Buying unloved shares can be a great way to lock in a high dividend yield, but it’s not without risk.
Both of the companies I’m looking at today offer a 7% yield. But, as I’ll explain, only one of them qualifies as a buy for me.
A promising turnaround?
FTSE 100 advertising giant WPP (LSE: WPP) has lost 50% of its value over the last two years. The group has been hit by falling sales and profits, client losses and the industry shift to online advertising.
But new chief executive Mark Read is fighting back. His first target is WPP’s fragmented and unfocused structure, the result of decades of acquisitions. He’s already sold 36 of the group’s businesses while also combining some of those which remain to provide a more streamlined and integrated offering for clients.
To provide an idea of the scale of this challenge, at the end of 2018, 70 of the planned 100 office mergers had been completed and 57 of 80 planned office closures had taken place.
Alongside these changes, Read was able to report a £466m reduction in net debt, which fell to £4,017m at the end of 2018. Further reductions are planned over the next couple of years, and I’m confident the firm’s borrowings are now under control.
Buy, hold or sell?
I was reassured to see WPP’s cash generation remained strong last year. Underlying free cash flow was £1,103m. This represented an impressive 97% of the group’s after-tax profit and means the shares are valued at about 10 time’s free cash flow. I see this as cheap, if it’s sustainable.
Analysts expect the group’s earnings to dip by about 6% in 2019, before starting to rise again in 2020. Based on these expectations, I believe the current 7% dividend yield is probably sustainable.
With the stock trading on just 8.4 times forecast earnings, I rate WPP as a long-term buy.
Watch out below!
I’m not so bullish about construction firm Kier Group (LSE: KIE). The Kier share price is down by 15% at the time of writing. Today’s fall was triggered when the company admitted that its 2018 year-end net debt figure would be £180m, 40% higher than January’s guidance of £130m.
The extra debt appears to be due to accounting errors, not overspending. But it’s not a good look, in my view. It means the average month-end net debt for 2018 — a far more useful metric — was £430m, instead of £370m.
You may wonder why I bang on so much about debt. The reason is that for equity investors, companies with debt problems are very risky investments. Kier Group has already had to raise cash from the market in December, when it struggled to find buyers for its new shares, causing the share price to crash.
In my view, today’s news increases the risk of further cash calls, especially as the company admitted its problematic Broadmoor Hospital project will now be subject to an extra £25m charge.
Although management says its 2019 performance is on-track to meet forecasts, the shares now trade on 4.3 times 2019 forecast earnings, with a forecast yield of 7.4%.
This tells me that the market expects further bad news. That’s a view I share. I’d avoid this stock.
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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.