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Will this 6.3% dividend yield end up costing you money?

Last year, income hunters were left in shock after Pearson (LSE: PSON) announced it was cutting its coveted dividend payout. 

The company’s decision to slash the payout came from nowhere and before the cut, Pearson was perceived to be one of the FTSE 100’s dividend champions. Unfortunately, the decline in the value of Pearson’s shares on the day the cut was announced wiped out years of income gains for investors. 

Pearson issued its fifth profits warning in four years last week, and now the shares are down by 60% from their 2015 peak. At the end of 2014, shares in the company supported a yield of 4.3% which, considering recent declines, now seems relatively insignificant. Another dividend reduction is planned for the year ahead. City analysts have pencilled-in a payout cut of nearly 40%. 

It looks as if Capita (LSE: CPI) is going the same way as Pearson. Even though Capita’s trading has hit a rough patch recently, the company’s management continues to prioritise the group’s dividend over anything else. 

Trouble ahead

Shares in Capita currently support a dividend yield of 6.3% and at first glance, the payout looks safe as it’s covered twice by earnings per share. However, management’s outlook for the business has deteriorated rapidly over the past year, and there could be more depressing news to come.

At the beginning of December, the company warned it expects 2016 underlying profit before tax to be at least £515m. Three months earlier, the firm was predicting a pre-tax profit of £535m to £555m, and before that it was expecting £614m.

Net debt is now expected to be some 2.9 times earnings before interest, depreciation and amortisation – up from a target already raised to 2.7 times in September.

To bring debt down, it’s selling the majority of its Capita Asset Services division. This sale is expected to bring debt down to 2.5 times EBITDA, but it will cost the group annual operating profits of £60m. To me, that sale looks like a poor decision. Capita’s outsourcing operations are under pressure, along with the rest of the outsourcing industry, and by selling off its asset management arm, Capita is divesting a key source of diversification. 

In the worst case scenario, Capita’s main outsourcing business may continue to see sluggish demand, which would mean trouble for the group’s balance sheet. 

Borrowing for the dividend 

For the past five years, Capita has been spending more than it can afford. For example, last year the group generated £502m from operations but spent £639m on acquisitions and organic growth. The dividend, which totalled £200m, was funded with debt. This trend isn’t just limited to 2015. In only one year of the past five has the company been able to cover capital spending and dividends with cash generated from operations. 

If Capita continues on this course, it won’t be long before it has to ask shareholders for cash to shore up its balance sheet. Based on the group’s current level of debt, such a cash call would likely cost investors more than a year of dividend payments — is that a risk worth taking? 

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Rupert Hargreaves 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.