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Are these 7% dividend yields a recipe for disaster?

Image: Taylor Wimpey. Fair use.

As a rule of thumb, dividend yields of more than 6% suggest that there’s an increased risk of a cut. But this isn’t always true.

Today I’m going to look at two stocks which currently boast a forecast yield of 7.1%. Are these payouts built on solid foundations, or should shareholders head for the exit?

There could be more to come

In May 2016, FTSE 100 housebuilder Taylor Wimpey (LSE: TW) announced a new dividend policy targeting a total return to shareholders of £1.3bn between 2016 and 2018.

The firm said its short-term land bank had reached “optimal size“, so it would only be buying new land to replace plots that have sold. As a result of strong housing market conditions, it expected to “continue to generate cash that is surplus to the business’s requirements”.

Taylor Wimpey plans to pay a total dividend of £450m for 2017. Analysts’ forecasts suggest that this should equate to about 13.9p per share, giving a forecast yield of 7.1%.

The group’s accounts for 2016 suggest to me that this payout should be comfortably affordable. My calculations show that Taylor Wimpey generated free cash flow of £511.6m in 2016. A similar performance seems likely this year, based on current profit forecasts.

The cyclical nature of the housing market suggests to me that Taylor Wimpey’s generous special dividends won’t last forever. But with housing demand still exceeding supply, it may be too soon to bet on a downturn in this sector.

For now, I’d argue that Taylor Wimpey’s 7.1% yield is affordable and sustainable. This stock could still be a good buy for income.

Fragile but affordable?

One of the big attractions of logistics firm Connect Group (LSE: CNCT) is its strong cash generation. Shareholders received a dividend of 9.5p per share last year, giving a trailing yield of 6.9%. This payout was covered comfortably by the group’s free cash flow of £49.6m.

Connect’s dividend is expected to rise to 9.8p for the year ending 31 August 2017, giving the stock a forecast yield of 7.1%. One of the reasons this yield is so high is that Connect stock trades on a forecast P/E of just 7.6.

In my opinion, this combination of a high yield and low P/E suggests that the market sees some weakness in Connect’s financial situation. I can see why this might be.

The group’s net debt was £141.7m at the end of August last year. Although this looks acceptable to me, when compared to pre-tax profit of £41.9m, this borrowing isn’t backed by assets. Excluding intangible assets such as customer relationships and trade names, which can be hard to monetise, Connect had a net tangible asset value of minus £151.8m at the end of August 2016.

While trading remains strong and credit is readily available, this probably won’t be a problem. But a slowdown in trading or tighter standards of lending could force the company to cancel the dividend and raise cash by selling new shares.

Although the pending sale of Connect’s Education business may improve its balance sheet, I’m not sure it will be enough. For now, I think the risks outweigh the potential rewards.

These dividends could help you retire

If you're looking for safe dividend stocks with long-term growth potential, then it might be worth targeting companies with slightly lower yields.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.