Is Telefonica's 7.5% Dividend Yield Safe?

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.

In contrast, 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 U.K.'s biggest listed companies, to see whether their dividends are being funded in a sustainable way -- from genuine spare cash. Today, I'm going to look at Spanish telecom giant Telefonica (LSE: TDE) (TEF 0.68%), which has just published its 2012 results, in which it confirmed that it intends to pay a dividend of 0.75 euros per share in 2013 -- providing a yield of 7.5% at the current share price.

Does Telefonica 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 Telefonica's cash flow from the last five years:

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

As the figures show, Telefonica has a good record of paying dividends that are covered by free cash flow. To some extent, this has been flattered by Telefonica's practice of paying a proportion of dividends as scrip dividends (i.e., as shares). Telefonica was also forced to cut its dividend payout in 2011 and cancel the dividend corresponding to the 2012 financial year (although parts of the 2011 dividend were paid during this period), to enable it to shore up its finances and refinance 15 billion euros of its 51 billion euro net debt.

However, in its results today, Telefonica says that the measures taken in 2012 have led to "significant liquidity improvement" and would allow "ample coverage of its dividend commitments for 2013." Telefonica's 2013 dividend guidance of 0.75 euros per share gives it a forward dividend yield of 7.5%, making it one of the highest-yielding shares in the U.K. market.

Is Telefonica's dividend safe?
Telefonica's confident return to dividend payments in 2013 does appear to be backed up by solid profitability and free cash flow. Along with many other large companies, it took advantage of a strong demand for corporate bonds to refinance 15 billion euros of its debt during 2012, and it also reduced overall debt levels by 5.1 billion euros last year. This year, it's targeting a further reduction in net debt from 51 billion euros to below 47 billion euros and expects revenue growth compared to 2012.

However, Telefonica expects operating margins to fall slightly in 2013, and although the company has improved its debt position, it still has a lot of debt and will remain under pressure to reduce this, at the same time as it needs to invest in new spectrum and infrastructure to support 4G network rollouts and upgrades.

Over the last few years, Telefonica's wide spread of operations have helped protect it from the worst of the eurozone downturn: in 2012, revenues from its Latin America division rose by 6.7%, whereas they fell by 6.5% in Europe. Any weakness in Latin America could place Telefonica's profits under severe pressure, threatening its dividend once more.

Overall, I think that Telefonica's dividend looks fairly safe for 2013, but I think there is a risk of further cuts or even cancellations from 2014 onwards, until Telefonica is able to substantially reduce its debt levels.

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