Earlier this week, a reader contacted me on social media with a question about the repayment of debt compared to paying or maintaining a dividend. Although I initially answered privately, I wanted to take the opportunity to write a longer response which is better suited to an article.
“Companies like Vodafone and Halfords which have large debts still continue to pay a dividend, do you think that’s the right strategy? Surely stopping the dividend and paying down the debt is more sensible with interest rates high? What are the arguments for and against?”
What are dividends
When a company takes on the decision to pay a dividend, a stream of capital is directed from funding the operations of the business and returned to shareholders, typically as cash, but sometimes as reinvestment in additional equity. The dividend yield is the measure of dividend paid per share and is expressed as the dividend value divided by the price of a company’s shares. For example, if a share costs £1 a share and the company paid a 10p dividend, the yield would be 10% (10p divided by £1).
In the early days of paying a dividend, they are usually funded by the profits of the business and paid out as a ‘reward’ to shareholders for the eventual success of a business. After all, in the earliest days of investment, a company is traditionally loss-making, and often requires significant investment to grow and become profitable over time. As a company becomes more profitable, they increase their dividend over time, and eventually the growth in the dividend can begin to outstrip the growth in the dividend. At this point “dividend cover”, or the ability to a company to pay a dividend from earnings, becomes reduced. In the most extreme cases, the cover drops below 1x, meaning that the company is being forced to use retained cash, sell assets, raise debt, or issue equity to fund the dividend. In the most egregious cases, a cynical management team may choose to deliberately pay too much out in dividends, as they often own a significant equity stake in the business and so by paying out a dividend use company assets to enrich themselves at the expense of the company’s health.
Debt vs. dividends – a question of capital allocation
Taking this into account, our question today is essentially a question about capital allocation. Readers will know of my preference for dividend-paying companies, which I have written about at length, but this has to be balanced with a need to run a profitable and healthy business. After all, if a business generates a million pounds in revenue but spends even a single penny more, then that extra expenditure can only be funded by one of three sources – either assets must be sold, debt must be raised, or equity must be issued. In all three scenarios, the shareholder is likely put in a worse position, as in the first, the company has fewer productive assets, the second create a liability which must be repaid (at a cost at least equal to the interest payments incurred), and in the third, their share of ownership in the business is diluted.
As a shareholder, I feel that the payment of a dividend should never be prioritised over the repayment of debt (or at least ensuring the sustainable servicing of debt) as whilst I can live without a dividend, a company can be entirely destroyed by lenders if debts are not repaid or debt covenants are breached. My preference is for companies to use debt sparingly and preferably to have a “net cash” position, which means that they hold more cash than debt and so could repay their debt entirely, if they even have any.
If debt is to be used at all, then it absolutely must be utilised sensibly. For example, if a company borrows £10m at an annual interest rate of 7%, then after five years it will have repaid £13.5m. If the original £10m can be invested in a project that returns more than £13.5m then the debt has at least been profitable, but if the project returns less then shareholder value has been destroyed.
Secondly, if the project only returns a fraction over £13.5m (say £14m), then the Return on Capital Employed would be rather derisory at less than 4%. On the other hand, if the project returned a far greater amount (say, £25m) then the Return on Capital Employed would be a fantastic 85%. As a shareholder, I am seeking long-term ROCE of over 10%. I expect my management team to be tracking this number assiduously, and as such to be raising debt sensibly and not simply utilising it for whatever pet project some random Director dreamt up over a pint of Guinness at the pub.
With these parameters in place, I turn to the two companies listed in our question – Vodafone, which I own, and Halfords, which I do not.
Vodafone – a telecoms catastrophe?
The first of these is a clear-cut case of pay down the debt. With revenue of €43bn and net profit of €2.2bn, Vodafone’s management team has run up an absolutely eye-watering €47bn in net debt, which peaked at over €54bn back in 2020. Having said this, their debt maturity profile over the next five years is nearly entirely covered with currently liquidity of €11.2bn and repayments of €15.4bn due over the same period. Of course, operating expenses will be incurred, but cash will also be generated, meaning that debts look as though they will be easily repaid as they fall due.
Alternatively, debts could be “rolled over”, meaning that new debt is raised to repay the old debt. Having said this, interest rates have shot up in the last two years, meaning that the cost of servicing new debt will be higher. This increases the hurdle rate of return needed to justify using the debt, making it increasingly unlikely that rolling it over will be the best course of action.
Add in the fact that telecoms business have historically generated lacklustre returns on capital and weak returns on assets, and the use of debt is less and less likely to be the right course of action for Vodafone.
Happily, although the business has accrued a significant debt burden over the last ten years, net debt is on a downward trajectory and my preference would be for this to continue – perhaps to even increase with a temporary suspension of the dividend.
Halfords – fixing it or fudging it?
Halfords is a business I have looked at previously but do not hold a position in. Unlike the multi-national conglomerate that is Vodafone, Halfords is a fairly parochial, UK retailer specialising in automotive, leisure and cycling products and services. The company has accrued £372m in net debt, which is significant when compared to profits of just £28m and revenue of £1.7bn.
Like Vodafone, the business has poor returns, with a 2% operating margin, 2% return on assets, and a 5% return on capital, paying out a 5% dividend. This has slim cover, at 1.2x earnings, but again, my preference would be for this to be paid down over time. Unlike Vodafone, which appears to be making headway into reducing its debt, Halfords is still on the rise, having increased from £277m in 2021 to £372m today, with their cash balanced having been decimated from £67m to barely £16m over the same period.
Conclusion
Both of these businesses have accrued substantial debts and accounts show a mediocre model of deploying capital on behalf of shareholders. In both of these instances, my preference is therefore be for debt repayment over dividend payment – as a general rule of thumb, I nearly always will. A company that is built on the use of debt is built on a shaky foundation. Borrowers can demand repayment and lenders sit above equity holders in the capital stack, meaning that in the event of a liquidation, lenders will be repaid before shareholders.
What concerns me with many businesses is that management do not act with the best interest of shareholders truly in mind. If a management team was personally liable for debts incurred by a company, they would think carefully before taking on borrowings, but instead, many management teams treat debt as a means of personal enrichment, incurring liabilities and extracting significant salaries and dividends for their own benefit at the expense of the health of the company.
I have often witnessed previously healthy businesses collapse under the weight of attempting to manage debt – Woolworths, Carillion, Arcadia, Comet, Blockbuster, Staples – the list goes on and on but the lesson never seems to be learned. A company will never go bankrupt with cash in the bank but the only companies that go bankrupt owe money to others that they cannot repay.
I happen to know that the individual that wrote in used to hold Vodafone, like me, but has since sold it. I am still invested, but debt management is definitely the top risk for me on a list of potential red flags. The gradual reduction in debt over time and prudent management of liquidity gives me confidence in the ability of the business to continue as a “going concern” over the next five years but as a shareholder, I strongly feel that breaking up the bloated conglomerate and using released capital to reduce debt would yield a better outcome than prioritising dividends.
So in short:
- Debt can be justified if the return generated by that debt is greater than the costs incurred in repaying it.
- If returns from using debt are lower, then debt repayment should be prioritised over dividend payments.
- If paid, Dividends should be paid from earnings, not debt or equity.