Vodafone(LSE: VOD) has a relatively high yield of 5.2%, but one major concern among investors is its weak dividend cover. In fact, profits last year fell well short of the level required to fund dividend payments, meaning its generous dividends could only be afforded through new borrowings and asset sales.
Free cash flow isn't looking too good either, due to its massive Project Spring investment programme. In Vodafone's 2016 financial year, the company generated just £1bn in free cash flow, which was sufficient to cover only around a third of the sum needed for its dividend policy. And although these big-budget investments should help to improve the company's long-term growth prospects, these cash uses will still put pressure on its medium-term dividend prospects.
Nevertheless, the telecoms giant still managed to increase dividends per share by 2% in each of the past two years and is expected to maintain a similar level of dividend growth over the next couple of years.
Granted, Vodafone has attractive earnings growth on the cards, with analysts expecting underlying earnings per share to grow 35% this year and 12% in 2017. But despite that rapid pace of growth, dividends may still be under-covered by earnings for at least another few years.
A better pick?
Of course, Vodafone isn't the only company in the telecoms sector with great dividend prospects. Domestically-focused BT Group(LSE: BT-A) has a good yield and is set to grow dividends at a faster rate than Vodafone over the next few years.
But investors have their concerns with BT too. The company has a large pension deficit and a relatively high level of indebtedness. In June, a funding update showed BT's pension deficit had widened by nearly £3bn to total £9.9bn. Moreover, due to its acquisition of wireless carrier EE, BT's net debt position almost doubled over the past year to £9.8bn.
However, near-term tailwinds in the form of synergies from the integration of EE and improvements in operational efficiency should provide comfort in the outlook for earnings and free cash flow generation. Looking ahead, BT is due to report a 2% fall in its bottom line this year, with earnings forecast to rebound 9% in the following year, valuing its shares on forward P/Es of 12.8 and 11.8, respectively.
BT's dividends are also well covered. Earnings per share last year were 2.4 times its dividends, while free cash flow exceeded dividends by more than two times. This should be more than enough for the company to gradually pay down its pension deficits, leaving sufficient room for further growth in dividends per share.
The stock may yield just 3.6% right now, but with dividends forecast to rise by 10% this year and 11% in 2017, its dividend growth outlook is tempting. Plus, with BT having increased dividends per share by 90% over the past five years, it has an excellent track record when it comes to rewarding shareholders.
The bottom line
So while Vodafone has a higher dividend yield, BT seems set to benefit more greatly from near-term tailwinds and is likely to deliver better dividend growth over the next few years.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.