, big blue-chip names tend to be consistently generous dividend payers. And telecommunications companies have traditionally been seen as relatively safe dividend investments.

One such income-investor favourite has been Vodafone (LSE: VOD), the global telecoms giant. Its five-year average dividend yield has been over 6%. But in 2018, if you had included Vodafone in a portfolio, although the stock would have generated excellent dividend income, its share price would have fallen by 35%. The stock’s 2019 performance has not been rewarding, either: year-to-date VOD shares are down about 4%.

After reaching a high of almost 239.65p in January 2018, the shares saw a low of 131p in March 2019 and investor sentiment has remained weak since.

But this means the current dividend yield stands at an eye-popping 9.4%.

Can the share price recover?

In recent years, Vodafone has pursued an ambitious acquisition strategy and invested in developing its network. Management is now working to integrate its various mergers and cut costs at the same time.

The group aims to save over €1bn in continental Europe alone (since 2016, it has been reporting in euros). And that should help toward the profit growth analysts are expecting from 2020 onwards.

Globally, the group offers telecom services to about 550m customers. Its primary markets are Germany, Italy, and the UK, accounting for over 50% of revenue. Recent growth numbers from both Europe and emerging markets have been encouraging. 

It also manages several 5G initiatives in the UK and rest of Europe. However, on the 5G front, its organic earnings growth will possibly not materialise until mid-2020 or even 2021.

I see its growth prospects improving as revenue and free cash flow levels are increasing, making the shares attractive for long-term investors.

Is the high yield sustainable?

However, City analysts are wondering if Vodafone’s prized dividend yield of over 9% is sustainable.

The dividend payout ratio can show investors if a stock is paying out either less or more than the company earns. In other words, if a company earns £1 per share but pays a dividend of £1.40, management may have to cut out the dividend at some point in the near future. A payout ratio of over 100% means that a company is paying out more in dividends than it earns.

VOD’s payout ratio is 75.9 which makes the the stock’s dividend sustainable as long as the company keeps the earnings around the current levels. However, in case of a miss in earnings, I’d become sceptical of the dividend amount and would even expect a cut.

Experienced dividend investors also pay close attention to a company’s free cash flow as dividends are ultimately paid out of cash. Vodafone is a large business that generates a lot of cash.

Finally the current ratio, which measures a firm’s ability to pay off its short-term liabilities, stands at a comfortable 1.3x. 

In its trading update of January 2019, the company reiterated the steps to cut costs, which makes me cautiously optimistic about its ability to maintain the dividend.