The Motley Fool

2 dividend champions I refuse to buy

There are some popular dividend stocks I refuse to buy. I’m not talking about ethical objections, which are a personal matter. These are stocks where I think the financial risks outweigh the potential benefits.

Today I’m going to look at two of these companies and explain why I’m staying away.

Good company, bad valuation?

Rolls-Royce Holding (LSE: RR) has made solid progress over the last year. The group’s chief executive, ex-ARM Holdings boss Warren East, has modernised the group’s supply chain and expects to have delivered £200m of annual cost savings by the end of 2017.

Mr East has also managed to negotiate a £671m settlement of bribery and corruption allegations with government agencies in the UK, US and Brazil.

The market has responded to this progress, and Rolls’ shares are worth 45% more than they were at the start of 2016.

I’m optimistic about its long-term future, but I don’t understand the stock’s valuation. In 2016, the group’s underlying earnings per share — the most generous measure of profit — fell by 54% to 30.1p. Adjusted pre-tax profit fell by 49% to £813m, but even this reduced figure wasn’t reflected in free cash flow, which was just £100m.

Analysts don’t expect much improvement over the next couple of years. Consensus forecasts suggest earnings of 33.9p per share in 2017, and 34p per share in 2018. The fact that so little growth is expected concerns me. Rolls-Royce trades on a demanding forecast P/E of 24, with a yield of about 1.7%.

It seems to me that if I buy stock at the current share price, I’m paying for growth and income that isn’t even on the horizon. The risk-reward balance doesn’t seem attractive to me, as there’s also a chance that things won’t improve as quickly as expected.

Dialling up a dividend cut

Headline profits are expected to have risen from £79m to £125.9m at TalkTalk Telecom Group (LSE: TALK) last year. This ought to be enough to put the group on a sound financial footing, but I’m not convinced.

In my view, TalkTalk has built up a combination of debt and dividend commitments that are unaffordable. The group’s dividend hasn’t been covered by earnings or free cash flow for several years. I believe this is one the reasons why TalkTalk’s net debt has risen from £497m in 2014 to £847m at the end of September 2016.

Interestingly, City analysts seem to be coming round to my point of view. TalkTalk said in February that the final dividend for 2016/17 is expected to be unchanged at 10.58p, giving a total of 15.9p. But the latest consensus forecasts show a dividend of 14.1p for 2016/17, with a larger cut of 15% to 11.7p pencilled-in for 2017/18.

I suspect analysts are starting to pencil-in changes which may be made after chief executive Dido Harding leaves the group in May. Baroness Harding will be replaced by internal hire Tristia Harrison as chief executive. But chairman Charles Dunstone will step up to executive chairman in May, suggesting that the Carphone Warehouse founder is going to play a more active role in running the company.

TalkTalk’s 7% dividend yield may seem attractive at first sight. But this generous payout looks unaffordable to me, and I believe a cut is inevitable.

Don't make this costly mistake

High-yield stocks such as TalkTalk need close inspection. Is the dividend really safe, or is a cut likely? Buying a stock just ahead of a dividend cut can be a costly mistake. The share price may not recover for a long time.

To help you avoid investing mistakes which could damage your portfolio, the Motley Fool has produced an exclusive new report, Worst Mistakes Investors Make.

This report is free and without obligation, so I'd strongly suggest that you take a look. To download your copy today, simply click here now.

Roland Head has no position in any 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.