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Why 7% yielder Interserve plc could rocket after today’s update

Shares of outsourcing group Interserve (LSE: IRV) rose by 7% today, after the company said that 2016 profits should be in line with expectations, but that net debt should be significantly lower than expected.

This news was greeted with such enthusiasm because Interserve warned investors in May 2016 that £70m of exceptional contract costs would push debt levels up. The firm’s shares have fallen by 22% since then and many people, including me, believed that a dividend cut was inevitable.

This looks much less likely after today’s news.

Although today’s release didn’t mention the final dividend, I’d be very surprised if management decided a dividend cut was necessary after hitting profit forecasts and generating more cash than expected.

Does cash boost make this a buy?

Interserve said today that strong results from its international construction business would offset a disappointing performance in the UK construction sector. Net debt is expected to be £270m-£280m, significantly below half-year guidance of £300m-£320m.

The group says it has accelerated cash collection and taken other measures to improve cash flow. I suspect that the weaker pound has also helped by boosting the value of overseas income.

The net result is that Interserve’s finances appear to be significantly stronger than expected.

However, there’s a risk that this performance has provided a one-off boost that can’t be repeated. Management hasn’t yet provided any guidance for 2017, but I’m becoming a little more optimistic than I was.

Interserve shares currently trade on a forecast P/E of 5, with a prospective yield of 7.2%. If profits and cash flow remain stable in 2017, I think the shares could deliver worthwhile gains from current levels.

How about this 8% yield?

Interserve’s forecast yield of 7% is the result of its weak share price. But there are other firms paying similar yields simply because they have surplus cash.

One example is Direct Line Insurance Group (LSE: DLG), which is expected to pay a total dividend of 30p per share this year. At the current share price of 351p, this equates to a potential 8.3% dividend yield.

Around two-thirds of this expected payout is likely to be as a special dividend. Direct Line’s ordinary dividend was just 13.8p per share last year, giving a yield of 3.9%.

Direct Line’s future policy will be to consider whether a special dividend is affordable once a year, ahead of the firm’s full-year results. The group has paid a special dividend every year since its flotation in 2013, in part because the market has been very competitive. Growth opportunities offering attractive returns have been limited, so Direct Line has returned the cash it might otherwise have used to expand.

As with all very high yields, Direct Line’s special payout carries some risk. But the company appears to be well run and generates attractive returns.

With the shares trading on a 2016 forecast P/E of 12 and a prospective yield of 8.3%, I think the downside risk is worth taking. I would rate Direct Line as a buy.

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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. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.