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Can BT and this 7% FTSE 250 income stock afford their massive dividends?

Today, I’m looking at two of the highest-yielding dividend stocks on the London market. With forecast payouts yielding 6.8% or more, I want to know if these giant-sized distributions can be maintained, or if they’re heading for a cut.

First up is telecoms giant BT Group (LSE: BT-A). As a shareholder myself, I believe there are attractive gains to be made from the group’s turnaround. But I’m not sure if the dividend is safe.

I discussed my views on BT’s strategy in a recent piece, so today I want to focus on the firm’s ability to sustain its £1.5bn per year dividend habit.

Show me the money

Yes, that’s right. BT currently pays out about £1.5bn in cash each year to shareholders. Let’s find out if this generous payout is supported by the group’s profits:

Year

2017/18

2016/17

Adjusted after-tax profit

£2.8bn

£2.9bn

Reported after-tax profit

£2.0bn

£1.9bn

Dividend payout

£1.5bn

£1.4bn

BT reported exceptional costs of £741m last year, reducing its actual after-tax profit to £2bn. The dividend payout accounted for 75% of this amount, giving earnings cover of just 1.3x.

This seems low, but it might be okay for a utility stock, if it’s backed by free cash flow.

I’ve taken a look. BT’s normalised free cash flow was £3bn in 2017/18, and £2.8bn in 2016/17. That should be enough to cover the dividend and leave some left over. The only problem is that there are competing demands for this cash.

BT already has net debt of £9.6bn, along with an £11.3bn pension deficit. The company has agreed to provide another £3.25bn of pension contributions by March 2020, some of which will come from extra debt.

My verdict

I think BT’s dividend is looking a little stretched. In my view, there’s a good chance that the group’s next chief executive will cut the payout when he or she takes charge later this year.

Despite this, I continue to rate the shares as a buy. Trading on a forecast price/earnings ratio of just 8.8, I think most of the bad news is already in the price.

A 7.2% payout on property

Shares of construction and housebuilding group Galliford Try (LSE: GFRD) were up by 7% at the time of writing. Investors were celebrating news that the group’s adjusted pre-tax profit rose by 28% to £188.7m last year, after a difficult year.

Sales only rose by 10% to £2,931.6m during the 12 months to 30 June. And tight control of costs and increased standardisation in the firm’s range of houses helped to lift the group’s operating margin from 5.9% to 6.6%.

The group’s Linden Homes division actually generated an operating margin of 19.5% last year. But this margin was diluted by much lower returns from the group’s Partnerships & Regeneration business (5%) and its Construction division (0.9%).

Still a buy?

Last year’s dividend was covered twice by adjusted earnings and seems affordable to me.

The difficulty for shareholders is guessing what might come next. Housebuilders face the risk that the Help to Buy scheme could end in 2021 and that mortgage rates might start to rise. Both measures could cause sales to slow.

Prior to today’s results, analysts were forecasting a 5% cut to Galliford’s earnings and dividend in 2018/19. These figures may now be revised. But in my view, this isn’t the right time to chase this stock higher. I’d rate the shares as a hold, for now.

Buy-And-Hold Investing

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Roland Head owns shares of BT. 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.