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Why I’d sell this 5% yielder to buy income stock Imperial Brands plc

Image source: Getty Images.

Shares of Halfords (LSE: HFD) are little changed at 350p in early trading after the group reported a 3.2% rise in Q3 revenue, which included “record sales for Black Friday and Christmas.” This was a good performance by the FTSE 250 firm in what it described as a “difficult UK retail environment.”

In particular, both of Halfords’ divisions delivered like-for-like revenue growth, with retail up 2.9% and autocentres up 0.7%, giving group growth of 2.7%. This is encouraging for new chief executive Graham Stapleton, who started on Monday, replacing Jill McDonald who left last autumn to lead the fashion and homewares arm of Marks & Spencer.

On yer bike?

While Halfords’ revenue has been rising, profit hasn’t fared so well. Earnings per share (EPS) declined 9% last year. And ahead of today’s update, City analysts were forecasting a further 1% fall (to 30p) this year. This gives a price-to-earnings (P/E) ratio of 11.7, which would be relatively cheap if the company can start growing its earnings.

In the meantime, despite the earnings weakness of recent years, the board has continued to increase the dividend and a further lift is forecast this year. The consensus is for a 5% increase to 18.3p, giving a prospective yield of 5.2%. My Foolish colleague Rupert Hargreaves has argued that Halfords should not be ignored as an income stock, but I’m concerned about the trajectories of some of the company’s key numbers, shown in the table below.

  2015 2016 2017
Operating margin (%) 8.5 8.1 6.7
Cash flow per share after capex (p) 41.8 23.3 19.2
Dividend per share (p) 14.4 16.7 17.1

Source: Morningstar

The company has a good deal of work to do to reverse falling margins and cash flows. It said in today’s update that it anticipates full-year profit before tax to be “broadly in line” with current market expectations. Typically, this phrase indicates a little below expectations, which suggests to me that margins remain under pressure. I don’t see the UK retail environment improving for some time, and I’d be inclined to sell Halfords and buy into a reasonably priced company with a more promising outlook.

Take up smoking?

The table below shows the corresponding numbers to those of Halfords above for FTSE 100 tobacco group Imperial Brands (LSE: IMB).

  2015 2016 2017
Operating margin (%) 9.9 8.0 9.0
Cash flow per share after capex (p) 221.7 254.5 241.8
Dividend per share 132.1 145.2 159.9

Source: Morningstar

As you can see, Imperial has a superior and more stable operating margin. Its cash flow after capex is also more stable and looks more robust in the context of dividend affordability.

At not much above 3,000p, the shares are trading well below last year’s high of nearer 4,000p, and I agree with my Foolish colleague Peter Stephens that the fall is less to do with its own performance, and more down to the attitudes of investors. As a result of the weakness in the shares, Imperial’s forecast P/E has come down a bit below Halfords’ 11.7. Meanwhile a continuation of its policy of 10% annual dividend increases gives a prospective yield a full percentage point higher than the FTSE 250 firm’s 5.2%. For these reasons, I rate Imperial a ‘buy’.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands. 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.