There's nothing worse than being on the receiving end of a dividend cut, especially when the company in question used to be a dividend champion.
Unfortunately, this is exactly what could happen to the likes of Devro(LSE: DVO) and Capita(LSE: CPI) as these two companies seem to be sailing into stormy dividend waters. So is investing in these two as risky as putting your money on a roll of the dice? It could be.
Devro is somewhat of a serial disappointer. Over the past five years, shares in the company have lost 43% of their value as the firm has consistently failed to make good on its promises to improve growth. Revenue has barely budged over the past five years, and pre-tax profit has slumped from £41m in 2012 to the £31m expected for the year ending 31 December 2017. Earnings per share over the same period have declined by 36%. The company's profit contraction has come even as management has spent millions trying to restructure the group. Net debt has exploded from £23m to £154m, and there is little to show for it.
With profits falling and spend rising, Devro's dividend cover has been deteriorating steadily since 2012. Specifically, during 2012 the company's dividend payout was covered 2.4 times by earnings per share. Today, dividend cover has slipped to 1.5 times and the payout has remained unchanged for the past five years. If earnings continue to deteriorate and net debt continues to grow, Devro may have no choice but to cut the payout and ask shareholders for more cash in the form of a rights issue to clean up its balance sheet. The firm's 5.1% dividend yield is not worth this risk.
Rising debt, falling cover
Capita, like Devro has made multiple mistakes over the past few years the latest of which is the decision to sell its £50bn fund administration business to free up cash to fund its dividend payout and pay down debt. Even though the sale of Capita Asset Services will significantly improve the firm's financial position, the sale of this trophy asset could substantially impinge the company's long-term growth potential. This is bad news for the dividend.
At the time of writing shares in Capita support a dividend yield of 5.8%, which looks attractive in the current low interest rate environment. However, over the past five years, the company's earnings per share have barely budged while the dividend payout has increased by around 50%. Like Devro, the combination of stagnating earnings and a rising dividend has pushed dividend cover down from two times to 1.7 times.
What's more, like Devro, Capita's net debt has increased by around a third over the past five years. Granted, the asset sale should go some way to bringing this debt mountain under control, but after selling off its crown jewel asset, one has to wonder how long it will be before Capita once again needs to improve its financial position. Again, the firm's 5.8% dividend yield does not seem to be worth the risk.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Devro. 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.