One dividend stock I’d buy with Lloyds Banking Group plc

Shares of bus and train operator Stagecoach Group (LSE: SGC) fell by 11% this morning, after management said that pre-tax profits fell by 82% to £17.9m last year.

This slump was caused by an £84.1m charge the company has made to allow for expected losses on its Virgin Trains East Coast contract over the next two years. This business isn’t expected to be profitable until 2019. But the picture was brighter elsewhere. As I’ll explain, I believe that Stagecoach could now offer good value for income investors.

A cash machine

Last year was clearly a tough year. Group revenue rose by 1.8% to £3.9bn, but underlying operating profit fell by 15.7% to £192.8m, as rail profits halved and bus profits came under pressure.

Bus operations provide the majority of the company’s profits. In 2017, UK regional and London buses contributed 72% of underlying operating profit, up from 69% in 2016. Profit margins on these services are relatively high, at 12% for regional buses and 7% for London buses. Bus services also make an important contribution to Stagecoach’s strong cash generation.

My interest in this stock is as a dividend share. So I’m more interested in free cash flow than profit, as cash is needed to fund dividend payouts. Looking at Stagecoach’s accounts for the last two years, I can see that free cash flow was £100m in 2016 and £131.4m in the 2017 financial year which ended on 29 April.

There’s obviously a risk that cash generation will fall next year, due to pricing pressure on bus services and the expected rail losses. But as this year’s figures show, cash flow doesn’t always mirror falls in accounting profits.

The shares now trade on a price-to-free cash flow ratio of just 7.9. This is very low, and means that the group’s 6.5% dividend yield is comfortably covered by last year’s surplus cash. I believe this stock could be worth a closer look for long-term income investors.

Lloyds could outperform

Lloyds Banking Group (LSE: LLOY) may not be the most original choice of stock, but its popularity is probably well deserved. The bank is one of the strongest and most profitable in the UK, thanks to its CET1 ratio of 14.5% and low cost-to-income ratio of 47%.

The bank’s first-quarter results showed continued improvement in most areas. After-tax profit rose by 68% to £890m compared to the same period last year. Net interest margin, a key measure of profitability, rose to 2.8%, up from 2.74% for the same period last year.

In my view, the main risk facing investors in Lloyds is that it’s heavily dependent on the UK housing market and on UK credit card spending. These are areas where profits could be hit hard next time the economy falls into recession.

Opinions vary about the likely outlook for the UK economy at the moment. I’m not going to venture an opinion, but it’s worth noting that fund manager Neil Woodford has recently put domestic stocks — including Lloyds — at the heart of the investment strategy for his new high-yield income fund.

Mr Woodford believes the outlook for the UK economy is fairly benign. If he’s right, then Lloyds’ forecast P/E of nine and dividend yield of 6% could prove to be very good value.

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Roland Head owns shares of Stagecoach. The Motley Fool UK has recommended Lloyds Banking Group and Stagecoach. 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.