“Marks & Spencer has already taken the plunge and announced a plan to cut its dividend and although BT has decided to keep its payment unchanged investors are understandably nervous about some of the yields offered by some of the UK’s biggest firms,” says Russ Mould, AJ Bell Investment Director. “With the best cash ISAs offering an interest rate of around 1.5% and the UK 10-year Government bond yield – or risk-free rate – coming in at barely 1.1% investors need think about why a stock is offering a yield of 8%, 9% or even 10%.
“The main reason companies such as Centrica, Persimmon, Taylor Wimpey, Evraz and Vodafone are offering huge dividend yields is that investors are demanding this as compensation for the capital risk that comes with owning the shares.
“In plain English, the huge yield is investors’ polite way of saying they do not believe the analysts’ forecasts for profits and the dividend – or at the very least that they want more proof that the dividend can be sustained.
“This is because there are few worse investments than a stock with a high yield that cuts its dividend. In these cases, the injury caused by loss of the yield is compounded by the insult of a share price fall – although in the case of Centrica and Vodafone (and BT for that matter) persistent share price falls mean that investors are already braced for a dividend cut. As such, you might start to wonder whether Iain Conn at Centrica and Nick Read don’t just get on with it and remove a millstone from their own necks and their companies’ share prices.
“To help decide whether a chief executive is going to bite the bullet and cut a dividend, investors can carry out four checks to see how safe a payment might be. They are
• Dividend cover, according to earnings
• Dividend cover, according to free cash flow
• Interest cover and net debt
• The size of the pension deficit or surplus
“Vodafone will be used as an example below, in all four cases.
1. Dividend cover is calculated as follows and is expressed as a ratio.
Prospective earnings per share (EPS)
DIVIDED BY
prospective dividend per share (DPS)
Ideally cover should exceed 2.0. Anything below two needs to be watched and a ratio under 1.0 suggests danger – unless the firm is a Real Estate Investment Trust, obliged to pay out 90% of its earnings to maintain its tax status; it has fabulous free cash flow and a strong balance sheet; demand is relatively stable and insensitive to swings in the economy, which really means utilities and consumer staples (although the increasingly active role of the regulator must be watched here rather than the economic cycle).
In the case of Vodafone in the year to March 2019, the forecast earnings per share figure is 9.9p and the dividend 12.9p, according to consensus. That is dividend cover of 0.76, less than ideal.
For the year to March 2020, the analysts’ consensus expects EPS of 11.4p and a dividend of 12.9p, so again cover looks lower than you would like at 0.88 times.
|
|
March 2019E |
March 2020E |
|
Earnings per share |
9.9p |
11.4 |
|
Dividend per share |
12.88p |
12.88 |
|
Dividend cover |
0.76 |
0.88x |
Source: Sharecast, consensus analysts’ forecasts. Assumes an unchanged dividend payment of €0.1507
2. Operating free cashflow cover adds extra reassurance, because it is cash that funds dividends – and there is another old saying here: “profits are a matter of opinion, cash is a matter of fact.” An extreme example of this is Carillion which was profitable and in theory offering an 8%-plus dividend yield just before it went bust owing to weak cash flow.
Operating free cash flow (OpFcF) - this can be calculated in the four-step process below. Quite simply the higher the figure the better, especially when taken as a percentage of sales or operating profit.
Net operating profit
MINUS tax
PLUS depreciation and amortisation
MINUS capital expenditure
MINUS increase in working capital.
The operating free cash flow number can then be measured against the actual total cash value of the annual dividend payment. Companies publish how many shares they have in issue, so multiplying that figure by the value of the distribution will quantify the total cost in millions of pounds.
If free cash flow cover exceeds 2.0 then that is a good start though again it may be worth looking at where operating profit and operating margins are compared to prior cyclical highs and lows and the average over the last decade.
Vodafone does at the moment generate enough cash, even after unavoidable expenses such as interest on debt, tax and licensing and spectrum payments. However, the margin of safety is getting thinner and three factors may start to work against Vodafone: competitive pressure on mobile margins in key mobile markets like the UK, Spain and Italy is growing; interest payments will rise if the acquisition of European cable TV assets from Liberty Global gets regulatory approval; and spectrum and licensing costs are going up as Vodafone prepares to launch 5G mobile services.
