Why I’d shun this FTSE 250 dividend and buy this FTSE 100 6% yielder instead

Roland Head takes a critical look at news from this FTSE 250 (INDEXFTSE:MCX) firm and suggests a FTSE 100 (INDEXFTSE:UKX) income pick.

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The share price of engineering outsourcing firm Babcock International Group (LSE: BAB) fell by as much as 12% on Thursday, after management warned that sales growth would be lower than expected this year.

The decline is due to a slowdown in government defence spending that’s hit the FTSE 250 firm’s marine division. Spending on the Queen Elizabeth aircraft carrier has declined as expected, but the group has also been hit by delays to planned spending on submarines. These changes are now expected to limit revenue growth to a “low-single-digit” percentage this year.

Businesses which work on large engineering contracts inevitably suffer occasional delays, so I’m not too concerned about this. Today’s trading update wasn’t a profit warning and management is trying to diversify by winning more overseas work.

Importantly, Babcock still expects to hit full-year targets for underlying profit and debt reduction. This should see its net debt-to-EBITDA ratio fall to around 1.4 times, down from 1.6 times at the end of last year. This level of gearing is significantly lower than some rivals, and looks comfortable to me.

Solid numbers

The order book appears to remain fairly stable, with an £18bn backlog of signed orders, unchanged from 31 March. About 83% of expected revenue is secured for the 2018/19 financial year, with 55% secured for 2019/20.

Analysts expect the company to deliver adjusted earnings of 85p per share this year, and a dividend of about 30p. After today’s fall, this puts the stock on a forecast P/E of 8.3 with a dividend yield of 4.4%.

This could be a reasonable entry point, but this is the second time this year that Babcock has warned on sales. I’m a little wary about the risk of further bad news. I wouldn’t rush to buy just yet.

On the rebound

The Imperial Brands (LSE: IMB) share price fell to a four-year low of 2,298p earlier this year, as investors registered concerns about the group’s lack of growth and its high levels of debt.

At the time, my Foolish colleague Ed Sheldon explained why he thought the stock looked oversold. Imperial’s half-year results seemed to confirm Ed’s view, revealing a £1.2bn reduction in net debt and flat sales. After-tax earnings fell by just 1% on an adjusted basis, suggesting that the outlook for profits remains stable.

Time to buy?

The tobacco giant’s share price has started to recover, but it remains well below the £30-£40 range seen in recent years.

Although I am concerned about the £13bn net debt, Imperial’s cash generation remains very strong. My calculations suggest that free cash flow has totalled about £2.5bn over the last 12 months. This compares to around £1.6bn paid out as dividends during this period. If this performance can be maintained, I think net debt should gradually fall.

In the meantime, the shares trades on 11 times 2018 forecast earnings with a prospective yield of 6.5%. In my view this is cheap enough to reflect the risks of investing in this sector. I’d rate the stock as an income buy at this level.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands. 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.

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