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Is the Micro Focus 7.5% yield too good to pass up now?

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After a very poor trading update released last week spooked the market, shares of Micro Focus (LSE: MCRO) now offer investors a whopping 7.8% yield on a trailing basis. For income-starved investors, the question is whether this yield is too good to pass up or too good to be true?

The bad news is that the company’s policy of paying out a dividend that’s twice covered by after-tax profit means a substantial downgrade to earnings this year could see management rightfully cut the dividend. However, Micro Focus has also made much of its record of increasing dividends annually for over a decade. So it wouldn’t be unimaginable for management to maintain payouts even without being covered by earnings, as they did in H1.

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The company’s balance sheet could take the hit of one year of uncovered earnings. Although net debt was 3.1x adjusted EBITDA, as of H1 results, this was already down from 3.3x immediately following the debt and equity-funded acquisition. This shows the underlying business remains cash flow positive despite the recent problems.

On a recent conference call with lenders, its CFO also disclosed he still expects the group’s leverage to fall to the target 2.7x next year. On top of this, the group’s term loans have no covenants and it has no repayments due until 2021, which gives management some leeway in delaying reaching deleveraging targets.

Now whether this makes Micro Focus a screaming buy right now is far from clear. The group has a long history of taking mature software assets and vigorously cutting costs. It still sounds as if cost cutting at HPE is going well with the recent sales and profit warning due almost entirely to self-inflicted IT problems and the loss of salespeople.

If the group can get a handle on these issues there’s plenty of money to be made for shareholders. But with further acquisitions off the table while the HPE problems are digested, I’d urge patience while we see what management’s plan to get things back on track looks like.  

Gloomy days ahead?

Another troubled company that’s offering a knockout dividend is DFS Furniture (LSE: DFS) and its 6.6% yield. Unfortunately for shareholders, DFS’s problems don’t relate to fixable, short-term internal screw-ups. Instead, it’s rather broader industry-wide trends that include the weak pound dampening margins, sales declines as shoppers embrace e-commerce, and weak consumer confidence.

These factors collided in the group’s H1 to send pre-acquisition revenue down 3.5% to £366.5m, while pre-tax profits fell from £16.7m to £7m on the same basis. All is not lost as the CEO sounded a rather positive note about strengthening trading at the start of H2 and maintained guidance for a small uptick in underlying EBITDA for the year.

However, I see plenty of issues that will stop me from buying DFS’s shares right now. The first problem is the aforementioned headwinds facing most brick & mortar retailers. Then there are DFS’s low margins and rising net debt that hit 2.17 times underlying EBITDA at period end following a small bolt-on acquisitions. While its shares may trade at only 9 times earnings, fast-falling profits and rising debt, together with a weak outlook, leave me thinking it could be a big mistake to sink money into DFS right now. 

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Ian Pierce owns shares of Micro Focus. The Motley Fool UK has recommended Micro Focus. 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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