New CEO, Ongoing Performance Challenges Could Threaten Vodafone's Dividend

British telecom giant Vodafone operates mobile and fixed networks in around two dozen countries across Europe and Africa. Germany (36% of adjusted EBITDA), the UK (10%), Italy (9%), and Spain (6%) represent the firm's most important markets.

Vodafone's lackluster revenue and profit growth over the past decade reflects the operational challenges of competing in numerous jurisdictions, many of which have challenging economics.

The European telecom market, which accounts for over 70% of Vodafone's revenue, is much more fragmented than America's. Regulators in Europe have historically wanted to maintain a more fractured marketplace to drive greater price competition.

Europe and America have similarly sized telecom markets. But while Verizon, AT&T, and T-Mobile generate almost all of the U.S. wireless industry's revenue, Europe has more than 100 mobile network operators across its member states, which are reluctant to give up control overseeing their own industries.

This results in more intense competition (most countries have at least four wireless providers) and makes it difficult for operators to generate the profits they need to invest in new infrastructure and meet rising demand for data usage.

Vodafone has faced company-specific challenges as well. In Germany, for example, service revenue has declined in each of the last four quarters due in part to IT problems and a slow response to a new telecom law that ended automatic subscriber renewals.

Vodafone installed company veteran Margherita Della Valle as its new CEO in May to take on these issues.

Della Valle's turnaround plan entails reducing the firm's workforce by around 12% over the next three years, improving performance in Germany, and exploring business combinations in the UK, Spain, and Italy.

This turnaround plan will take time and remains sensitive to the competition authorities in each country, which can block mergers if they are deemed harmful for consumers.

Assuming Vodafone eventually jettisons some of its businesses to simplify its operations, the company's dividend coverage could face pressure.

Management's recent guidance for the fiscal year ending in March called for adjusted free cash flow of around €3.3 billion, missing analysts' estimates by around 10% and declining from €4.2 billion in the prior year.
 
After accounting for "one-time" spending on restructuring actions and spectrum, which are not reflected in the firm's adjusted metrics, we do not believe Vodafone's cash flow will cover the firm's €2.5 billion dividend.

With new leadership in place looking to shake up the company, we would not be surprised if Vodafone cut its dividend by 30% to 50%. This could happen as soon as November, when the next semi-annual payout is usually declared.

A smaller dividend would give Vodafone more breathing room to pursue restructuring activities, necessary capital investments, and asset divestitures without stretching its BBB-rated balance sheet.

Coupled with Vodafone's poor long-term track record (with shares declining over 40% in the past decade while the S&P 500 gained 219%, including dividends), conservative income investors interested in the telecom industry may prefer Verizon or AT&T due to their stronger credit ratings and free cash flow payout ratios closer to 60%.

Investors who stay the course need to believe that this time is different for Vodafone, and regulators will allow for some market consolidation to improve the industry's economics.

Several notable investors also have a combined stake of more than 20% in the stock, including United Arab Emirates telecoms and investment group e&, French telecoms billionaire Xavier Niel, and John Malone's Liberty Global.

We will continue monitoring Vodafone's turnaround, providing updates as needed.