With interest rates on cash ISAs still hovering around the 1% mark, it’s not hard to find dividend stocks that provide a much higher rate of income.
Of course, investing in stocks carries the risk of losses. Dividends can be cut, and the value of your shares may fall. Despite this risk, I think building a diversified portfolio of dividend stocks is one of the best ways to create a retirement nest egg.
Today, I want to look at two possible picks.
Unloved but very profitable
Cigarette giant British American Tobacco (LSE: BATS) owns brands including Dunhill, Lucky Strike, Rothmans and Camel. The group also owns next-generation brands such as vaping firms Vype, Vuse and glo.
Falling smoking rates mean that most investors view Big Tobacco as a business that’s in structural decline. To combat this, British American has made several big acquisitions. The most notable of these was of US rival Reynolds American in 2017. This combination lifted group revenue by 57%, and added 72% to operating profit during the first half of 2018.
However, buying the 57.8% of Reynolds that BAT didn’t already own cost the firm $49.4bn. Most of this cash was borrowed, leaving the group with a net debt of £46bn, up from about £17bn, previously.
BAT’s high debt levels and low growth rates have made the City nervous. The shares have fallen by 33% so far in 2018, as investors ditched the stock.
A contrarian buy?
Reducing debt has become a priority for management. In BAT’s latest trading statement, the firm says that, at current exchange rates, it expects to reduce net debt to 3.3-3.5 times adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) by the end of 2019.
That’s still a long way above my preferred limit of 2 times EBITDA. However, this business generates a lot of free cash flow, and the Reynolds deal is expected to deliver further cost savings.
My sums suggest that BAT should be able to reduce debt fairly quickly. For this reason, I believe there’s a good chance this stock’s 6% dividend yield offers a decent buying opportunity for income investors.
A top turnaround buy?
Things have moved on since then. In a trading update today, Provident said that the recovery plan for its home credit business was “substantially completed.” Collections remain 10% below historical levels, but this situation is expected to improve as loans, originated during the problem period, are repaid.
Prior to 2017, Provident Financial was generating an annual return on equity of about 35%. That’s very high. Analysts’ forecasts for 2018 and 2019 are more cautious and seem to suggest a figure of about 20%. That seems reasonable to me.
Estimates for 2018 put the shares on a price/earnings ratio of 10.5, falling to a P/E of 8.4 for 2019.
Dividend payments are also expected to resume at the end of this year. The company’s guidance for dividend cover of 1.4x earnings indicates a dividend yield of nearly 8% could be possible in 2019.
These numbers suggest to me that the shares could be worth 50% more in 1-2 years’ time, so I’d rate Provident Financial as a buy at 550p.
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Roland Head has no position in any of the shares mentioned. 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.