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2 dividend stocks I’d avoid in 2018

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Shares of Pets At Home (LSE: PETS) moved as much as 9% higher this morning after the FTSE 250 firm reported strong revenue growth in Q3 and said trading momentum built over the Christmas period.

Group revenue for the 12 weeks to 4 January increased 9.6%, including like-for-like growth of 7.2%. Both its divisions made a positive contribution. Merchandise, which consists of food and accessories, was up 9% (6.8% like-for-like) and Services, which includes veterinary, grooming, pet sales and insurance, was up 13.6% (10.1% like-for-like).

At a time when more than a few retailers have reported poor Christmas trading, the market warmed to Pets At Home’s progressive Q3 sales and management’s reassurance that the business remains on track to meet guidance for its full financial year, which ends on 29 March.

Unattractive valuation

Although revenue has increased nicely since the company’s flotation at 245p a share in 2014, earnings growth has stalled as a result of lower margins. City analysts expect a double-digit fall in earnings for the current year, because the company has cut prices in its Merchandise division, which contributes 87% to group revenue. While the smaller Services division is higher-margin and growing faster, it will be insufficient to offset the smaller margin in Merchandise. Management has said it’s laying the foundations for “sustainable profit growth.” However, its transition plan to deliver this runs through to fiscal 2020.

At a share price of 195p and a current-year earnings consensus of 13.5p, the price-to-earnings (P/E) ratio is 14.4. This looks poor value to me for a company where earnings are not forecast to advance meaningfully until at least 2020. The balance sheet is reasonable and a 7.5p dividend, giving a running yield of 3.8%, looks sustainable, so this is not a business in financial distress. It’s simply that the ungenerous earnings multiple and ordinary yield compare unfavourably with some very much stronger growth-and-income candidates in the market. As such, I’m avoiding Pets At Home.

Scary level of debt

While operating in a very different sector, AA (LSE: AA) has a number of things in common with Pets at Home. It was floated in the same year, is a member of the FTSE 250 and its shares, currently at 156p, are trading below the flotation price (250p).

However, the roadside recovery group has seen revenue contraction as well as earnings declines. And while it reported a stabilisation of the membership base and growth in motor insurance in its latest half-year results, the City consensus is for another drop in earnings — 3% to 20.6p a share — for its current financial year, which ends on 31 January. This gives an ostensibly bargain basement P/E of 7.6 and the company also boasts a running dividend yield of 6% on a trailing 12-month payout of 9.3p.

However, the analyst consensus is for the board to announce a cut to the dividend in the full-year results. AA has a huge debt pile. Net debt stood at £2,688m at the half-year end and trailing 12-month EBITDA was £404m. This gives an eye-watering net debt-to-EBITDA ratio of 6.7 (compared with a sensible 1.2 at Pets At Home). Due to AA’s scary level of debt, it’s firmly on my list of stocks to avoid.

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G A Chester 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.