Warning! I think this 9%-yielding FTSE 100 dividend stock could crash

The fundamentals of this FTSE 100 (INDEXFTSE: UKX) business are looking increasingly shaky, says Rupert Hargreaves.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Tobacco group Imperial Brands (LSE: IMB) currently supports one of the highest dividend yields in the FTSE 100, at 8.7%. The stock also trades at forward P/E of just 8.8, a discount of around 30% to the rest of the market.

Usually, I would be excited to acquire such a high-quality income stock at such a low valuation. However, I’m starting to become worried about Imperial’s future and, based on current trends, I think its dividend yield could be living on borrowed time.

Crunch time

There are two main reasons why I am worried about the company’s potential. Firstly, operating profit is not growing. Excluding the impact of currency fluctuations, adjusted operating profit for the year ended 30 September 2018 only rose 0.1%. Reported unadjusted earnings per share declined to 0.7%. Despite this, management still increased the group’s dividend for the year by 10%.

At the same time, Imperial has a lot of debt. Even though the company managed to reduce net debt by £0.8bn during the year, it’s still an elevated 2.9 times EBITDA. I’m cautious of any enterprise that has a debt-to-EBITDA ratio of more than 2. At the current rate of pay off, it will take the firm more than 15 years to eliminate its deficit.

But management has promised further dividend increases, which suggests Imperial’s debt reduction efforts are going to take a backseat. If earnings continue to stagnate, the company isn’t going to have the financial flexibility to both increase its distribution and pay down debt. Indeed, dividend cover was only 1.3 times for 2018, a ratio that tells me the business has little financial headroom.

Looking at these numbers, I think it’s only a matter of time before Imperial’s dividend is reduced to free up more capital for debt reduction. Until the company finally admits this, I reckon the shares will continue to trade at a discount the rest of the market. And when it does, the shares could slump as income investors flee. 

Paying out too much

Another company that I am sceptical about with regards to its dividend is SSE (LSE: SSE). 

The power provided has been one of the most dependable dividend-paying shares since it was privatised three decades ago. But dividend growth has outpaced earnings growth in recent years, so much so that the dividend cover has declined from 1.8 in 2008, to just 1.1 today.

Like Imperial, SSE also has a weak balance sheet. Over the past decade, as the company has paid out almost all of its earnings from operations to shareholders, net debt has soared and now stands at just under £10bn, more than three times the level reported for 2008. In my opinion, the company cannot continue on this path.

I can’t tell you exactly when management will decide to reconsider SSE’s payout policy. However, I can say with confidence is that SSE can’t repeat its dividend policy of the last decade during the next 10 years. That would leave the business with nearly £20bn of debt and, unless regulators suddenly let the utility deliver a massive increase in prices to customers, a dividend payout that isn’t covered by earnings per share.

When SSE does finally admit it can’t sustain its current 7.4% dividend yield, I expect the share price to crash. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Rupert Hargreaves owns Imperial Brands. The Motley Fool UK has recommended Imperial Brands. 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.

More on Investing Articles

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »

Investing Articles

Are HSBC shares a FTSE bargain? Here’s what the charts say!

There are plenty of dirt-cheap FTSE 100 banking stocks for investors to choose from today. Our writer Royston Wild believes…

Read more »

Three signposts pointing in different directions, with 'Buy' 'Sell' and 'Hold' on
Investing Articles

Just released: Share Advisor’s latest ‘Hold’ recommendation [PREMIUM PICKS]

In our Share Advisor newsletter service, we provide buy, sell, and hold guidance for our universe of recommendations.

Read more »

Investing Articles

Investing £5 a day could help me build a second income of £329 a month!

This Fool explains how £5 a day, or one less takeaway coffee, could help her build a monthly second income…

Read more »