BT vs Vodafone: where should investors put their cash?

• BT and Vodafone both have track records of sluggish growth and high debt levels

• Both firms have cut their dividends in recent years, but offer attractive yields today

• Both have attracted high-profile major shareholders over the last two years

• Is there a clear choice for retail investors today?

BT (LON:BT.A) and Vodafone (LON:VOD) remain two of the most popular FTSE 100 dividend shares with UK retail investors. High dividend yields, seemingly cheap valuations and well-known brands make for an obvious choice.

However, the share prices of both companies have fallen by more than 50% over the last 10 years – a period when even the staid FTSE 100 has managed a near-25% rise. Dividend cuts, falling revenue and uncomfortable debt burdens have all highlighted these firms’ constant struggle to balance low growth with high spending requirements.

In this article I’m going to take a fresh look at both companies following their recent trading updates. Where should investors put their cash today – or should we steer clear of both stocks?

Let’s recap what each of these groups does. Despite being widely compared, they’re quite different businesses.

BT

BT is the incumbent fixed-line operator in the UK, with by far the largest network. An accelerated upgrade to fibre is underway.

In mobile, BT owns EE, which is said to offer the UK’s best coverage.

Finally, BT offers a wide range of services to business and enterprise customers.

Recent trading: In its recent nine-month trading update, the company said its fibre rollout is now passing 62,000 premises each week. There’s been a 51% year-on-year increase in customer orders for fibre-to-the-premises (FTTP) services.

CEO Philip Jansen believes this investment will generate growth in the future, but the benefits have yet to feed through to BT’s trading performance. Revenue for the nine-month period fell by 1% to £15.6bn, while adjusted EBITDA rose by 3% to £5.9bn.

Here’s how BT’s valuation looks at the moment, based on consensus forecasts:

The valuation appears to be tempting, but this has been true for many years, suggesting a possible value trap.

Vodafone

Vodafone’s biggest single market is in Germany, where it’s a major broadband and mobile operator. Spain and Italy are also important markets, as well as the UK.

In total, Vodafone’s European operations have around 67m mobile customers and 25m broadband users.

Vodafone is also one of the largest mobile operators in Africa, under the Vodacom brand. The group operates networks in eight African countries and also runs one of the continent’s largest mobile money services, M-Pesa.

The African networks have 188m mobile users and 90m data users. These contribute around one-third of Vodafone’s EBITDA.

Recent trading: Revenue rose by 2.7% to €11,638m during the nine months to 31 December, on an organic basis. Declines in some European markets were offset by gains elsewhere.

Full-year guidance was left unchanged, suggesting flat EBITDA and a slight reduction in free cash flow.

The group expects to raise somewhere between €4.9bn and €8.8bn from the sales of its Hungarian network and its remaining stake in the Vantage Towers business. However, this wasn’t enough progress for investors; CEO Nick Read resigned in December.

Here’s how Vodafone’s valuation looks at the moment, based on consensus forecasts:

Vodafone’s high forecast yield reflects a low level of earnings cover for its dividend. As we’ll see, this is also mirrored by free cash flow performance.

What do the StockRanks say?

Stockopedia’s factor-based ranking system is all about trying to tilt the odds in our favour by harnessing the forces of quality, value and momentum. So what do the StockRanks say about BT and Vodafone?

Here’s a snapshot:

Vodafone appears to have a slight edge, with a higher StockRank and Balanced, Contrarian profile. According to Stockopedia’s research, this is statistically likely to be less volatile and perform better than an Adventurous, Neutral share. But there’s not a massive difference.

However, Vodafone’s slight quantitative advantage is maintained if we turn to the Compare Stocks tool. Vodafone scores more highly in areas including earnings growth, yield and free cash flow, although it’s less profitable than BT:

Summary: As far as Stockopedia’s algorithms are concerned, Vodafone seems to have a slight but consistent advantage over BT.

Profitability

In recent years, BT has been significantly more profitable than Vodafone. However, this advantage appears to be dwindling. Vodafone’s performance has been improving:

Return on capital employed – a key metric for such capital-intensive businesses – also shows similar trends:

Vodafone’s ex-CEO Nick Read admitted that the group’s ROCE had been below its cost of capital in recent years. In effect, the group’s spending has been destroying shareholder value. One of Mr Read’s key objectives was to improve this performance.

In contrast, BT’s ROCE has worsened. The firm looks at risk of falling into the same trap Vodafone is trying to escape.

Rising interest rates are likely to make it more difficult for both companies to improve their profitability, due to the increased cost of capital implied by higher borrowing costs.

