2 High yield shares in the danger zone

The stock market doesn’t offer shares with high yields without good reason.

Sometimes the companies are out of favour with investors because they’re having a bad PR day, but nothing more.

In other cases, the company might be in serious trouble with a dividend that is about to be cut.

Most high-yield shares sit somewhere in between. The risks are clear if you look in the right places, but how they’ll affect the company is far from obvious.

In this blog post, I’m going to look at two companies sitting in that middle “danger zone”.

Stagecoach Group PLC

• Share price: 170p
• Dividend yield: 7.0%
• Index: FTSE 250

You’ve probably heard of Stagecoach; it operates buses, coaches and trains across the UK and the US and has been around since the 1980s.

As a general rule of thumb, dividend yields of more than 5% are a warning sign, so Stagecoach’s 7% yield should definitely start some alarm bells ringing.

But then again, such high dividends are sometimes sustainable and the capital gains can be enormous once the market realises it.

So is Stagecoach’s dividend sustainable?

Let’s start with the positives. Stagecoach has a long history of dividend growth, with the last cut occurring way back in 2002. Here are the company’s more recent results:

This sort of steady growth is exactly what I and most dividend-focused investors want to see.

But the company also carries some hidden dangers:

Danger #1 – Large capital expenses

As a public transport business, Stagecoach needs to get its hands on buses, coaches and trains before it can generate a penny of revenue.

These things don’t come cheap, and they’re expensive to upgrade too.

And then there’s also ticketing technology which needs to be bought and regularly upgraded, as well as all sorts of other IT infrastructure which is required to make sure all the services run like well-oiled machines (hopefully).

The result is a large and ongoing need for heavy investment in capital assets, i.e. those buses, trains and IT systems.

In Stagecoach’s case, it spent about £1.5 billion on capital expenses (capex) in the last ten years compared to total normalised post-tax profits of £1.3 billion over the same period.

This makes Stagecoach a high capex company by my definition because its capex is typically higher than its profits.

This isn’t necessarily a problem, but it does make it harder for high-capex companies to grow. They have to invest massive amounts of actual money today to generate potential profits in the future.

If those potential profits don’t come through then the company can run into serious problems, as I learned from my investment in Tesco.

Large capital investments also need large amounts of cash. This means that high-capex companies often carry lots of debt because it’s easier to borrow cash than it is to generate spare cash from existing operations.

And that is Stagecoach’s second danger.

Danger #2 – Large debts

With debts of around £750m and average post-tax profits of just £140m, Stagecoach has a debt-to-profit ratio of 5.3.

That’s like having a mortgage 5.3-times your income, but where your income is volatile like a company’s profits rather than steady and relatively certain like most salaries.

If earnings fall then it may be difficult to meet the debt interest payments, and the same could happen if interest rates rise.

This level of debt doesn’t guarantee a dividend cut, but it does make it more likely, especially for a cyclical sector company like Stagecoach (Stagecoach operates in the cyclical Travel & Leisure sector).

This much debt also breaks one of my investing rules:

• INVESTING RULE: Only invest in a cyclical sector company if its debt-to-average profit ratio is below 4

On top of this debt, the company has another form of debt as well.

Danger #3 – Large pension obligations

Stagecoach has a defined benefit pension scheme for its own employees and is also obliged to pay into several schemes relating to its rail franchises.

Looking at just the Stagecoach pension, the total obligations are £1.6 billion. That’s 12-times the company’s average earnings and that breaks another one of my rules:

• INVESTING RULE: Only invest in a company if its pension-to-average profit ratio is below 10

And it gets worse. The pension scheme’s assets are enough to cover most of its obligations, but not all of them. There is in fact a £250m pension deficit.

A pension deficit is effectively another form of borrowing which, when added to the company’s existing £750m debt pile, leaves Stagecoach with pension-adjusted borrowings of about £1 billion.

That’s more than seven times the company’s average profits, which is way above my limit for prudent borrowings of four-times profits.

All of this means that despite Stagecoach’s attractively high 7% yield, I think the dangers outweigh the potential rewards.

Inmarsat PLC

• Share price: 633p
• Dividend yield: 6.8%
• Index: FTSE 250

Inmarsat is another company with an attractive but worryingly high dividend yield.

It also has an interesting history. It was set up in 1979 as the International Maritime Satellite Organisation, an inter-governmental body tasked with enabling ships to stay in contact no matter where they were.

Today it’s a private company and its business is still based around communications satellites, selling services to both governments and enterprises.

Like Stagecoach, it’s a company with a long track record of steady dividend growth, which makes it very attractive when combined with such a high dividend yield:

The chart shows a reasonable track record, although the dividend is now uncovered by normalised earnings thanks to non-existent earnings growth over the last decade.

That’s a problem, but I think there are bigger problems.

Danger #1 – Large capital expenses

As with Stagecoach, Inmarsat has to definitely spend money today in order to possibly make money tomorrow. Satellites don’t come cheap, and Inmarsat has spent almost £2.2 billion in capital expenses over the last decade.

That’s 1.4-times its normalised post-tax profits of £1.5 billion, earned over the same period.

Using the same definition as before, this makes Inmarsat a high capex and therefore potentially high-risk company.

In this case, I would say the risk is access to cheap funding. If Inmarsat cannot get its hands on large amounts of low-cost cash then launching satellites will become more expensive and less profitable.

In fact, the “less profitable” bit already seems to be happening, despite the current record-low cost of borrowing.

Over the past decade, the company has increased its capital employed (fixed and working capital) by about 100%, from £1.7 billion to £3.3 billion.

You might reasonably expect a doubling of capital employed in the business to produce a doubling of revenues and earnings, but this has not been the case.

Yes, revenues have increased by about 80%, which is good, but normalised earnings have actually decreased. Of course, earnings are volatile, but you can see from the chart that they’ve basically gone nowhere.

This means that Inmarsat’s profitability (return on capital employed) has fallen from a respectable 11% a decade ago to a worryingly weak 5% today.

In other words, the earnings (which belong to shareholders) that Inmarsat is investing in new capital assets may be generating a return of just 5% per year, or even less. That is not good.

Danger #2 – Large debts

Perhaps unsurprisingly, Inmarsat also carries a lot of debt, which it needs to fund all those capital expenses.

In its latest annual results, total borrowings came to £2 billion, or some 11-times its recent average profits.

That’s more than double my preferred limit for defensive sector companies (Inmarsat operates in the defensive Mobile Telecommunications sector).

Here’s the rule:

• INVESTING RULE: Only invest in a defensive sector company if its debt-to-average profit ratio is less than 5

To be fair to Inmarsat, it has carried lots of debt over many years without running into any major problems.

However, its debt ratio has averaged about 6 over the past decade, which is high but not outrageously high. I’m not sure you can say that about debts that are now 11-times average profits.

Fortunately, Inmarsat doesn’t have a large pension, so its debts of 11-times profits are slightly lower than Stagecoach’s pension deficit-adjusted debts of 12-times profits. But neither debt burden is anything to be proud of.

So as you might expect, and as with Stagecoach, Inmarsat’s combination of massive capital expenses and related high debt levels is a potentially explosive combination I would rather avoid.

Top Tip: Use these investment spreadsheets to calculate the capex ratio and debt ratio for other companies (such as BT, Dairy Crest and Shell, which also fall into this high capex, high debt danger zone).