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Why I’d avoid the turnaround proposition at Connect Group and what I’d buy instead

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Since I last looked at distributor Connect Group  (LSE: CNCT) back in early 2017, those holding the stock have endured a tough time. Back then, the dividend yield was in excess of 6%, and City analysts watching the firm had rated the share a ‘strong buy’. But I was sceptical, and said: I worry that such a high dividend payment may be unsustainable, or perhaps it’s a sign of trouble ahead for the underlying business.”

Yet, Connect had raised its dividend by around 32% over the previous five years and had a record of rising cash flow that lent decent support to earnings. So what could possibly go wrong? Apart from its high debt, one problem I saw back then was the firm’s “high level of cyclicality“ in its operations, and I thought it deserved its low rating.

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Things unravelled fast

I concluded by saying that I’d keep “a close eye” on the firm for signs of deterioration in trading if the shares were in my portfolio. Luckily for me, the shares were not in my portfolio, because things unravelled fast for the company. The share price is now around 80% lower than it was back then and at first glance, the immediate damage has been caused by a more than 40% plunge in earnings and a slashing of the dividend, which now stands around one-third of its previous level.

The company did dispose of its Education and Care Division during the summer of 2017, which accounted for around 12% of annual operating profit. The transaction raised around £56m, which the firm used to pay off some of its debt. However since then, trading became very difficult for the remaining operations and profits fell off a cliff. I think it was probably right to be wary of the cyclicality in the enterprise all along. The firm’s activities as a distributor in News and Media, Parcel Freight and Books all strike me as lacking any pricing power, or economic niche, to distinguish them from competitors.

Let’s pick up the story with today’s full-year results statement. Compared to the previous year, adjusted revenue slipped 3.8%, and adjusted earnings per share plunged by 40%. That’s grim, considering adjusted figures are aimed at showing the true performance of the business. The directors slashed the dividend by just over 68%.

Now it’s a potential turnaround

Chairman Gary Kennedy was blunt in the report and said: “A year of significant challenge exposed weaknesses in our strategy and its execution, with a consequent impact on results.” But he’s optimistic that the new chief executive, Jos Opdeweegh, can turn things around. Opdeweegh started on 1 September, so it’s early days. And if you like the idea of a turnaround proposition, now is a good time to look at the firm, I reckon.

But I’m not interested. At best, Connect Group is a commodity-style operation and will probably always face challenging trading conditions. I’d rather target a company with better quality indicators and a stronger trading niche, or invest in a tracker fund such as one that follows the FTSE 100 index, which would shield me from individual company risk. When shares go wrong, the results can be catastrophic in your portfolio, so it pays to select your investments carefully, and abstain from investing if you have any doubts, such as those I had with Connect almost two years ago.

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We think it has the potential to become the next famous tech success story.

In fact, we think it could become as big… or even BIGGER than Shopify.

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Kevin Godbold has no position in any of the 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.

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