Hunting among high-yield stocks for potential bargains is hard to resist. Stocks with yields of around 6% can sometimes be genuine bargains.
Of course, these generous payouts often come with an above-average risk of a dividend cut. Today I’m going to look at two of the more controversial 6% yielders on the market.
Surprisingly successful
Shares of Games Workshop Group (LSE: GAW) climbed 6% on Friday morning. They’re now worth 235% more than 12 months ago, thanks to a series of strong earnings upgrades.
Today’s surge followed news that management expects to report half-year sales of £109m and operating profit of £38m. This equates to respective rises of 54% and 175% compared to the same period last year.
We already knew that today’s figures would be good. But the share price rise suggests that investors may not have fully priced in the effect of operational gearing on Game Workshop’s profits.
Operational gearing is an important concept for retailers because costs such as store rents and staffing are fixed regardless of sales. That means an increase in sales can result in a much bigger increase in profits, and that’s what’s happened here.
Of course, operational gearing works in reverse, too. A small drop in sales can result in a big fall in profit.
Is Games Workshop still a buy?
This stock currently trades on a forecast P/E of 13, with a forecast dividend yield of 5.7%. Cash generation should remain very strong and this payout is covered by earnings. However, cover isn’t that high, at around 1.3 times forecast earnings for 2017/18.
One potential concern is that analysts currently expect profits to fall by around 15% to 136p per share next year, as sales growth tails off. This would leave the forecast dividend of 120p covered just 1.1 times by earnings.
The outlook for this business seems hard to predict. I’m not sure whether there’s much more upside in the near term, so I probably wouldn’t invest at the moment.
Breakdown or recovery?
The AA (LSE: AA) brand is known and trusted by motorists throughout the UK. However, investors are more wary about the group’s shares, which have lost 45% of their value over the last year.
August’s profit warning and the sacking of its executive chairman spooked the market. But I didn’t think September’s interim results were too bad. And the shares now look very cheap, on 7 times forecast earnings and with a prospective yield of 5.6%. So is it time to consider a recovery buy?
The elephant in the room
The biggest risk for AA shareholders is the group’s £2.7bn net debt. Although this has come down from a peak of more than £3bn, it’s still equivalent to a multiple of more than six times forecast EBITDA. A multiple of around 2.5 times is generally considered a prudent maximum.
There is a risk that the firm’s new chief executive Simon Breakwell will decide to cut the payout to speed up debt repayments. He’s already warned that delays to the group’s IT upgrades will result in £35m of additional spending in 2018/19.
In my view, AA shares are cheap for a reason. If things go well, they could be a bargain buy… but shareholders still face significant risks.
