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Why I’d avoid this 4.5% dividend yielder and buy GlaxoSmithKline plc instead

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Engineering services company Babcock International Group (LSE: BAB) released a trading update this morning and the shares are down around 2.5% as I write, at 636p. Considering the wider market carnage, that fall isn’t too bad, but I think there are some areas for mild concern in the statement.

In line with expectations

The directors expect full-year earnings and cash conversion to be in line with their expectations, which tells us that nothing has thrown the outlook. City analysts following the firm forecast growth in earnings per share of 3% for the trading year to March 2018 and 4% the year after that. That’s nothing to become excited about, but it’s better than a decline in expected earnings.

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Although earnings aren’t growing fast, the quality of those earnings looks like it is improving. The directors say that margins will be higher than they thought for the year “due to a combination of more favourable margin mix and a continued management focus on efficiency improvements.” But although margins are rising, revenue is falling and looks set to come in “slightly lower” than expected at between £5.3bn and £5.4bn.

Revenue under pressure

Revenue is under pressure because of ongoing “tough trading conditions and short cycle order placement delay” in the offshore and oil & gas sector. There has also been a slowdown in volumes relating to defence sector commodity and spares procurement, and “slower mobilisation on the MSSP equipment and engineering management contract for MoD.”

Should we be worried? Maybe. The dividend yield for the current year sits at around 4.6% with the payment set to be covered a healthy-looking 2.8 times by forward earnings. Over four years, the dividend has grown 26%, but that’s the main attraction from an investment point of view, because earnings growth is so pedestrian.

Strong bidding activity continued during the second half of the year and the short-term bid pipeline has increased to around £12.5bn, driving a “combined order book and near-term opportunity pipeline at £31bn.” However, I reckon there’s a fair degree of cyclicality in the operational set-up, which could send earnings and the dividend into reverse at some point if the economic sun stops shining, so I’d rather take my chances with defensive pharmaceutical firm GlaxoSmithKline (LSE: GSK).

An attractive dividend

When it comes to medicines, demand is far less cyclical, which means we can invest in GlaxoSmithKline with reasonable confidence that the cash flowing into the business will remain constant whatever the economic weather. To me, that situation makes the dividend yield of around 6.4% attractive. However, I’m not expecting rapid growth in either the dividend or in earnings. The dividend payment has been flat for around five years and the firm is struggling to grow earnings. The well-reported problems big pharmaceutical firms have endured due to patent expiry has allowed generic competition to swoop in, pulling the rug from margins on many of GlaxoSmithKline’s big-selling drugs.

Back in October, the firm’s third-quarter results suggested ongoing workmanlike progress rebuilding earnings. We can find out more about the headway being made with the full-year results due tomorrow, Wednesday 7 February. I’m expecting more of the steady operational advances we’ve seen lately.

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Kevin Godbold has no position in any of the shares mentoned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. 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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