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Don’t buy this FTSE 100 dividend stock until you’ve read this

Image: Sky TV. Fair use.

Shareholders in media giant Sky (LSE: SKY) have endured a rough ride in 2016. It traded as high as 1,100p on the first trading day of the year, yet 10 months later the stock is hovering around the 800p mark, a year-to-date fall of an ugly 27%.  

One benefit of a share price fall is that it pushes a company’s dividend yield up, and observant dividend investors will have noticed that the dividend yield has now been elevated above the coveted 4% mark.

However if you’ve been thinking about pouncing on Sky shares for the elevated yield, there are a couple of things you should know first.

Rising debt levels

The first important factor that investors should be aware of is that after the recent purchases of Sky Italia and Sky Deutschland, debt levels have risen significantly. Indeed, the current and non-current borrowings have risen from £2669m in FY2014, to a huge £8932m in FY2016. And it’s the composition of this debt that has investors worried, with much of this debt being denominated in US dollars and euros.

The problem here is twofold. Firstly, with the pound falling heavily against the US dollar since Brexit and no US dollar revenues, any US dollar debt is now more expensive to service. Secondly, even though Sky is now generating revenue in euros through Sky Italia and Sky Deutschland, these acquisitions are failing to add significantly to the company’s operating profit at the moment.

So this mounting debt pile is a factor to keep in mind, as significant debt levels can detract from a company’s ability to pay dividends to its shareholders.

Rising competition

The next issue is that competition in the entertainment space is increasing rapidly. A combination of new services such as Netflix and Amazon Prime, combined with significant competition from the likes of BT and Virgin Media, mean that Sky has its work cut out to retain customers.

Furthermore, with BT going all-out to bid up rights to the Premier League, it means Sky’s costs are rising rapidly and profit margins may be affected negatively.

It’s not all bad though

However before you write-off Sky, there are many positives about the company that are worth keeping in mind.

The first is its dividend growth history, which in the last decade has been nothing less than outstanding. It has increased its dividend from 12.2p in FY2006 to 33.5p in FY2016, a compounded annual growth rate (CAGR) of 10.6%, which is a dividend growth investor’s dream.

Furthermore, it has an amazing ability to generate cash flow and the company’s free cash flow yield currently stands at a level of above 8%.

Q1 results released in mid October were solid, with group revenue rising 13% or 7% in constant currency. And with 21st Century Fox owning 39% of Sky, the fall in sterling may make it an attractive bid target for the multinational mass media corporation.

Overall, I’m cautiously optimistic, given its forecast P/E ratio of just 13.7 times next year’s earnings and dividend yield of over 4%, however it’s worth keeping in mind that there are several key risks that could potentially affect the dividend.

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Edward Sheldon owns shares in SKY. The Motley Fool UK has recommended Sky. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.