Vodafone (LSE: VOD) is one of the most popular dividend stocks for investors in the UK and, right now, the stock supports a dividend yield of 9.2%, which I think looks extremely attractive.
However, I’m avoiding the Vodafone share price because I think its dividend is living on borrowed time. Here’s why.
The first, and possibly most important reason why I believe the dividend is not sustainable, is Vodafone’s current level of debt. The company isn’t drowning in debt but, in my opinion, it’s getting close.
At the beginning of November, its fiscal first-half results revealed the group’s net debt had jumped 6.4% year-on-year to €32.1bn. That was after the disposal of Vodafone India and included the cost of acquiring Liberty Global’s European cable assets for €31bn.
Because Vodafone has a large balance sheet with lots of freehold property, this level of debt doesn’t look too bad compared to its overall book value. Net assets of €62bn give a net debt to assets ratio of 52%. Compared to earnings, it’s a lot more precarious. Vodafone’s net debt-to-EBITDA ratio is just over two. I’d usually avoid any business with such a ratio of two or more.
When combined with the company’s cash obligations, this debt mountain starts to look dangerous.
Vodafone has to invest in its business to remain relevant. That means spending billions of euros on things like infrastructure and spectrum rights. For example last year, the company spent €2.4bn on the purchase of 5G spectrum in Italy. The group cannot avoid these costs as, if it did, it would lose customers.
Management believes Vodafone can foot the bill of doing business and continue to return plenty of capital to investors. At the end of last year, CEO Nick Read told investors and analysts the company is looking to deliver a free cash flow of £15bn over the next three years, with around £10.5bn earmarked for dividends and £4.5bn for 5G investment.
These forecasts might look as if the company has everything under control, but I don’t think they leave much room for manoeuvre. There’s also no money earmarked for debt reduction.
It seems to me as if management is only kicking the can down the road.
Watch out below
The Vodafone share price has lost nearly half of its value since the beginning of 2018. But despite this decline, the shares are still not what I would call cheap. The stock is trading at a forward P/E of 17 at the time of writing.
Historically, investors have been willing to pay a premium for the shares due to Vodafone’s dividend credentials. But if the company cuts the distribution, investors could be in for a shock. Even though the Vodafone share price has slumped from a high of nearly 240p at the beginning of 2018 to 140p today, I estimate the shares could fall by a further 23% before the valuation is in line with sector peers.
So overall, I think Vodafone’s dividend is safe in the near term, but a cut could be on the horizon. If the firm does slash its payout, the shares could fall much further. Because we don’t know when a dividend reduction is coming, I don’t think it’s worth taking the risk of investing.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.