The Motley Fool

A 10% yield I’d sell to buy this cheap FTSE 250 income stock

I’ll admit, for a long time, I’ve recommended photo booth and laundry business Photo-Me International (LSE: PHTM) as a top income investment. The company looked to have all the right qualities of an income play. It was highly cash generative, has a strong balance sheet, and earnings were growing steadily. Unfortunately, over the past 12 months, Photo-Me has hit a speed bump.

Problems first started to emerge last May. Management had expected the launch of the Japanese government’s My Number ID card programme to drive a significant uplift in revenues its Japanese division. But this growth failed to materialise and, as a result, Photo-Me issued a profit warning and announced that it was restructuring its Japanese business.

Further problems 

Nearly 12 months on and the company’s situation has improved slightly, although other headwinds are now starting to emerge. 

According to the company’s latest trading update, following last year’s restructuring, the Japanese business is performing strongly and so are Photo-Me’s operations in continental Europe.

But the UK market has now become the group’s problem child. According to management, trading has become more “challenging than expected” thanks to Brexit uncertainty. 

The slowdown began at the beginning of last year, and management was expecting sales to pick up in the second half. This recovery has not happened. As a result, “the group now does not expect to achieve a recovery in order levels before the end of the current financial year.

With the slowdown expected to continue, management now believes profit for the financial year ending 30th April will now be at least £42m, below previous guidance of £44m.

Dividend confirmed 

The one piece of good news Photo-Me’s shareholders have received over the past 12 months is that the company is committed to maintaining its current dividend. At current prices, the stock yields 10% and is supported by a cash-rich balance sheet. 

Despite management’s dividend commitment, I’m no longer as confident on the outlook for the company as I used to be and I don’t think it’s worth chasing this yield. The distribution is only covered 1.1 times by earnings per share, indicating the payout could be for the chop if profits continue to slide.

On the other hand, I’m much more optimistic on the outlook for homebuilder Redrow (LSE: RDW).

Cheap income 

There is lots to like about Redrow. For a start, the stock is outrageously cheap. It’s changing hands for just 6.8 times forward earnings at the time of writing. That’s without adjusting for the group’s cash balance, which stood at £100m at the end of 2018.

Then there’s the company’s dividend yield. City analysts have pencilled in a total dividend per share of 48p for the group’s fiscal 2019, and earnings per share of 89p, implying a dividend cover of 1.9.

In total, I estimated the distribution will cost the company around £123m, which should be easily covered by free cash flow. Indeed, last year the group generated nearly £200m of free cash more, which was more than enough to cover the dividend and pay down £85m of debt at the same time. 

Now that the business is debt free, it can afford to return much more cash to investors. I think that’s exactly what management will look to do over the next few years.

You Really Could Make A Million

Of course, picking the right shares and the strategy to be successful in the stock market isn't easy. But you can get ahead of the herd by reading the Motley Fool's FREE guide, "10 Steps To Making A Million In The Market".

The Motley Fool's experts show how a seven-figure-sum stock portfolio is within the reach of many ordinary investors in this straightforward step-by-step guide. Simply click here for your free copy.

Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Redrow. 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.