A dividend yield of 9% is often unsustainable. But not always. Sometimes, high payouts like this are a sign that the market has mis-priced a stock.
Fund manager Neil Woodford has made no secret of his view that a number of high-yield UK stocks are undervalued at the moment. Today, I’m going to look at two such shares, including one I own myself.
A turnaround success
Woodford has bet heavily on UK housebuilders in his income portfolios. According to my colleague Ed Sheldon, he’s recently sold his funds’ shares in Lloyds Banking Group to buy even more housebuilding shares.
I’m a little more cautious about the outlook for the housing market, but one builder I do own is Bovis Homes Group (LSE: BVS).
The firm ran into problems in 2016 when it failed to hit build targets and experienced a surge of complaints about the poor quality of completed properties. Experienced chief executive Greg Fitzgerald was brought in to sort out these problems and get profits back on track.
The group’s latest results suggest that Fitzgerald is succeeding. Customer satisfaction scores and profit margins both improved during the six months to 30 June. Bovis also achieved an average net cash position of £6m during the period, compared to average net debt of £96m a year earlier.
More to come
Bovis recently lifted its interim dividend by 27% to 19p and declared a special dividend of 45p per share. Analysts are forecasting a total payout for this year of 102p per share, giving the stock a forecast yield of 9%.
I think the shares are still too cheap. The group’s half-year operating margin of 14.6% remains well below the 17-20% being achieved by most peers.
I think more gains are likely and remain a buyer at current levels.
A gift at this price?
Another high-yield choice favoured by Woodford is discount retailer Card Factory (LSE: CARD).
He has a 7% stake in a firm that differs from most rivals, by designing and printing its own cards. This approach supports a surprisingly high operating margin of 18.7%, and results in very strong cash generation.
Unfortunately, the firm isn’t immune from the pressures being experienced by other retailers. Figures published today show that although sales rose by 3.2% to £185.3m during the six months to 31 July, this was only achieved by opening new stores.
Like-for-like sales fell by 0.2%, and the group’s underlying operating profit fell 11.6% to £24.5m.
Buy, sell or hold?
Card Factory’s interim dividend was left unchanged at 2.9p per share today. But the company did declare a special dividend of 5p per share in order to return £17.1m of surplus capital to shareholders.
My concern is that the firm is paying out dividends that are not covered by free cash flow. In the 2017 and 2018 financial years, the group paid out £164m in dividends. During the same period, my sums show free cash flow of £125.8m.
Although the group’s £160m net debt is unlikely to become problematic, I’d prefer to see a low-growth business like this restrict its dividends to genuine surplus cash. This would minimise the risk of problems if trading conditions continue to worsen.
I accept that I may be too cautious. The stock certainly looks tempting, with a P/E of 10 and a prospective yield of 7.3%. I’m not buying, but I’d understand if you did.
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Roland Head owns shares of Bovis Homes Group. The Motley Fool UK owns shares of Card Factory. The Motley Fool UK has recommended Lloyds Banking Group. 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.