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Is Saga plc a falling knife to catch after sinking 20% today?

Fund manager Neil Woodford’s Income Focus Fund received another body blow on Wednesday when shares of over-50s travel and insurance group Saga (LSE: SAGA) fell by more than 20% following a profit warning.

The firm’s trading has been hit by the collapse of Monarch Airlines and by tougher conditions in its insurance business, which generates around 90% of the group’s profit.

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Underlying pre-tax profit for the year to 31 January 2018 is now expected to rise by just 1-2%, down from an increase of 5.5% during the first half of the year. The outlook for 2018/19 has also been cut. Management now expects underlying pre-tax profit to fall by 5% next year, compared to previous analysts’ forecasts of 7% growth.

I believe shareholders need to take a view on the safety of the dividend. Is this a one-off problem, or the start of a longer period of depressed profits?

Travel vs insurance

Saga’s travel business is expected to return to growth next year, boosted by £10m of extra marketing spend. Saga’s goal is to add to its customer base of affluent over-50s and sell them both insurance and holidays.

However, it’s worth remembering travel profit during the first half of the year was only £11.9m, out of a total trading profit of £123.8m.

The group’s dependency on insurance concerns me, as comments in today’s update seem to suggest profits and cash generation by the insurance business could be weaker going forward. This is due to lower levels of reserve releases and certain other technical changes.

What about the dividend?

Management says this year’s dividend will be paid in line with expectations for a payout of 9.2p. That gives the stock a forecast yield of 6.7% after today’s crash.

Looking ahead, the firm says it remains committed to its stated dividend policy. This sees the group paying out 50-70% of net earnings to shareholders. On that basis, I estimate that the dividend is likely to be flat at best next year, and could fall if results are weaker than expected.

Saga shares may offer value at current levels. But I don’t see any need to rush in here. I’d wait until we know more before making a decision.

One 7% yield I’d buy

Big utility stocks are out of favour at the moment, thanks to falling customer numbers and regulatory uncertainty. But I believe the tide is likely to turn in favour of these income giants at some point, as some smaller players merge or prove unviable.

SSE (LSE: SSE) now offers a forecast yield of more than 7%. This firm’s payout has never been cut since its 1999 flotation and is proudly touted — at least to investors — as one of the board’s top priorities.

Dividend cover has become slim but is expected to improve. The group is expected to report adjusted earnings of 116.1p per share for the current year, rising to 123.3p in 2018/19. Based on this year’s forecast dividend of 94.3p, this gives dividend cover of 1.23 times, rising to 1.27 times next year.

The safety of SSE’s payout isn’t guaranteed. But I suspect any cut would be fairly modest. With the shares now offering a yield of 7.1%, I see the stock as a good risk for income investors.

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Roland Head has no position in any of the 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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