Why I’d sell this value share to buy Saga plc’s massive yield

One Fool would sell this dirt-cheap stock to secure Saga plc’s (LON: SAGA) 7% dividend yield.

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The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Shares in utility cost management consultancy Utilitywise (LSE: UTW) are showing up on my value screen at the moment and at first glance appear to offer a bargain. Last year the company recorded a net profit of £15.8m, but you could snap up the entire operation today for only £41.6m. 

In reality, the shares aren’t quite as cheap as the historic P/E of 2.6 implies. Accusations that the company’s revenue recognition policy was too aggressive proved prescient. A trading update in July revealed that a change in accounting policy meant revenue would be £4m to £4.5m below previous management expectations.

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It went on to explain that “given the Group’s relatively fixed cost base, substantially all of the shortfall in revenue will impact the profit before tax of the Group.” 

As a result, 2018 profit before tax will reduce roughly 40%. For some investors, this significant profit warning might come as a shock, but the warning signs were there all along for anyone keeping an eye on the balance sheet. 

The company’s accounts receivable, or revenue that has been recorded but not yet received, as of 31 July 2016 was a massive £19.7m. When the receivables figure is greater than an entire year’s worth of profit, I begin to feel uneasy.

On top of this, the company has discontinued the practice of seeking cash advances from the utilities it works with, meaning net debt could balloon by £16.4m to around £26m at year-end, unless my calculations are off. 

Utilitywise looks set to book a profit before tax of £11m if its estimates are accurate, but I’ve lost faith in its commentary and don’t consider it investible at the moment given the sudden change in expectations for both cash flows and profits this year. 

Contrarian dividends

I consider Saga (LSE: SAGA) a more attractive, yet still risky, value investment. The shares trade on a P/E of nine and offer a prospective yield of 7% to investors. Shares in the over-50s insurance and travel company tumbled roughly 30% earlier this month after revealing that underlying profit before tax is expected to grow 1% to 2%, compared to the previously expected 5%. 

The news doesn’t seem all that bad to me given the company’s strong cash flow, so I presume the market is expecting further downgrades in the near future. Perhaps the shares are currently so depressed because the insurance arm, where the business generates the majority of its profits, is performing slugglishly, or perhaps it is due to fears that conditions could deteriorate further after Brexit. 

Regardless, I believe the current valuation offers a significant margin of safety for those willing to take on a little more risk for the chunky payout. Promisingly, it seems that CEO Lance Batchelor agrees with me, having purchased over 70,000 shares since the profit warning. 

If I were to invest in the company, I’d consider a smaller  speculative position to benefit from the gigantic dividend because it is still covered 1.5 times by earnings per share. 

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