Vodafone Group (VOD): A High Dividend Opportunity or Value Trap?

Telecom stocks such as AT&T (T) and Verizon (VZ) often serve as core holdings for income investors who have a low tolerance for risk, especially retirees living off dividends.

 

That makes sense because many telecom companies enjoy large, recurring streams of cash flow that support generous and slowly growing dividend payouts over time.

 

However, not all telecom giants make for good dividend investments. The industry is increasingly battling slow growth and increased competitive pressures, and some firms are better positioned than others.

 

Let’s take a closer look at Vodafone Group (VOD), one of the world’s largest telecom behemoths, to see if its 5.7% dividend yield is safe and appealing for our Conservative Retirees dividend portfolio, or if the company could be a value trap.

 

Business Overview

Vodafone was founded in 1984 in the U.K. and has quickly grown into one of the world’s largest telecom conglomerates.

 

Along with its joint venture partners, the company offers telephone, internet, cable TV, and wireless mobile services in 75 countries on six continents. In total, Vodafone serves 470 million mobile customers, 14 million fixed broadband customers, and 9.8 million TV customers.

 

 

While Vodafone’s global diversification is impressive, the vast majority of its business remains dominated by Europe, especially Germany (22% of EBITDA), Italy (13%), the U.K. (11%), and Spain (8%).

 

Region	Q3 2016 Revenue (Euros)	% of Revenue
Europe	8.878 billion	64.8%
Africa, Middle East, Asia, Pacific	4.484 billion	32.7%
Other	349 million	2.5%
Total	13.711 billion	100.0%

Source: Vodafone Earnings Release

 

The company’s long-term plan calls for continued diversification into emerging markets, especially India, but management’s strategy is far from guaranteed to succeed.

 

Business Analysis

At first glance, Vodafone’s been struggling with sales, earnings, and free cash flow growth that has been not just lackluster for years, but also very volatile. However, that’s largely due to “Project Spring,” management’s major three-year restructuring plan which it launched in 2013.

 

 

Project Spring included some major asset sales, including Vodafone’s 2014 sale of its 45% stake in Verizon Wireless for $130 billion (mostly used for a special dividend, taxes, and debt reduction), as well as a $9 billion increase in capital spending as the company invested massively into expanding and improving its European 4G LTE network.

 

In addition, Vodafone went on a major acquisition spree including:

 

• Germany’s Kabel Deutschland
• Dutch Wireless company Ziggo
• U.K.’s Cable & Wireless Worldwide
• Spain’s Ono
• Merger of its Vodafone India with Idea Cellular

 

Vodafone’s M&A spree was driven by the company’s positioning as pretty much a pure play wireless company, and one with very little exposure to 4G.

 

In fact, in mid-2014, Vodafone had only 4.7 million 4G customers in Europe and was losing market share quickly. However, Vodafone now offers a full suite of telecom services, including landlines, cable TV, internet, and far improved wireless services.

 

Meanwhile, the firm’s $23 billion merger with Idea Cellular will now create the largest wireless provider in India, with almost 400 million customers.

 

Idea’s strong spectrum coverage in rural areas will complement Vodafone’s India’s excellent coverage in urban areas and create a potentially dominant wireless network across the entire country.

 

 

Better yet? After the merger is complete Vodafone’s market share in 21 of 22 regions in the country (what it calls “circles”) should be #1 or #2. And the meaningful cost synergies (annual savings of $2.1 billion within four years) should help Vodafone become profitable in nearly all of India’s circles, compared to just 12 of 22 pre-merger.

 

In other words, Vodafone is hinging much of its growth hopes on India, which seems likely to remain one of the fastest growing economies and a large telecom growth opportunity in the coming decades.

 

That being said, Vodafone’s management still has a lot to prove because while the growth opportunities in India are enormous, Vodafone is only a majority partner in the combined company.

 

 

That means that Vodafone will need to de-consolidate its India business, which will make short-term growth harder. In fact, analysts expect Vodafone’s 2017 and 2018 fiscal revenues to decline by 3.5%, and 12.5%, respectively, before finally returning to growth starting in 2019 as the India business develops.

