Very high dividend yields are incredibly tempting. But they are also a reliable reminder that problems may lie ahead.
Take Interserve (LSE: IRV). Shares in the construction and outsourcing group fell by 25% on Monday morning, after management warned that the cost of exiting its Energy for Waste business is now likely to total £160m. That's more than double last year's estimate of £70m.
Cash outflows relating to Energy for Waste in 2017 are now expected to be about £60m, up from a previous estimate of £35m. Unsurprisingly, Interserve's debt levels are rising fast. Average net debt was £390m last year and is expected to reach £450m in 2017.
Interserve has secured an extension to its borrowing facilities, but in my view equity investors should be worried. These debt levels look high to me, relative to a forecast 2016 adjusted profit of £91m.
Is this the bottom?
Interserve's 24p per share dividend costs about £40m each year. I don't think that the company will have this kind of spare cash in 2017. In my view, a dividend cut is almost certain. Indeed, I believe there's a real risk of a placing or rights issue to raise cash from shareholders over the next year.
Another concern is the contrast between Monday's update and January's much more positive trading statement. I don't think management guidance has much credibility after this shocker, and wouldn't be surprised if there is more bad news to come.
I expect broker forecasts for the year ahead to be slashed. In my view, Interserve is a strong sell.
Can this 8% yield be safe?
FTSE 250 member Carillion (LSE: CLLN) is three times the size of Interserve. But the group's mix of construction and outsourcing businesses is similar.
Carillion's share price has fallen by 24% over the last six months, even though earnings forecasts for the firm have remained fairly stable. The firm's shares now trade on a forecast P/E of 6.4, with a whopping prospective yield of 8.6%.
The problem is that Carillion appears to be suffering from a change in the profile of its activities. Profits from overseas construction work are falling. The group is becoming more dependent on low-margin outsourcing work. This means sales are rising much faster than profits, reducing Carillion's profit margins.
A second concern is that the firm's revenue visibility for 2017 was just 70% in December. A year ago, the equivalent figure was 84%.
A hidden risk?
Carillion expects year-end net debt to be below the £290m reported in its interim results. However, the group admits that average net borrowing across 2016 is expected to be above the £540m reported in 2015.
Carillion isn't the only company that manages its financial activities to minimise the net debt reported in its accounts. Many companies do this. But the difference between £290m and £540m is very great. In my view, this adds a considerable amount of risk to the stock.
If business conditions improve in the construction and outsourcing sectors, companies such as Carillion and Interserve could become contrarian buys.
But I'm discouraged by their high levels of debt and uncertain outlook. In my view, now isn't the right time to invest in either company.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.