Dial in to Vodafone’s cash flow

Big blue chip companies that pay large dividends are one of my favourite investments. That's because you are getting a large part of your investment return from dividends which are independent of the stockmarket's mood swings so they should prove to be quite resilient investments.

Enter Vodafone the biggest dividend payer on the UK stock market. The company reports its full year results tomorrow (Tuesday) and is expected to announce a 7% increase in its dividend to 9.5p per share. At its current share price of 164p that gives it an inflation-busting yield of 5.8%.

However, the Vodafone share price has not escaped the general market's jitters about Europe in recent weeks. That's not surprising given that Italy and Spain account for nearly one quarter of its total profits. While it's important not to be complacent about the challenges Vodafone faces, I think that its shares are worth buying. Here's why.

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The challenges

Like BT, Vodafone has had to become an efficient utility company. Mobile phones have become as essential a part of modern life as gas, electricity and water.

While it is possible to achieve good rates of sales growth in emerging markets such as India, South Africa and Turkey, growth in more mature markets is harder to come by. This means Vodafone has had to manage its costs and do more with less to stop profits falling.

In Europe, voice revenues continue to come under pressure as regulators bear down on the prices that customers pay. For example, the price that users pay to use their phone abroad is coming down, as is the amount they pay to call mobiles from landlines. This is offset to some extent by growth in text messages and internet data. Vodafone has managed these challenges well so far.

Vodafone's ace card - cashflow

But what makes Vodafone stand out from other big dividend-paying utilities is its ability to generate lots of surplus or free cash flow. Electricity network companies such as National Grid or water companies have to take most of the cash they get from customers and re-invest it back into their networks. Most of the time this is OK because higher levels of investment now should mean higher profits later on. But from a cash flow perspective, more often than not, these companies have to borrow money to pay their dividends.

Not Vodafone. Have a look at the chart below. It shows Vodafone's ability to pay its dividends from its cash flow. This is known as its 'free cash dividend cover'.

Vodafone free cash dividend cover (x)

As you can see, for the last four years its free cash flow has comfortably covered the amount it has paid out in dividends. But can Vodafone keep growing its dividends?

In the short-term, the answer is yes. Vodafone has already promised that dividends per share will be no less than 10.18p for the year to March 2013. But that's before any cash flow from Verizon Wireless is taken into account.

Will Verizon boost the dividend?

Vodafone has a 45% stake in the US mobile phone operator. In 2011, its share of profits made up 39% of Vodafone's total profits. But until last year, Vodafone had not received any dividends from Verizon since 2005. In February this year, Vodafone paid an extra 4p dividend (equivalent to £2bn) to shareholders as Verizon Wireless resumed dividend payments.

If this 4p can become a permanent source of cash, then Vodafone's dividend could be over 14p next year giving it a yield of 8.6%. So what the chances of this happening?

Well it depends on who you listen to. Majority partner Verizon Communications has played down the prospect of annual dividend payments. It has said that it wants to hold on to its cash flow just in case it wants to buy other mobile businesses. This might be necessary because smartphones are very data hungry and may require more investment in bandwidth.

There's also the effect of smartphones on Verizon Wireless' profits. In its latest results release, profit margins fell, with some Wall Street analysts pointing to the high cost of subsidising smartphones. For example, a mobile phone operator like Verizon Wireless might pay Apple over $600 for the latest IPhone but will charge its customers a lot less for it to get them on board. Some analysts are worried that phones are upgraded so often that profit margins will be under pressure for some time. This may hamper the size of dividends that Verizon Wireless can pay.

City analysts seem more upbeat with most dividend forecasts seeming to factor in an extra cash payment to Vodafone. While it may not be an annual event, it is likely that Vodafone shareholders will be receiving bigger dividends.

So while Vodafone faces some difficult markets and some uncertainties such as its ongoing dispute with the Indian tax authorities, we think it shares are a good place for your money. Even if dividends don't grow much, they are backed by cash, whilst the effect of reinvesting and compounding your income over a reasonable length of time could pay off. My conclusion - buy.

Disclosure: I own shares in Vodafone