Where Next for Vodafone's Dividend?

LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at mobile telecoms giant Vodafone (LSE: VOD  ) (NASDAQ: VOD  ) .

Vodafone's U.S. cash machine
Vodafone is one of the most generous dividend payers in the FTSE 100, and is a big favorite with income investors. The firm's shares currently yield 6.1% and have a five-year average yield of 5.4% -- well above the FTSE 100 average of 3.1%.

Although Vodafone is a profitable, cash-generating business, it is only able to pay shareholders such generous dividends because of the dividends it receives itself from its 45% stake in U.S. mobile operator Verizon Wireless. In the 2011/2012 financial year, for example, Vodafone received a 2.9 billion pound dividend from Verizon, 2 billion pounds of which was paid out to Vodafone shareholders by means of a special dividend.

This year, Vodafone's share of Verizon's dividend is 2.3 billion pounds, but the company does not plan to distribute this directly to shareholders. Instead it will use 1.5 billion pounds to fund a share buyback program that is currently under way. By reducing the number of shares for which a dividend needs to be paid, this should improve dividend cover for future payouts.

Does Vodafone have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments and tax deductions. With that in mind, let's look at Vodafone's cash flow from the last five years:

Year

2008

2009

2010

2011

2012

Free cash flow (millions of pounds)

385

3,909

4,026

8,535

14,965

Dividend payments (millions of pounds)

3,658

4,013

4,139

4,468

6,643

Free cash flow/dividend*

0.1

1.0

1.0

1.9

2.3

Source: Vodafone annual reports. *A value of >1 means the dividend was covered by free cash flow

Vodafone's free cash flow situation has improved steadily over the last five years. 2012 was a bumper year, thanks in part to the 2.9 billion pound dividend it received from Verizon, as well as a 3.5 billion pound profit it made on the disposal of its stakes in French operator SFR and Polish operator Polkomtel.

Although we can't predict the level of future dividend payments from Verizon, it's worth noting that in 2011, Vodafone still delivered a very healthy level of free cash flow cover and a dividend increase, without receiving a dividend from Verizon. If we strip out Verizon's 2,000 million pound share of Vodafone's 2012 dividends, which were paid as a special dividend, we are left with 4,643 million pounds, showing that Vodafone would have delivered a further increase in its payout last year, even without Verizon's contribution.

Is Vodafone's dividend safe?
Vodafone is a more mature business than it was a few years ago, and this, combined with the ongoing eurozone recession, is likely to slow the company's growth. At the same time, I expect its capital expenditure requirements to remain high as the firm rolls out its 4G network across the U.K. and Europe. These twin pressures could limit the future growth rate of Vodafone's dividend, especially if the dividend from Verizon Wireless is cut or suspended.

However, Vodafone remains a large, profitable business and the company expects its profits to be in line with guidance this year. Vodafone also has growing operations in emerging markets such as India and Turkey, which should help support the company's profits in its more mature European markets. Finally, there's every possibility that the Verizon dividend will continue at current levels.

Overall, I think that the outlook for Vodafone's dividend is fairly robust, but I do expect to see its growth rate slow over the next few years.

Top income tips
One man who really understands how to assess the quality of a company's dividends is legendary City fund manager Neil Woodford, whose High Income fund grew by 342% over the fifteen years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%.

Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. His record is one of the best in the City and at the end of October 2012, he had 21 billion pounds of private investors' funds under management -- more than any other City fund manager.

You can learn about eight of Neil Woodford's largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but is available for a limited time only. I strongly suggest you click here and download the report today to avoid missing out.

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