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Vodafone just cut its dividend by 40%. Here’s how you could have seen that coming

Yesterday, Vodafone (LSE: VOD) announced a substantial dividend cut, which is bad news for income investors. Reporting full-year results for the year ending 31 March, the group stated that it was ‘rebasing’ its dividend from 15.07 euro cents in FY2018 to just nine euro cents for the year just passed, in an effort to tackle debt and help pay for auctions for mobile phone airwaves in Germany and Italy.

Does this dividend cut come as a surprise? Not really, in my opinion. Here were four warnings signs that Vodafone’s dividend looked unsustainable.

Sky-high yield

For starters, the dividend yield has looked dangerously high recently, which is a classic red flag when it comes to dividend sustainability. On Friday’s closing share price of 139p, last year’s dividend payout of 15.07 euro cents equated to a trailing yield of around 9.4% – over twice the average yield of the FTSE 100.

When it comes to dividend yields, the phrase if it looks too good to be true it probably is happens to be highly appropriate. That’s because a high yield is often a signal that the market is expecting a dividend cut and what has happened is that many investors have already sold out of the stock, pushing its yield up. So, when a yield is abnormally high, you have to be careful. 

Low dividend coverage

Secondly, dividend coverage was worryingly low. The dividend coverage ratio is the ratio of earnings to dividends. Generally speaking, for a dividend to be considered safe, you want to see a ratio of two or more. A ratio under one is a real problem because it indicates that the company is paying out more than it is earning.

In Vodafone’s case, adjusted earnings per share were 11.59 euro cents last year, which gives a dividend coverage ratio of 0.77. That suggests the dividend was unsustainable. The free cash flow-to-dividends ratio was low too, at around 0.99, which was another warning sign.

Zero dividend growth

Next, dividend growth had slowed. Last year, growth was only 2%, which is a low increase. Then, in its most recent half-year results, the group held its interim dividend steady. Zero dividend growth is often a precursor to a dividend cut. 

A mountain of debt

Finally, moving on to the balance sheet, Vodafone also had a big pile of debt that was rather concerning. Last year, the group had total liabilities of €78bn on its books, whereas total equity was only around €67.6bn. That gives a debt-to-equity ratio of 1.15, which is far higher than the ratio of 0.5 that Warren Buffett likes to see.

Additionally, the group took on more debt in the last year, including an $11.5bn fixed and floating rate bond. Ultimately, the large debt pile looks to be the straw that broke the camel’s back as the group has said that the reason the dividend has been cut is to help the company reduce debt and delever to the low end of its target range in the next few years.

So, looking at all these red flags, Vodafone’s dividend cut should not come as a surprise. There were certainly warnings signs. The takeaway here is that when investing for dividends, it’s important to always do a little bit of research into the sustainability of the payout.

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Edward Sheldon has no position in any shares 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.