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Why I’m avoiding these ‘bargain’ FTSE 250 dividend stocks

Housebuilding and construction group Galliford Try (LSE: GFRD) was one of this morning’s biggest fallers. The firm’s stock fell 9% after it revealed expected cost overruns totalling £98m on two major construction projects.

By contrast, shares of outsourcer Mitie Group (LSE: MTO) rose by 6% after it said that an accounting review would result in expected writedowns of £40m-£50m.

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So why has Galliford tumbled while Mitie has flown? One reason, of course, is that we already knew Mitie had problems. The bad news from Galliford was a surprise. The second reason is that, as I’ll explain, Mitie’s news could result in the firm’s 2016/17 profits beating expectations.

What’s gone wrong at Galliford?

Galliford is both a housebuilder and a construction firm. It’s the construction business that has problems, with significant cost overruns on “two major infrastructure joint venture projects” with fixed-price contracts.

The company says that “a reappraisal of costs and recoveries” has led the firm to expect non-recurring costs of £98m between now and mid-2018. This is a significant amount of cash, given that the group’s full-year profit was expected to be £124m this year.

Despite this, the group expects to pay a final dividend in line with expectations for the current year, giving a forecast yield of 7.1% at the current share price of 1,330p.

Time to buy?

Galliford’s housebuilding business appears to be performing well. In construction, the group says that its newer contracts are contributing to an improvement in profit margins and do not have the same risk of cost overruns as older contracts.

Today’s dip could be a buying opportunity. However, I’m concerned about the impact these hefty cash costs will have on the balance sheet. I plan to wait for the firm’s next set of accounts before considering whether to buy.

Is Mitie really on the up?

Markets hate uncertainty, but they have short memories. This combination could explain why Mitie Group’s shares have risen by more than 6% so far today.

Investors aren’t overly worried about an extra £40m-£50m of balance sheet writedowns, most of which are non-cash. Better still was that the group said “material errors” discovered in its 2016 accounts would actually result in an increase of £10m-£20m in its 2016/17 reported results.

I’m not sure that this rather odd piece of news warrants much celebration. I’m more concerned about whether Mitie’s debt situation will force the company to raise cash from shareholders.

It said today that although the group’s year-end net debt of £146m was within covenant limits, headroom is expected to be “limited”. So the group is going to ask its lenders if they’ll agree to relax their covenants to “remove the risk of a possible technical breach”.

The group’s lenders will have access to more detailed information about cash flow and outlook than we do. They may agree to the firm’s request. But I suspect that new chief executive Phil Bentley may end up opting to raise cash through a placing or rights issue. By doing this at the start of his tenure, he should be able to avoid problems down the line.

Mitie may well become an attractive recovery play. But I’d like to learn more about the group’s financial situation before making a final decision. For now, I’m going to avoid this stock.

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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. 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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