Recent market declines have thrown up some fantastic bargains for dividend investors. Unfortunately, it looks as if some of the market’s top income plays could also be struggling.
Shares in global catering giant Compass Group (LSE: CPG) have slumped around 25% from their 2020 high, printed in the first few days of February. It looks as if this could be just the beginning of the decline for the stock.
Compass is the world’s largest catering company. As a result, it’s extremely exposed to the coronavirus outbreak. It primarily supplies large events with catering services.
Governments are cancelling large events around the world as they try to contain the outbreak. These cancellations will almost certainly have a significant impact on Compass’ bottom line.
Like many catering companies, its profit margins are razor-thin. This suggests the group doesn’t have much financial flexibility if revenues fall significantly. Management will have to make some tough decisions in this situation, and that could mean a dividend cut or rights issue if things get really bad.
Indeed, Compass already had quite a bit of borrowing on its balance sheet. The group’s net gearing ratio — the ratio of shareholder equity to net debt — was 104% at the end of its last financial period. A ratio of more than 100% is considered high.
On top of all the above, the stock looks expensive at current levels. It’s currently dealing at a price-to-earnings (P/E) ratio of 18, that’s compared to the market average of 11.6. These figures suggest shares in Compass could fall another 36% from current levels if the global economic situation continues to deteriorate. A dividend yield of nearly 3% is on offer, but it doesn’t look as if investors can trust the payout.
As such, it might be better to avoid the stock for the time being, until there’s more clarity on the impact the Covid-19 outbreak will have on the global economy.
If business activity declines further, Whitbread (LSE: WTB) could also suffer. The owner of the Premier Inn, Beefeater and Brewers Fayre brands has seen profits multiply over the past few years as UK economic growth has picked up. However, if growth starts to slow, the business might have to make some tough choices.
A slowing economy will hit consumers in the pocket, and that could lead to a decline in spending on activities such as eating out and travelling. An economic slowdown could also hurt spending by business customers in the group’s hotels — a key market for Premier Inn.
Declining revenue isn’t the only issue that could impact shares in Whitbread. Like Compass, the shares also command a premium valuation. The stock is currently dealing at a P/E of 17.3. Once again, that’s a substantial premium to the rest of the market and sector.
Therefore, it seems as if the risks of investing in this business right now are higher than the potential rewards. Revenues could decline significantly over the next few months if the economic environment continues to deteriorate, hitting the group’s bottom line.
That suggests Whitbread no longer deserves the group multiple currently assigned to the stock. Falling earnings could also hurt the company’s dividend payout. If the valuation falls back to the market average, a decline of 33% could be on the cards.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Compass 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.