 

However, even after 2019, revenues are only expected to grow at around 2% per year because Vodafone’s European operations are likely to continue to struggle with slower economic growth and highly mature markets.

 

However, shareholders can likely look forward to stronger earnings and free cash flow growth because the company’s future capital spending is set to decrease substantially.

 

That should be good news for dividend lovers, although there are numerous risks that could plague the company and threaten its dividend.

 

Key Risks

The first risk that Vodafone shareholders will have to contend with is a large degree of currency risk. After all, Vodafone’s primary businesses obtain revenue in British Pounds, Euros, and Indian Rupees.

 

And U.S. investors get paid dividends in dollars, which means that the vagaries of currency exchange rates between these four currencies will only add to the volatility of Vodafone’s reported revenue, EPS, FCF, and dividend growth in the coming years.

 

Another major risk to consider is that, while Vodafone’s India business is now the largest in the country, the wireless market there remains highly competitive. In fact, even with 395 million total customers, Vodafone India’s market share is only 35% with major local rivals such as Airtel and Reliance Jio likely to provide strong pricing pressure.

 

 

In fact, Reliance Jio has been making headlines and winning major market share with its recent free offerings, including free 4G service through March of 2017, and after that just 99 Rupees ($1.54) per month.

 

In a nation with a GDP per capita of just $1,751 per year, Indian consumers are among the most price-sensitive in the world. As a result, well capitalized rivals such as Jio can, and likely will, keep Vodafone India’s margins low for the foreseeable future.

 

That in turn could wind up resulting in disappointing long-term revenue, EPS, and FCF growth, especially since the telecom industry is monstrously capital intensive.

 

The transition to 5G technology over the next decade could especially make that true because 5G could end up costing global telecom providers over one hundred billion dollars in new equipment costs.

 

To give you an idea of the kinds of spending we’re likely to see, iGR, a leading telecom industry consultant, estimates that in the U.S. alone, 5G infrastructure spending between 2017 and 2025 (not including operating costs) could be $56 billion.

 

Then there’s the threat that comes from potentially hostile regulators. The European telecom industry is much more fragmented than America’s (Vodafone’s highest market share position is 33% in Germany), resulting in fiercer price competition, and regulations and spectrum policies are inconsistent from one region to the next.

 

As a result, Vodafone’s latest annual report notes that these characteristics “have led to a steep deterioration in return on capital employed over recent years.” You can see that the company’s organic service revenue shrunk in 2014 and 2015 before rebounding slightly in 2016:

 

 

In India, the situation is even murkier. For example, the Indian government recently passed a law that retroactively raised Vodafone’s taxes from its 2007 acquisition of Indian telecom Hutchison Essar by $2.5 billion. This caused the company to write down the value of its Indian business by 5 billion Euros in 2016.

 

Speaking of write-downs, it’s worth noting that Vodafone has a terrible record of overpaying for acquisitions. In fact, in the past decade Vodafone has written down $87.6 billion in goodwill (with another $28.7 billion remaining on its balance sheet).

 

In other words, management admits that it overpaid for previous acquisitions by this amount and thus has a questionable track record of allocating shareholder capital. The latest gamble in India needs to pay off.

 

Vodafone’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Vodafone’s Dividend Safety Score of 27 indicates that VOD’s dividend could prove to be unsafe over the coming years. For U.S. investors, this shouldn’t come as a surprise.

 

As you can see, Vodafone’s dividends paid in U.S. dollars have been somewhat unpredictable, driven mostly by volatile foreign currency exchange rates.

 

In other words, if you are looking for steady payout growth, then you probably want to stick to U.S. firms offering more dependable dividend growth, such as dividend aristocrats or dividend kings.

 

 

Aside from its volatile payout history (in U.S. dollars), Vodafone’s dividend safety is dinged by the firm’s disappointing cash flow coverage in recent years. In fact, the company’s “Project Spring” investment program suppressed free cash flow to the point where it failed to cover the dividend from fiscal years 2013 through 2016.

