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How Vodafone went from Facebook to flat and hit UK yields

20 May 2019

Once the ‘Facebook of its sector’ Vodafone is now ‘flatlining’, say managers of Merchants trust, while Neptune fund manager Robin Geffen describes its dividend cut as a ‘canary in the coal mine’ for the UK stock market.

Once the ‘Facebook of its sector’, Vodafone (VOD) is now ‘flatlining’, demonstrated by the mobile operator slashing its dividend last week, said the managers of Merchants (MRCH) trust.

Outgoing chairman of the £531 million UK equity income trust, Simon Fraser, remarked that Vodafone was once considered the ‘Facebook of its sector’ at the investment company’s recent 130th anniversary event.

In 1999, Vodafone represented 13% of the UK stock market, pointed out manager Simon Gergel.

However, he added: ‘For several years they have been struggling to generate enough cash to generate a dividend - debt's been going up gradually, the business is flatlining.’

Vodafone, one of the FTSE 100’s most popular and highest paying income stocks, with a yield of nearly 10%, confirmed market suspicion and announced it was to cut its dividend by 40%.

The mobile operator cited high-debt levels and the cost of developing its 5G networks, as the reason for reducing the payout.  

This will reduce the FTSE All Share’s yield by 1.7% and the Investment Association’s UK Equity Income sector yield by 1.1%. Half of the UK equity income open-ended funds hold Vodafone, with it accounting for a 5.4% of the overall yield of the sector. This group of funds is therefore expected to see a 2.2% fall in yield, according to Neptune Investment Management.

Gergel, whose trust is one of the highest yielding in the Association of Investment Companies UK Equity Income sector, at 5.5%, said Vodafone had turned out to be an example of a value trap and showed that buying high-yielding stocks did not always work.

He sold the position Merchants’ held in Vodafone in 2014, when selling its exposure to its US business Verizon Wireless.

Sunset industries

However, Gergel added that there have been examples in the past when markets have been wrong about writing-off high-yielding stocks and sectors. Oil was one case, when a few years ago the likes of Shell (RDSb) yielded 9.5%, and there was a lot of discussion about ‘peak oil’ demand, as oil prices remained depressed.

‘We thought yes the valuations have bottomed out, we thought yes ultimately oil demand will peak and decline, but it’s a very long way in the future,’ he said.

Shell is the top holding in Merchants, at 5.9%, and now has a yield of 5.7%. As yields move in the opposite direction of prices, this shows the strong increase in the oil giant’s shares since Gergel bought in.

Tobacco giant Imperial Brands (IMB), a 3.5% position and the highest-yielding stock in Merchants, at 9.5%, having just raised the dividend by 10%, and was another of Gergel’s holdings in a sector said to be under threat.

‘The cash flow of Imperial is very strong…[the dividend’s] certainly nowhere the threat that it needs to be cut, their cash flow is fine for investing in the business as it needs to,’ he said.  

British American Tobacco (BATS) is also a 3.5% holding in the trust.

But Gergel also acknowledged there were companies in his trust where structural threats had more of an influence over the size of the position.   

‘There are clearly companies in the portfolio like WPP and ITV where there are open debates about the future of those industries and those challenges and you have to take a balanced assessment of those,’ he said. 

WPP (WPP) accounted for 1.3% of the portfolio as of the trust’s annual results in January, while ITV (ITV) was a 1.1% position. 

‘The UK stock market definitely has preponderance of what I would call sunset industries so there aren’t the companies in the FTSE 100 that could reinvest back into their companies in the way that Facebook has done,’ said co-manager Matthew Tillett. ‘There just physically isn’t enough growth for them to go after to do that and if they did they would potentially risk destroying value.’  

‘Whether we’re running the economy in the right way and whether we are attracting the types of businesses that can grow into the Facebooks and Amazons - maybe we’re not. But in a way I see that as a different point to the stock market - the stock market is what it is and we still have to take what is given to us.’ 

Merchants was able to raise its dividend for 37th year by 4.8%, partly thanks to improving income growth of its stocks but also due to a refinancing of debt at the end of 2018. This reduced the trust’s average interest rate from 8.5% to 6.1%, enabling it to reallocate funds to growing dividends faster. 

Despite seeing a 5.2% fall in its underlying return on net assets in the year to 31 January, Merchants’ shares delivered a total return - including dividends - of 1.7%, beating the 3.8% dip in the FTSE All-Share index. So far this year its net asset value (NAV) has rebounded 13.8% although this time the shares have lagged, rising 8.5% versus an 11.7% gain in the benchmark. 

Gergel also runs the £50 million Allianz UK Equity Income fund, which is up 9.6% so far in 2019.

Canary in the coalmine

Neptune founder and manager of its £238 million Income fund, Robin Geffen said he sold out of Vodafone earlier last year. 

‘We felt the company had unsustainable leverage on the balance sheets (which was built up to fund inorganic expansion), a new breed of agile companies disrupting its business model and changing pricing structures – meaning investors can no longer rely on the company to provide sustainable dividends and capital appreciation,’ he said. 

‘Effectively, our view was that Vodafone was entering a difficult operating backdrop with limited capital available to react to changes in its competitive landscape and to meet its capital expenditure requirements.’ 

Geffen argued Vodafone signified a ‘canary in the coalmine’ moment for UK equity income investors, expecting other so-called ‘safe’ UK dividends payers to follow suit.

He included British American Tobacco, Imperial Brands, telecoms business BT Group (BT) and major utility stocks in this category – something analysts have forecast in their outlook for income payers. 

The Neptune Income fund is up 10.6% year-to-date. 

Investment company news brought to you by Citywire Financial Publishers Limited.


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