High dividends cast doubt on Vodafone growth

Serious Money: One of the first companies tackled by Serious Money was Vodafone. Over two years ago, it was becoming apparent that competition and technological disruption were serious issues for Vodafone.

Nevertheless, Vodafone was (and is) a supremely profitable company, throwing off prodigious amounts of cash.

To cut a long story short, we concluded that any investment in Vodafone was likely to prove very boring and that AIB was likely to prove a more profitable home for our cash. That was one of Serious Money's better calls: anyone who had shorted Vodafone at the time and simultaneously bought AIB would have produced a total return of nearly 38 per cent. The UK telephony giant is actually around 12 per cent lower than when we first wrote about it.

It might seem odd, given the headlines this week, to assert that Vodafone is a profitable company. After all, the company announced a rather large pretax loss of £14.9 billion (€21.7 billion) for the year ended March 31st.

But this loss was entirely down to the £23.5 billion "impairment" charge. This bit of accountancy is largely ignored by investors, as it relates to the widely anticipated decision to write off large chunks of previously acquired assets.

Specifically, that means Vodafone is telling us that its purchase of Germany's Mannesmann for $186 billion (€144 billion) in 2000 wasn't actually worth very much. A large proportion of that amount is gradually being written off, but this seeming disaster has long been anticipated by the market.

Vodafone wants analysts to focus on Ebitda - earnings before interest, tax, depreciation and amortisation. This piece of tortured accountancy is a measure of "operational" performance: the money Vodafone makes from its core businesses. Cynics have termed it "earnings before bad stuff". On this measure, Vodafone produced £16.4 billion in 2006.

Another key metric always worth looking at is "free cashflow". While not wholly immune from potential manipulation, this measure is perhaps the cleanest yardstick of performance and answers those who demand "show me the money". Free cashflow was actually 2.6 per cent lower than last year - at the very least, this measure seems to correlate better than most others, not least Ebitda, with share price performance. And on that note, we should remind ourselves that the company is guiding free cashflow to fall next year.

As with most large companies, we could get lost in a long and not terribly fruitful discussion of accountancy-related issues. I'm not sure how the intelligent investor is supposed to appraise the published accounts of many businesses these days: the moves to common international standards seem to have made things worse. The intentions were good, but the outcome was a boon to forensic accountants. The rest of us get frustrated as we try to slog our way through the fog of published numbers.

One key statistic to focus on is the amount of cash that the company is going to give us in the form of dividends and share buybacks. A 79 per cent increase in the ordinary (final) dividend was much more than had been expected and was welcomed by the market. That 6.07p per share will be enhanced by a one-off distribution of 15p per share resulting from the prior sale of a Japanese subsidiary and some balance sheet tinkering.

Shareholders are going to be getting a lot of money back in 2007, and the basic dividend going forward will be healthy 5 per cent or so, not allowing for any future growth.

Is this enough to get the share price moving again? The answer to that question depends on whether or not that dividend can be grown in any meaningful way.

As with almost any equity investment decision, the analysis comes down to growth. Can this company grow its earnings and dividends? What does the market think and can we arrive at a different conclusion? The market is now very doubtful about Vodafone's growth prospect: that's what a relatively high dividend yield of 5 per cent tells us. The company, of course, tries to strike a more upbeat note than this. But in its presentation to analysts, one of the first slides described "the new realities of the mobile industry". These are:

intensifying competition;

significant price erosion;

increasing customer choice;

growth of broadband;

emerging markets as the source of future growth;

regulatory pressures.

Serious Money might be slightly cynical about all of this, but my reading of Vodafone's description of its changing business environment is that developed markets (basically Europe) are close to going ex-growth and that the main opportunities lie with emerging markets. Vodafone will pursue these opportunities.

Other that that, all they can do is cut costs. Indeed, cost cutting now features very highly in all strategic pronouncements by the company. Growth companies do not present cost cutting as the single most important strategic step that can be made. Whenever any chief executive tells you that attacking the costs is his main vision, you know that the company concerned has gone ex-growth. This may be because there is nothing that can be done: the business environment is simply too challenging. Or it might just be that the management team is too feeble to think up growth strategies.

To be fair, there probably isn't too much that could be done with Vodafone in its current form. The basic business model has changed too much. If management were to reorient the company around a growth strategy, the implied changes would almost certainly have been too radical for shareholders to stomach. Those investors are disenchanted with management and would like them to continue to sell off assets and hand the money back via special dividends. That hardly amounts to a cry for radical action.

What kind of radical steps could they have taken to restore growth? In my opinion, they should have bought BT. But that's another story.

Vodafone's investment case? The last time I wrote about the company, I suggested any rallies should be used as selling opportunities. The story has moved on, but the conclusion is the same.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.