Investors love big dividends because of the income they bring into a portfolio. However, income-hungry investors should also be aware that the highest dividend stocks in the market are usually only yielding so much because they’re very risky. When the share price of a stock declines so much that its dividend yield climbs above 5%, investors ought to ask themselves whether the dividends look sustainable for much longer.
Construction and support services group Carillion (LSE: CLLN) is one such stock which has seen its share price slump and its dividend yield soar. After a 28% fall in its share price over the past 52 weeks, the stock currently yields 8.5%.
Carillion is one of the most heavily shorted companies in the FTSE 350 as hedge funds worry about its mounting debt and the uncertainty of its long-term revenues. Although the company continued to deliver steady double-digit revenue growth in 2016, investors seem increasingly sceptical that the company can continue to grow revenues at its current pace and avoid further margin pressure.
The company’s balance sheet is not looking too good either, with average net borrowing rising to £586.5m, up from £538.9m in the prior year. And it’s not just the company’s growing debt levels that investors have to worry about. Carillion also has a sizeable pension deficit, which has only gotten worse as bond yields have declined following the Brexit vote last June. In its final results for 2016, the company revealed that the deficit had widened to more than £800m, which is worth nearly 90% of its market cap.
As such, Carillion’s long-term dividend outlook seems uncertain. It’s likely that earnings will continue to deteriorate over the next two years, and there isn’t a great deal of financial flexibility given its weak balance sheet.
Another high-yield stock I’m staying away from is LSL Property Services (LSE: LSL), the UK’s second largest estate agency chain. Its dividend, which had been cut by 18% in 2016, could face another squeeze this year as analysts expect earnings to come under pressure from a weak housing market.
The company has in place a variable dividend policy, with LSL currently targeting a dividend payout ratio of between 30% to 40% of group underlying operating profit after interest and tax. This means falling profits would have a direct impact on dividends, especially as its 2016 dividend was at the upper end of its targeted dividend payout ratio.
On the upside though, LSL nearly halved its net debt to £20.3m from £39.9m last year, following the sale of its remaining shares in online property portal Zoopla. As such, the company benefits from a robust balance sheet with relatively low levels of gearing, which should help it to weather the downturn for longer than some of it peers.
LSL has also reacted decisively to the changing market conditions, by investing in its lettings and financial services businesses, which helped to offset the 10% decrease in residential sales exchange income.
Nevertheless, City analysts expect underlying earnings to fall 12% this year, which means LSL’s dividend yield is forecast to fall from its current figure of 5.1% to around 4.3%.
Jack Tang 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.