Soon after Vodafone Group (VOD) CEO Nick Read started his new job in late 2018, he expressed optimism that he would not have to cut the dividend. Fast-forward just seven months, and the European phone carrier has slashed its dividend by 40%. But that might not be bad news for investors. The dividend cut will give the company flexibility to improve its balance sheet and make key investments that could lead to healthy growth.

Earnings weakness

On May 14, Vodafone reported its FY 2019 earnings and hit investors with a double whammy of bad news. The company not only reported weak operating performance in its core business, but also announced a steep dividend cut from 15.07 eurocents per share to 9 eurocents per share.

Vodafone is an enormous company with operations spanning many countries and numerous ongoing strategic initiatives, so it's tough to pinpoint a precise reason why the company's results are weak aside from a general sluggishness in the European economy. However, the company did highlight that its operations in Spain and Italy have suffered from intense price competition.

VOD Revenue (Annual YoY Growth) Chart

VOD Revenue (Annual YoY Growth) data by YCharts

Weak financial results are nothing new for Vodafone shareholders. The company has mostly reported declining revenue and earnings for the past several years. In fact, operating income has been cut more by than half since 2012. For FY 2019, Vodafone reported a 6.2% decline in revenue and an operating loss. However, when adjusting for the divestiture of its India business and a goodwill writedown, the company posted organic growth of 0.3% and a 9.4% gain in operating income -- suggesting a glimmer of hope.

After years of weak results, the company has had a tough job justifying its massive dividend payout. Last year, Vodafone paid 4.1 billion euros in dividends, which was just shy of the operating income generated by the company.

The dividend cut may be a smart move.

A family looking at their cellphones

Image source: Getty Images.

Shoring up the balance sheet

One of the principal reasons cited for the dividend cut was the desire to reduce debt. The company's goal is to bring its debt leverage ratio down into the 2.5-to-3 range within a few years. The table below shows the company's debt and leverage position.

Metric FY 2019
Cash and equivalents 28,366 million euros
Total debt 55,955 million euros
2019 adjusted EBITDA 14,139 million euros
Leverage ratio (total debt to EBITDA) 3.96

Data source: Vodafone. Vodafone's fiscal year ends March 30.

Taking the company's total debt and dividing it by EBITDA shows a current leverage ratio of approximately 4. If the company is able to use 1 billion or 2 billion euros per year to reduce its debt load, it could show progress toward the leverage goal within a few years.

Of course, Vodafone also has a 28.1 billion-euro cash hoard, much of which could be used to pay off debt, but that cash is spread out in subsidiaries all around the world and may not be easily accessible. If push came to shove, the company could also sell assets to pay debt. Last year, the company divested its India business in exchange for stock in a public company. It is also expected to receive 2.1 billion euros this year for the sale of its New Zealand business.

The dividend cut is a prudent move to ensure that the balance sheet will continue to be manageable.

Investing in the business

The reason Vodafone shareholders shouldn't be too upset about the dividend cut is that in addition to providing money to reduce debt, it will provide funds for investment in the business. At the top of the list is upgrading the network to 5G technology. Also on the list is funding the company's acquisition of Liberty Global's European assets.

If Vodafone wants to keep up with its largest competitors, it will need to upgrade its network to 5G. The upgrade will be expensive, as Vodafone still lacks the necessary spectrum in several markets, and it will also need to pay for additional cell tower equipment. Vodafone has made some progress on rolling out 5G; the company announced that it will launch 5G service in the U.K. this summer.

In a pending transaction, Vodafone agreed to pay 18.4 billion euros for Liberty Global's assets in Germany, the Czech Republic, Hungary, and Romania. It is financing the deal with cash on hand and debt.

The acquisition will give Vodafone greater scale in several European markets, which will help the company compete with local rivals. Having more scale in certain markets means Vodafone will have more customers in countries like Germany using the same basic network infrastructure. This is a more efficient use of a telecom network and will ultimately result in a more profitable business for Vodafone in those newly expanded markets.

The acquisition also helps the company accelerate the 5G upgrade cycle in those markets because the same expenditures needed to buy the spectrum and cell tower equipment can be used over a larger customer base. Therefore, investing in the business by strategically acquiring customers goes hand in hand with investing in network upgrades.

The dividend cut may be a tough pill to swallow, but it is a better alternative than letting the core business stagnate due to underinvestment.