 

The company’s cash flow situation is improving today, however. Management expects to generate free cash flow of €4 billion this fiscal year, which would mark a nice increase from last year’s total (€1.3 billion) but will likely fall just short of covering total dividend payments.

 

Vodafone’s lack of free cash flow wiggle room with its dividend makes the company’s steadily rising debt levels a bigger concern. Part of the proceeds received from the 2014 Verizon Wireless sale were used to de-leverage the balance sheet, but Vodafone has since been taking on billions in debt in order to finance its acquisitions and network upgrades.

 

 

Today Vodafone has a highly leveraged balance sheet, with nearly $45 billion in total debt. While Vodafone’s overall debt/capital ratio is actually better than most global telecom providers and it maintains an investment-grade credit rating, much of the company’s future free cash flow is likely to have to go towards paying down its high debt load.

 

Company	Debt / EBITDA	Debt / Capital	Current Ratio	S&P Credit Rating
Vodafone	2.10	30%	0.74	BBB+
Industry Average	1.77	51%	0.98	NA

Sources: Morningstar, Fast Graphs

 

That’s because the company will need to maintain a great deal of financial flexibility to continue acquiring bolt on acquisitions and spending heavily to remain competitive in all the fragmented markets it operates in (investing in 4G and 5G wireless infrastructure).

 

With the dividend already absorbing all of Vodafone’s free cash flow and competitive dynamics rapidly evolving in major markets such as India, the company’s dividend could ultimately be on shaky ground in the coming years.

 

Vodafone’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Vodafone’s Dividend Growth Score is 6, which is among the weakest of any company on Wall Street.

 

In Pence Sterling terms (the U.K.’s currency), Vodafone has increased its dividend each year since 2000. While annual dividend growth averaged about 7% from 2010 through 2014, the pace decelerated to 2% increases in 2015 and 2016.

 

While Vodafone intends to grow dividends per share annually in euros, holders of ADRs have experienced much less predictable income growth due to fluctuating currency exchange rates.

 

In fact, holders of ADRs received more than a 10% reduction in dividends paid by Vodafone in 2016, and total dividends declared in fiscal year 2016 were roughly equal with dividends declared in 2008.

 

Currency fluctuations aside, Vodafone shareholders are looking for management to prove that its turnaround has been a success.

 

That means shoring up the dividend in the face of ongoing competitive pressure and high de-leveraging needs. Barring better than expected results, Vodafone’s dividend isn’t likely to see much growth in the coming years.

 

In fact, currently analysts are expecting Vodafone’s dividend to remain largely frozen (in U.S. dollars) until 2020 as management de-levers the balance sheet and waits for Vodafone India to scale up sufficiently to generate meaningful top line growth.

 

However, even then the dividend is likely to grow slowly, perhaps by 3% to 4% per year. Despite VOD’s high yield, the stock leaves a lot to be desired for income investors due to its lack of dividend predictability.

 

Valuation

In the past year Vodafone’s stock has meaningfully lagged the market, returning -12.5% while the S&P 500 has gained more than 10%.

 

Despite its drop, Vodafone’s 5.7% dividend yield remains well below its long-term average yield of 8.7%, and its stock trades at steep P/E multiple of 36.2, which is above its historical norm of 25.9.

 

With organic growth difficult to come by and U.S. dividends remaining largely unpredictable from one year to the next, there doesn’t seem to be a strong case for buying Vodafone at today’s share price.

 

Concluding Thoughts on Vodafone Group

It’s important for dividend investors to always remember that, when it comes to regular corporations, very high yields often signal high risk.

 

Vodafone’s ambitious turnaround efforts may ultimately prove successful, but the highly competitive and capital-intensive nature of this industry, along with Vodafone’s tight free cash flow coverage of its dividend, make this a rather speculative investment.

 

Until management (and the company’s historically poor track record of capital allocation decisions) can prove that this time really is different, Vodafone may end up remaining a long-term value trap.

 

As a result, I prefer to stick with some of the safer high dividend stocks here that are on more solid ground.