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The 3 worst dividend stocks of 2018 (so far)

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Today I’m looking at three popular FTSE 100 and FTSE 250 dividend stocks. All three have fallen by at least 20% so far this year.

Two of these firms have been forced to slash their dividend payouts since January.

The third company is struggling to deliver the promised benefits of an acquisition which quadrupled the size of its operations.

Despite these setbacks, I believe that each of these stocks offers a potential opportunity at current levels. Today I’ll be asking whether any of these companies deserves my buy rating.

This breakdown was inevitable

Roadside assistance firm AA (LSE: AA) made a confident return to the stock market in 2014, tempting investors with its strong brand, high profit margins and strong cash generation.

Well-known City figures like fund manager Neil Woodford bought into the stock, which was expected to become a high-yield dividend favourite. Unfortunately the shares have lost 70% of their value over the last three years. So what’s gone wrong?

For a short period in 2016 and 2017, the AA lived up to its promise, paying an annual dividend of 9p per share. But this payout was slashed to 5p in 2017/18 and has now been cut to just 2p per share for the foreseeable future.

Two big problems

The biggest problem is debt. AA floated with net debt of about £3.2bn. Thanks to lengthy efforts to refinance this mountain of borrowed money, this total has now fallen to about £2.7bn. But that’s still about 24 times last year’s annual profits.

This level of gearing was always likely to be hard to manage, given the group’s second problem — a lack of growth. Since 2014, annual sales have remained largely unchanged at about £950m, and profits have fallen from £153m in 2014 to just £111m last year.

Luckily, the group’s operating margin has remained high, at about 32%. Chief executive Simon Breakwell expects this to result in free cash flow of about £80m next year and at least £100m from 2020/21 onwards.

The bad news is that I expect most of this cash to be used to service the group’s debt. What little is left will likely be needed to try and find ways of boosting growth.

The shares currently trade on a forecast P/E of 7.6 with a prospective yield of 1.7%. I don’t see much attraction in investing until debt falls or growth improves.

I’m tempted by this shocker

One of the biggest fallers in the FTSE 350 this year is broadband and mobile provider TalkTalk Telecom Group (LSE: TALK). The shares have lost 24% of their value since January and the dividend has been cut again. This year’s dividend is expected to be 2.9p per share, 80% less than the 15.9p payout shareholders received in 2015/16.

This situation has been brewing for some time. A couple of years ago, I noted how the company appeared to be paying its dividends without earnings cover, using borrowed cash. Companies that do this consistently tend to run into problems, and TalkTalk was no exception. The group’s net debt rose from about £390m in 2013 to a peak of £782m in 2016/17, when after-tax profit was just £58m.

The group is now firmly in turnaround mode under new chairman Sir Charles Dunstone, who originally founded TalkTalk as part of his Carphone Warehouse group. Net debt is down to £755m and operational progress seems positive. I think this could be a decent turnaround story.

The right time to buy?

Market conditions for telecoms firms appear to be tough. Larger rivals Vodafone and BT Group are both out of favour with investors at the moment. But I think TalkTalk’s low-cost, no-frills ethos could be a winner in today’s uncertain economic climate.

The group’s latest trading update showed a net increase of 80,000 broadband customers during the first quarter, taking the total to more than 4.2m. Headline revenue rose by 4.1% during the first quarter and chief executive Tristia Harrison expects to report a 15% increase in earnings before interest, tax, depreciation and amortisation (EBITDA) this year.

Analyst forecasts put the stock on a 2018/19 price/earnings ratio of 18.9 with a prospective yield of 2.5%. That still seems a little expensive to me, given that net debt remains high. But I expect to see a successful turnaround here over the next few years.

This FTSE 100 flop could bounce back

IT group Micro Focus International (LSE: MCRO) has built its reputation by acquiring legacy software businesses and cutting costs. This worked very well until the group agreed an $8.8bn deal to acquire the software business of Hewlett Packard Enterprise.

This deal quadrupled the size of the business and has lifted revenue from £1,381m in 2017 to a forecast level of £3,910m this year. But integrating the HPE software business has proved challenging. In March, Micro Focus warned that sales would be lower than expected this year.

However, interim accounts published earlier in July suggest the group could be getting back on track. The company said that revenue was falling more slowly than earlier this year, and that good progress was being made on integration.

Executive Chairman Kevin Loosemore blamed the earlier shortfall on “inconsistent” application of the Micro Focus operating model, which is now being applied “fully and robustly” across the group following management changes.

This 5.9% yield looks tempting

Micro Focus is expected to deliver earnings of around $1.87 per share this year, with a dividend of about $1 per share. This puts the stock on a forecast P/E of about 9.2 with a prospective yield of 5.9%.

In my view this could be worth considering as a long-term dividend pick. Mr Loosemore’s record was good prior to the HPE deal. It may be that changes to management have resolved the operational problems which followed this super-sized acquisition. I can see decent value here on a medium-term timeframe.

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Roland Head owns shares of BT. 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.