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Capita plc’s 6.7% dividend yield is too good for me to pass up

Dividend stocks appeal to those of us looking for income, with many investors drawn to the stocks with the highest dividend yields. But for investors relying on them for living expenses, consistency is just as important as yield.

The challenge is to find those high-yield stocks where current dividend payouts are sustainable, and to avoid those stocks which are in imminent danger of drastic cuts to their payouts.

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With this in mind, I reckon outsourced services provider Capita (LSE: CPI) belongs to the former category. The stock’s 6.7% dividend yield may seem too good to be true for many investors, but I’m confident about the safety of its income prospects.

Strong free cash flow

Although the company has been on the receiving end of a string of misfortunes, which includes the loss of its key MoD contract in September and a bigger-than-expected fall in its first-half profits, Capita has a strong balance sheet and is generating robust free cash flow.

While pre-tax profit in the six months to 30 June dropped 26% to £28m, reported free cash flow fared more resiliently over the period — down just 9% to £182m, which was well in excess of what was needed to cover organic capital expenditure and current dividend payments.

Capita’s balance sheet in also in better shape than many of its rivals, with an adjusted net debt-to-adjusted EBITDA ratio of 2.86 times at the end of June, following a £183m reduction in net debt to £1.6bn in the first half.

Immense potential

Looking ahead, there’s immense potential for Capita to make a comeback too. Although the company is seeing delays in decision-making by customers caused by Brexit uncertainty, market conditions could perk up on further progress on a trade and a transition deal.

Meanwhile, Capita is undergoing a restructuring to make the business more efficient and focus on more profitable work. It is already showing some encouraging progress, after having recently won a new contract to deliver apprenticeship services to the Civil Service and a lucrative £15m deal with Nats to provide a new network for the UK’s air traffic control company.

Regulatory risk

Elsewhere, water company United Utilities (LSE: UU) may be catching investors’ attention lately. Although the stock has a more modest yield of 4.8% compared to Capita, the company has a significantly higher yield than its closest peer Severn Trent, which yields just 3.9%.

On the downside, there may be good reason for its higher yield. The company’s share price is trading near a three-year low on growing concerns about its regulatory risks. Given mounting political pressure on water companies to reduce bill increases for customers and to reduce water leakages, analysts are beginning to question whether windfall returns are sustainable as a tougher regulatory regime looks set to come into place.

United Utilities is seen to be at particular risk because it has relied more heavily on outperformance against Ofwat’s Outcome Delivery Incentives to deliver attractive returns than have its sector peers. This makes the company more vulnerable to a cut in permitted returns in its next price review.

Still, given the sizeable yield gap with its closest rival, I reckon investors may be adequately compensated for the higher risk associated with the company’s future prospects.

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Jack Tang has a position in Capita plc. 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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