Last year, income hunters were left in shock after Pearson (LSE: PSON) announced it was cutting its coveted dividend payout.
The companys decision to slash the payout came from nowhere and before the cut, Pearson was perceived to be one of the FTSE 100s dividend champions. Unfortunately, the declinein the value of Pearsons shares on the day the cut was announced wiped out years of income gains for investors.
Pearson issued its fifth profits warning in four years last week, and now the shares are down by 60% from their 2015 peak. At the end of 2014, shares in the company supported a yield of 4.3% which, considering recent declines, now seems relatively insignificant. Another dividend reductionis planned for the year ahead. City analysts have pencilled-in a payout cut of nearly 40%.
It looks as if Capita (LSE: CPI) is going the same way as Pearson. Even though Capitas trading has hit a rough patch recently, the companys management continues to prioritisethe groups dividend over anything else.
Trouble ahead
Shares in Capita currently support a dividend yield of 6.3% and at first glance, the payout looks safe as its covered twice by earnings per share. However, managements outlook for the business has deteriorated rapidly over the past year, and there could be more depressing news to come.
At the beginning of December, the company warned it expects 2016 underlying profit before tax to be at least 515m. Three months earlier,the firm was predicting a pre-tax profit of 535m to 555m, and before that it was expecting 614m.
Net debt is now expected to be some 2.9 times earnings before interest, depreciation and amortisation up from a target already raised to 2.7 times in September.
To bring debt down, its selling the majority of its Capita Asset Services division. This sale is expected to bring debt down to 2.5 times EBITDA, but it will cost the group annual operating profits of 60m. To me, that salelooks like a poor decision. Capitas outsourcing operations are under pressure, along with the rest of the outsourcing industry, and by selling off its asset management arm, Capita is divesting a key source of diversification.
In the worst case scenario, Capitas main outsourcing business may continue to see sluggish demand, which would mean trouble for the groups balance sheet.
Borrowing for the dividend
For the past five years, Capita has been spending more than it can afford. For example, last year the group generated 502m from operations but spent 639m on acquisitions and organic growth. The dividend, which totalled 200m, was funded with debt. This trend isnt just limited to 2015. In only one year of the past five has the company been able to cover capital spending and dividends with cash generated from operations.
If Capita continueson this course, it wont be long before it has to ask shareholders for cash to shore up its balance sheet. Based on the groups current level of debt, such a cash call would likelycost investors more than a year of dividend payments is that a risk worth taking?
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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. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.