I've often found that hunting through the market for dividend stocks with yields of around 5% can turn up some real bargains. In today's article I'm going to look at one 5% yielder I'd buy and one I'm happy to avoid.
A mixed picture
Shares of FTSE 250 omnichannel fashion retailer N Brown Group (LSE: BWNG) fell by 14% in the opening hour of trading on Tuesday, after the group issued a trading statement.
Given this reaction, you might expect news of a profit warning. But that wasn't the case. Full-year profit guidance was unchanged and the group reported revenue growth of 3.2% for the 18 weeks to 6 January.
So what's gone wrong? It seems that achieving sales growth has required heavy promotional spending. As a result, gross profit margins on products are now expected to fall by between 2.25% and 2.5% this year, compared to previous guidance for a drop of 0.7%-1.2%.
However, this fall in profit from retail should be offset by higher finance profits. Like a number of fashion retailers, N Brown makes a lot of its profit from customer credit.
An increase in the size and quality of the group's loan book means that gross margin from financial services is now expected to be around 5% higher this year, compared to previous guidance for an increase of 1%-2%.
Cheap enough to buy?
I estimate that financial services are likely to provide around one third of N Brown's total profits this year. This should help to support profit and dividend forecasts for the current year.
However, I'm concerned that profit margins on clothing may continue to weaken. I'm also unhappy at the risk that a slowdown in credit sales would result in a double hit to profits, as customers would buy less and pay less in interest charges.
Although the stock's P/E rating of 11 and forecast yield of 5.9% might be said to look cheap, I think there are better options elsewhere in the retail sector.
One stock I'd buy
One potential example is cycle and automotive retailer Halfords (LSE: HFD). Like-for-like sales at the group rose by 2.7% during the third quarter, and are up by 1.9% for the year to date.
Halfords attracts me for several reasons. The group's focus on cycling, car accessories and car servicing (Autocentres) has allowed it to navigate a changing market without serious problems. A strong balance sheet has also helped to maintain stable free cash flow and to support the dividend.
Although profit margins have fallen over the last five years, the group's return on capital employed is still attractive at around 13.6%. This compares well to N Brown's 2017 ROCE of 7.7%.
Strong returns help to generate plenty of cash, and Halfords scores well here too. The group's shares trade on a trailing price/free cash flow ratio of 15, compared to a figure of 27 for N Brown.
Halfords cash generation underpins its dividend, which has been consistently covered by surplus cash in recent years. The group's shares currently trade on a forecast P/E of 12, with a prospective yield of 5.1%. In my view they provide a much better quality opportunity to make money than those of N Brown.
Profit from quality dividends
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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.