When Vodafone (LSE: VOD) published its full-year results on the 14th of May, the company also revealed that it is planning to slash its dividend payout by 40%, walking back on its promise to maintain the payout.
I’ve been speculating that Vodafone will have to cut its dividend for some time, and it seems the market was as well.
More often than not, when income stocks like Vodafone announce a dividend cut, their share prices crash. Vodafone’s share price actually rose a couple of percentage points in early deals on Tuesday after the announcement, which suggests to me that much of the bad news was already factored in. Over the past 12 months, shares in the company have lost 31% as investors have prepared themselves for the worst.
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And now that Vodafone has cut its dividend, my opinion of the company has improved.
Improving outlook
Before Tuesday’s announcement, I was worried that Vodafone was trying to spin too many plates, balancing the dividend with capital investment requirements, debt repayments and acquisitions. Now that management has decided to reign in the distribution, the company has more money to invest in growing the business and winning customers back from competitors.
According to City analysts, cash saved from the cut will enable the group to reduce its debt to EBITDA ratio by 0.3 over the next three years to an estimated 2.9 times. In my opinion, this level of debt is still quite high, but the company is also pursuing other initiatives to free up capital, including the sale of its New Zealand business for €2.1bn. Combined, analysts believe these two initiatives will help Vodafone reduce leverage to the bottom end of its 2.5 times to 3 times EBITDA target in the medium term.
With more financial flexibility the company should be able to pursue growth with renewed vigour. It is still planning, pending regulatory approval, to acquire Liberty Global’s assets in Europe, which will give it unrivalled scale in the market. Management is also pursuing further disposals of non-core businesses, that should reduce borrowing further and give the business more capital to reinvest in operations.
Undervalued
All of the above leads me to conclude that Vodafone’s outlook is improving, and after factoring in the stock’s relatively attractive valuation, I think it might be worth building a small position at current levels.
Indeed, shares in the company are currently trading at an EV to EBITDA multiple of 6.7, compared to the telecommunications sector average of 9.3. The Vodafone share price is also dealing at a price to free cash ratio of just 8.5, compared to the sector average of 12.6. I think it is better to use these metrics over the P/E ratio to evaluate Vodafone because, for telecommunication companies, which tend to own a large number of depreciating assets, cash flows are a more reliable indicator of value creation than earnings.
As well as the company’s attractive valuation, even after the dividend cut, the stock still supports a dividend yield of more than 5%, nearly 1% above the market average.
So overall, now that Vodafone has finally bitten the bullet and decided to cut its dividend, I think the stock could be a ‘buy’ after recent declines.
