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British American Tobacco plc & Imperial Tobacco Group PLC Pass Two Key Tests (But Vodafone Group plc Fails)

Income investors tempted by the 5% prospective yield offered by Vodafone Group (LSE: VOD) (NASDAQ: VOD.US) shares should think carefully.

The firm’s next quarterly statement is due in less than three weeks, and could result in analysts adjusting their forecasts for the FTSE 100’s eight-largest company.

The problem is that current forecasts suggest Vodafone will pay a dividend of 11.3p this year and 11.5p in its 2016 financial year. Alongside this, earnings per share (eps) are expected to be around 6.5p in both years.

Although companies sometimes pay dividends that are not covered by earnings for odd years, it is unusual for a firm to plan to pay an uncovered dividend for at least two years, probably more. A dividend cover level of between 1.5 and 2 is usually considered prudent for most large businesses.

I may be wrong

Vodafone has very little debt after selling its stake in Verizon Wireless, and can afford to subsidise dividend payments for a few years if it chooses to. What’s more, the mobile giant has recently made several medium-sized acquisitions that could fuel earnings growth.

So far, the City seems to have accepted Vodafone’s dividend plan, but I’m not sure that this will continue. Vodafone trades on 34 times forecast earnings, and paying the planned dividend this year will cost almost £3bn, most of which seems likely to come from cash reserves or borrowings.

Any hint of downgraded profit guidance could result in a sharp correction to Vodafone’s share price, and could trigger a dividend cut.

How it should be done

I am not generally a big fan of tobacco stocks, for ethical reasons, but anyone wanting to understand what a high quality, cash-backed dividend looks like needs to consider British American Tobacco (LSE: BATS) and Imperial Tobacco (LSE: IMT):

Company

5-year total free cash flow per share

5-year total dividend payout per share

British American Tobacco

943p

617.5p

Imperial Tobacco

1,088p

529.5p

Both tobacco firms generate huge amounts of free cash flow each year, thanks to operating margins of more than 35%, and low capital expenditure. Anyone who bought BAT shares five years ago has received dividends worth around 30% of their original purchase price; the equivalent figure for Imperial is 26%. That’s outstanding.

Don’t underestimate cash

Although I’m a Vodafone shareholder, I am concerned about the firm’s dividend — ultimately, a safe dividend needs to be backed by free cash flow.

Imperial and BAT offer dividends that are comprehensively covered by cash, with a business model that has proved more resilient and long-lived than many investors expected. They may be worth a closer look.

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Roland Head owns shares in Vodafone. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.