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Why I’d avoid this 11% yielder and buy this Neil Woodford stock instead

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Repeated profit warnings from PVCu window and door firm Safestyle UK (LSE: SFE) have left me thinking that the whole sector might be due for a collapse. So imagine my surprise this morning when a rival firm reported a 10% increase in sales and rising profits for 2017.

I’ll come back to the other company in a minute, but first I’d like to explain why I think Safestyle’s forecast dividend yield of 11% is likely to be a trap you should avoid.

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The game has changed

Market conditions may well be tough. But in its latest profit warning, Safestyle also complained about an “aggressive new market entrant”. Presumably this company is forcing down profit margins in the sector with lower prices.

However, it’s worth remembering how profitable Safestyle has been in recent years. In 2016, it reported an operating margin of 12% and a return on capital employed of 48.1%.

Those are very high figures, given that replacement windows are a fairly standard product. I’m not surprised that such high returns are attracting more competition.

The company is safe, but the dividend isn’t

There doesn’t seem to be any immediate risk that Safestyle will go bust. The group reported net cash of £17.7m at the end of June last year, and says that its operations remain cash generative.

But 2018 results are expected to be “materially below 2017 levels”. I expect margins to fall, as market conditions remain competitive.

Current forecasts suggest that earnings could fall by 10% to 12.8p per share in 2018. That leaves very little cover for the projected dividend of 11.3p per share. In my view, a cut is likely. I’d look elsewhere for income.

Try this for size

If you’re attracted to the homebuilding and construction market, you might want to consider Eurocell (LSE: ECEL). Like Safestyle, this door, window and roofline product firm is vertically integrated. In other words, it manufactures and retails its own products.

Eurocell only floated in 2015, when it attracted big name backers including fund manager Neil Woodford, whose funds have a 15% stake in the firm.

The group’s 2017 results suggest performance remains stable. Sales rose by 10% to £224.9m last year, while adjusted pre-tax profit rose by 1% to £24.5m. Adjusted earnings per share were 2% higher, at 20.44p.

Shareholders will receive a total dividend of 9p per share, a 6% increase from 2016. My calculations suggest this £9m payout should be covered comfortably by last year’s free cash flow, which I estimate at £14.5m after acquisitions.

The way forward

Like Safestyle, Eurocell benefits from good cash generation. Net debt fell by 28% to £14.5m last year, despite the firm investing in 31 new branches. This Alfreton-based company now trades from 190 branches, but the recent rapid pace of growth seems likely to slow.

Chief executive Mark Kelly says that the firm’s focus in 2018 will be “on optimising our branch network” and “expanding further our recycling capability”.

Although “challenging” markets and rising prices for raw materials remain a risk, analysts expect earnings to rise by 10% to 22.4p per share this year. The dividend is expected to rise by 9%. These figures put the stock on a 2018 forecast P/E of 9.5, with a prospective yield of 4.5%. In my view, this could be one of the best buys in this sector.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Safestyle UK. 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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