Although fund manager Neil Woodford has come in for a lot of criticism in recent months, I think it’s far too soon to write off his stock-picking skills. So today I’m going to take a look at two high-yield dividend stocks which feature in Woodford’s funds.
Turnaround temptation
Outsourcing group Capita (LSE: CPI) has lost 57% of its value over the last two years. The recent half-year results weren’t great either. Free cash flow was 9% lower than last year and operating profit fell by 28% on flat revenue, suggesting costs remain a problem.
The shares fell sharply following the release of these figures, and Capita stock now trades on a forecast P/E of 10, with a prospective dividend yield of 5.9%. That may seem cheap, but the group’s £1.6bn debt burden means gearing has become uncomfortably high, at 2.9x earnings before interest, tax, depreciation and amortisation (EBITDA).
The group’s target is 2.0x-2.5x. Personally, I’d prefer to see this figure fall below 2x, given the increasingly low-margin nature of Capita’s business. The group’s operating margin has fallen from 12% in 2011, to just 3% last year.
Incoming chief executive Jon Lewis seems unlikely to be able to deliver rapid sales growth. So he will need to cut costs in order to boost profits and reduce leverage. It’s not yet clear how easy this will be.
IT opportunity?
Looking further ahead, the big opportunity for Capita may be in the technology sector. Much of the group’s core strength lies in technology and Lewis has said that he sees “a real opportunity to build a world-class, technology-enabled services business”.
Shifting Capita’s focus from labour-intensive, low margin work and towards technology-based projects could lift margins. But this won’t happen overnight and the process of transition could be painful.
For this reason, I think it might be prudent to wait until after Lewis has had a chance to have a good look round before committing any fresh cash to the stock.
An affordable 7% yield?
One Woodford stock that has caught my attention is motoring claims management and legal services group Redde (LSE: REDD).
This company has delivered consistent growth, despite changes to the regulatory environment. Redde also generates a surprising amount of free cash flow, which has enabled the firm to pay generous dividends.
Analysts are forecasting a total dividend of 11.5p per share this year, giving a prospective yield of 7.1%. I believe that the group’s strong cash generation means this should be affordable. However, it’s worth noting that this payout is only covered once by forecast earnings, which are also 11.5p per share.
This would normally raise warning flags for me, but the group’s free cash flow – from which dividends are actually paid – has historically exceeded its earnings per share. With net debt extremely low, there’s no reason to think that the group will need to cut its payout if trading remains stable.
It’s not often that the market offers you the chance to invest in a stock with a supportable 7% yield. And while Redde does carry some regulatory risk, I think these shares could be worth considering as part of a diversified income portfolio.
