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Over the last few years, Vodafone’s share price has fallen from 240p in 2018 to about 73p today. At the same time, its dividend yield has grown to more than 10%.

That’s enough to catch the attention of even the most cautious dividend investor, and it was enough to propel Vodafone to number four on my list of high-yield blue-chip UK stocks.

However, double-digit yields are rarely sustainable, and Vodafone has many problems that could turn it into a classic dividend trap.

Problem 1: The dividend hasn’t been covered by profits

One of the first rules of dividend investing is that profits should consistently cover the dividend. Unfortunately, Vodafone stumbles at the first hurdle because it fails to meet this standard.

It recorded a loss in four of the last ten years, and its ten-year average dividend cover (including share buybacks) comes in at just 0.8.
In other words, Vodafone paid out more in dividends than it made in profit, which means the current dividend is unsustainable unless the company can significantly improve its earnings.

The losses were mostly caused by significant write-downs of goodwill and deferred tax assets that were originally created decades ago, back when Vodafone was being cobbled together through a series of occasionally enormous acquisitions.

The good news is that goodwill and deferred tax write-downs are non-cash expenses, so they don’t reduce a company’s ability to pay dividends. That means we can ignore them and focus, instead, on Vodafone’s adjusted earnings (adjusted to remove non-operational expenses like write-downs).

However, even if we do that, the overall picture is still grim because Vodafone’s adjusted earnings still failed to cover its dividend for most of the last ten years.

Problem 2: The dividend has been repeatedly cut

One obvious consequence of an uncovered dividend is that the dividend is much more likely to be cut, and that is exactly what Vodafone has done on more than one occasion.

In fact, Vodafone’s revenues, earnings and dividends have all fallen over the last decade, and this is not what you should expect to see from a quality dividend stock. Instead, you should expect to see broad growth across all of these factors, in line with inflation at the very least.

Problem 3: Profitability is extremely weak

Why has Vodafone been shrinking over the last decade?

There are many reasons, but an important one is that despite Vodafone’s well-known brand, almost nobody really cares if they get their mobile and internet services from Vodafone or from one of its competitors.

If there is little difference between one company’s services and another, price becomes the main point of competition, and that can devastate the profitability of companies selling undifferentiated commodities (like mobile and broadband services). In Vodafone’s case, its (adjusted) average return on capital over the last ten years is a simply unacceptable 2.1%.

In some industries, it’s relatively easy to escape commoditisation by pivoting towards new products and new markets. But that isn’t the case in telecoms, where companies like Vodafone have tens of billions invested in physical infrastructure that cannot easily be used as anything other than a telecoms network.

Vodafone is, in other words, stuck with an enormous base of infrastructure that (a) produces terrible returns, (b) is relatively fixed in terms of the services it provides, and, perhaps worst of all, (c) has to be constantly upgraded just to keep up with its peers.

Problem 4: Capital intensity is extremely high

Technology is advancing at an ever-increasing pace, so Vodafone is forced to upgrade its infrastructure every few years, going from 3G to 4G to 5G, and soon we’ll probably be moving on to 6G.

None of this comes free of charge. In fact, over the last ten years, Vodafone spent an incredible €92 billion on capital assets. In comparison, it only generated €27 billion in adjusted earnings.

This means Vodafone’s capital expenses were equal to 337% of its adjusted earnings, and that is extraordinarily high.

This is a problem because capital-intensive companies are often starved of cash because they have to reinvest so much of it back into their physical assets, so they’ll occasionally compound their problems by funding their growth aspirations with debt.

Problem 5: The debt mountain is huge

High debts are an obvious threat to the dividend because interest has to be paid to lenders before dividends are paid to shareholders.

Unfortunately, Vodafone’s debts are more than 20 times its average annual earnings, which is a far higher multiple than most people’s mortgages. Perhaps those debts were affordable when interest rates were near zero, but that may not be the case in an era of sustained mid-single-digit interest rates.

Conclusion: Vodafone looks like a dividend trap

In summary, Vodafone has made large losses, paid an uncovered dividend, failed to grow, cut the dividend more than once, produced low returns on capital and reinvested all of its profits and more into its capital assets, much of which was funded by debt.

That is the polar opposite of what I expect from a quality dividend stock, which would typically have a long track record of relatively steady organic growth, consistent double-digit returns on capital, a capital-light business model and prudent debts.

Having said that, Vodafone recently hired a new CEO, and she has announced a bold transformation programme, which involves the merger of Vodafone and Three in the UK and the reduction of at least 11,000 jobs over the next few years. I hope she succeeds in turning Vodafone around, but I still wouldn’t touch it with a bargepole, double-digit yield or not.

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