Could this dividend champion's 5%+ yield be in jeopardy?

Yesterday, shares in retail group N Brown(LSE: BWNG) jumped by more than 6% after the company issued an upbeat trading statement. For the 13 weeks to 3 June it reported a 5.6% increase in group revenue and announced that it is planning to shut some lossmaking stores to improve overall trading. Including the losses from closing these stores, the group expects to meet City earnings expectations for the full-year.

For the fiscal year ending 28 February 2018, analysts are expecting the company to report earnings per share of 21.4p, down 6% year-on-year on a pre-tax profit of £75.5m.

Improving outlook

N Brown's shares jumped after yesterday's update because it confirmed that the company's recovery is starting to gain traction. From their peak in 2014, the shares fell 71% to 180p during June 2016 as investors fled N Brown fearing for the company's future. However, over the past 12 months, shares in the retailer have risen 30% thanks to efforts by management to reposition the business and assure shareholders that all is not lost.

And so far, management has been able to maintain the company's dividend payout, which has remained at 14.2p per share for four years.

City analysts expect the payout to stay at this level for the next two years, giving shareholders a prospective dividend yield of 5.2%, but N Brown has a hidden secret that could force the company to cut its payout.

Underlying problems

At first glance, it looks as if N Brown's dividend is secure. The per share payout is covered 1.5 times by earnings, and on a cash basis, the total value of money paid out via dividends amounted to £40.2m for the last fiscal year, which was covered twice by free cash flow.

Nonetheless, N Brown's most lucrative business line is its financial services arm, which offers credit to customers shopping on its sites and stores. For the fiscal year to February 25, 2017, this financial services division produced £261m in revenue compared to £627m for retail sales. Financial services gross profit for the period was just under £150m compared to gross profit of £350m for retail sales.

The financial services arm has already come under scrutiny from the FCA due to the high-interest rates and other charges levied on customers. But as shown above, the group depends on this revenue to help it remain profitable.

With concerns growing about the level of consumer indebtedness across the UK, and the fragile state of the UK consumer, N Brown might be heading towards stormy waters. For the past two years, the company has booked a bad debt charge of around £110m, a high figure and one that's more likely to rise than fall in the years ahead. Without this charge, the financial services gross profit margin would be over 95%, which shows just how reliant the company has become on income from this division.

The bottom line

So overall, with a dividend yield of 5.2% at the time of writing, shares in N Brown might look like an attractive dividend stock, but with such a broad exposure to financial services, the dividend might not be as safe as it initially seems. There could be better buys out there.

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Rupert Hargreaves has no position in any 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.

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