Debt amp; Dividends

We can’t discuss Vodafone and BT without considering debt and dividends. In BT’s case, we must also consider the deficit in the group’s legendary £40bn pension scheme.

Are today’s high dividend yields sustainable? My approach is to compare the payouts with free cash flow, as any shortfall here generally leads to an increase in debt.

Vodafone: the current dividend of €0.09 per share costs around €2.5bn per year. The company’s favoured measure of adjusted free cash flow has been running at just over €5bn in recent years, suggesting a comfortable margin of safety.

However, this figure excludes spectrum and restructuring costs. Including these, actual free cash flow was €3.3bn last year and €3.1bn the year before. Despite its 2019 dividend cut, Vodafone has continued to pay out the vast majority of its free cash flow as dividends, limiting its ability to repay debt or fund growth.

Vodafone’s net debt stood at about €45bn at the end of September, excluding lease liabilities. That gives a trailing net debt/EBITDA multiple of 3.1x. That’s high, but perhaps not unsustainable for a major telco.

BT: the dividend was suspended during the pandemic and then reinstated with a 50% reduction.

Forecast earnings cover of 2.6x for the current year suggests a reasonable margin of safety. Let’s see how this stacks up against cash generation.

The current dividend costs around £765m each year. BT’s normalised free cash flow is expected to be £1.3bn-£1.5bn this year, but again, this excludes pension deficit payments and spectrum costs. Including these, I estimate free cash flow was about £940m in 2021/22, and somewhat less the previous year.

As with Vodafone, we see that most of BT’s true surplus cash is being paid out to shareholders.

In terms of debt, BT reported net debt of £13.5bn at the end of September, excluding lease liabilities. That’s equivalent to a net debt/EBITDA ratio of 1.8x. This would be comfortable, except BT also has to service a £4bn actuarial pension deficit.

I estimate the pension scheme will require deficit reduction payments of £800m-£900m this year, continuing on a sliding scale through to 2030.

BT’s pension scheme has around £40bn of assets and liabilities. It’s somewhat akin to a large hedge fund. Small changes in interest rates and market movements can lead to huge swings in the deficit, which in turn has a big impact on the group’s equity value.

With a market cap of £13bn, BT is a classic example of a pension scheme with a business attached to it. Ultimately, shareholders will always be in third place for cash payouts, behind the pension scheme and the group’s lenders.

Competitive position

One of the main challenges facing BT and Vodafone is the maturity of their core markets. This chart from Statista shows UK mobile subscriptions since 2000. I’d imagine a similar story applies in most European markets.

Here’s a similar chart showing the percentage of UK households with broadband between 2011 and 2019:

What this means is that the only way to win a new customer is to take them from a rival. Not easy, when services and pricing are generally similar and competitive.

However, in the UK at least, the speed and quality of the services on offer aren’t always world beating. Improving this – profitably – is the main opportunity for BT, in my view.

In contrast to BT’s UK focus, Vodafone’s operating businesses sprawl across much of Europe and Africa. This has endowed the group with a complicated structure. For Vodafone, simplification seems to be the main opportunity. Interim CEO Margherita Della Valle says she has already started to simplify the group’s structure to give local units more autonomy.

Discussions between Vodafone and Three owner CK Hutchison about a merger of the two companies’ UK networks are also said to be ongoing. This could create value through cost savings and economies of scale.

Activist investors

BT and Vodafone have both caught the eye of heavyweight industry investors over the last 18 months.

The UAE’s state-controlled telecoms group became Vodafone’s largest shareholder last year and currently has a 13% stake.

US cable network operator Liberty Global has also just taken a 4.9% stake in Vodafone, Chairman John Malone seems to think the stock is cheap, with the potential to release value through restructuring.

Over at BT, telecoms investment group Altice has built an 18% stake in BT, with founder Patrick Drahi apparently holding a similar view of the UK incumbent.

Conclusions

I think there’s plenty of latent value locked up in both BT and Vodafone’s operations. But each group’s debt-laden situation (and BT’s pension deficit) mean that they’re not creating value for shareholders in the way I’d like to see.

As things stand, this is perhaps a choice between two not-very-great businesses. On balance, however, I would choose Vodafone. Despite the group’s frustrating track record, Vodafone isn’t burdened with BT’s regulatory obligations and staggering pension liabilities.

On balance, I think that Vodafone’s European operations should be able to generate consistent returns, while the African business has exciting potential. While revenue per user is lower in Africa than in Europe, I think the growth potential of this business is far greater.

Although both group’s dividends carry some risk, I think they may well be safe, at least for now.

Stockopedia