|
€ millions |
2016 |
2017 |
2018 |
|
|
|
|
|
|
Sales |
49,810 |
47,631 |
46,571 |
|
Operating profit |
1,320 |
3,725 |
4,298 |
|
Depreciation & amortisation |
11,724 |
12,086 |
10,884 |
|
Net working capital |
(496) |
(48) |
(858) |
|
Capital expenditure |
(10,561) |
(7,675) |
(7,321) |
|
Operating Cash Flow |
1,987 |
8,088 |
7,003 |
|
OpFcF from discontinued operations |
1,645 |
1,203 |
858 |
|
Operating Cash Flow |
3,632 |
9,291 |
7,861 |
|
|
|
|
|
|
Tax |
(738) |
(761) |
(1,010) |
|
Interest |
(982) |
(830) |
(753) |
|
Pension contribution |
0 |
0 |
0 |
|
Licensing and spectrum spend |
(3,182) |
(474) |
(1,123) |
|
Operating Free Cash Flow |
(1,270) |
7,226 |
4,975 |
|
|
|
|
|
|
Dividend |
(4,188) |
(3,714) |
(3,920) |
|
Remaining free cash flow |
(3,921) |
2,783 |
1,320 |
Source: Company accounts. Financial year to March
3. Net debt and interest cover. A badly-stretched balance sheet can jeopardise a dividend payout, since a heavily-indebted firm will have to pay interest on its liabilities and repay those obligations at some stage. Ultimately a firm could have to reduce or pass its dividend to preserve cash and ensure its banks and lenders are paid so they do not pull the plug. One good measure of a firm's balance sheet is its gearing, or net debt/equity ratio. This is calculated as follows and expressed as a percentage:
Short-term borrowings PLUS long-term borrowings MINUS and cash equivalents
DIVIDED BY
Shareholders funds
MULTIPLIED BY
100.
A more thorough analysis will include pension liabilities and assets, as well as off-balance sheet liabilities such as leases (which are now coming on balance sheet under IFRS16 accounting rules) and contingent payments.
Just looking at Vodafone’s basic cash and debt figures takes us to a net figure of €38.5 billion. Although this only presents a gearing ratio of 56%, Vodafone is about to take on another €18.4 billion of debt thanks to the European cable TV deal.
Moreover, Vodafone also has some substantial leases on network equipment so the total net debt figure is nearer to €45 billion, once other items are accounted for.
|
€ million |
March 2018 |
|
Cash |
4,674 |
|
Retirement benefit assets |
110 |
|
Assets for sale |
13,820 |
|
Cash and cash equivalent |
18,604 |
|
|
|
|
Short term debt |
10,351 |
|
Long term debt |
32,908 |
|
Liabilities for sale |
10,999 |
|
Retirement benefit liabilities |
520 |
|
Leases |
8,835 |
|
Debt and liabilities |
63,613 |
|
|
|
|
Net debt |
45,009 |
|
Equity |
68,607 |
|
Net debt / equity ratio (“gearing”) |
66% |
Source: Company accounts
You can then add interest cover to the mix. This ratio is also a good litmus test of a group's financial soundness. It is calculated as
Operating income PLUS interest income
DIVIDED BY
interest expense.
The higher the ratio, the stronger a firm's finances and although Vodafone has plenty of debt, its interest cover ratio of 3.85 times suggest it is currently profitable enough to easily fund such a burden.
|
€ million |
March 2018 |
|
Operating profit |
4,299 |
|
Net interest income |
339 |
|
Total |
4,638 |
|
|
|
|
Net interest expense |
1,202 |
|
|
|
|
Interest cover |
3.85x |
Source: Company accounts
4. The final check involves the pension fund, not least as this is becoming a political as well as an economic issue, following, Carillion, BHS and others. The regulator is clearly becoming increasingly intolerant of companies that distribute cash to shareholders via dividends or share buybacks while they still have a big pension deficit.
To check for the risk of political interference, or the possibility that a company must plug a financial hole, always look to see whether a company has a pension deficit or surplus.
The good news is that Vodafone has a tiny deficit, with the balance sheet showing a net deficit of just €410 million. The annual costs of topping up the pension fund to profits in the year to March 2018 was a perfectly manageable €222 million.
Conclusion
“In conclusion, Vodafone passes three of the four tests, which may be why boss Nick Read has so far stated it was his intention to hold the dividend unchanged at 15.07 euro cents for the year to March 2019 (even if this in itself was a big decision as it ended a streak of annual dividend increases that dates back to 1998).
“Free cash flow cover looks adequate, there is no pension problem and the company seems built to withstand its debts. However, earnings cover is weak, debt will rise if the Liberty Global deal is approved and free cash flow could be put under pressure by spectrum and network equipment costs relating to 5G, so it would be no shock if Mr Read were to decide to prioritise investment in the company’s long-term competitive position and sacrifice some of the dividend payment. The share price is already expecting it and for the long-term good of the business it could well be the right thing to do.”
