Debt-Free Dividend Investing

As seen in the latest issue of Master Investor Magazine

If there was a league table for reasons why companies cut their dividends, then I’m pretty sure that excessive debts would be somewhere near the top. So the need to avoid companies with too much debt is important, but it’s even more important for high yield investors. Why? Because high yields are usually only on offer because the company paying the dividend has run into problems of one sort or another.

To help you avoid debt-laden companies I’m going to run through how I measure debt and how I measure what’s “too high”. After that I’ll follow up with a quick look at a handful of high yield stocks from companies with little or no debt.

A debt ratio for long-term investors

There are lots of different ways to measure debt and some of the most common approaches are to look at the ratios between earnings and debt interest, debt and shareholder equity or debt and assets.

When I look at debt I’m more concerned about the affordability of a company’s debts rather than the funding structure of the company. So of the ratios mentioned so far, the one relating to earnings and interest payments (or interest cover as it’s known) would be my preferred metric, rather than the ones between debt to equity or debt to assets.

However, in my opinion the interest cover ratio is too short term in nature as it compares a company’s current earnings (before interest and tax) with its current interest payments. But both earnings and interest payments can be volatile; earnings go up and down from one year to the next and interest payments can change with interest rates when a company rolls over its debts. This means that today’s interest cover might not tell you very much about whether a company can afford its interest payments over the next few years.

Because of these limitations I prefer to look at the ratio between a company’s total borrowings (both short-term “current” borrowings and longer-term “non-current” borrowings) and its average post-tax profits over the past five years.

Both of those factors are more stable than one year’s earnings or interest payments and so, in theory at least, the resulting debt ratio between them should be more stable over time and more informative as well.

Goldilocks debts: Not too much, not too little

Generally speaking I’m happy to invest in a company if this debt ratio is below four, i.e. if its total borrowings are less than four-times its average post-tax profits over the past five years. Companies that operate in defensive sectors are often able to carry more debt because their earnings and cash flows are more stable, and so for defensive sector companies I raise that debt ratio limit to five.

But those are upper limits and in most cases I prefer debts to be much lower than that.

On the flipside, companies that totally avoid debt might be operating inefficiently. Most companies can comfortably handle some amount of debt and so – as long as a company can generate significantly higher returns on capital than it has to pay to borrow that capital – a conservative amount of debt can be more sensible than being completely debt free.

Okay, let’s switch from theory to practice and have a look at a few stocks which combine high yields, fairly consistent dividend growth and very little in the way of debt.

The Restaurant Group (RTN): Yield = 5.1%; Growth rate = 10%; Debt ratio = 0.6

The Restaurant Group (which I’ll refer to as TRG) is the largest independent operator of branded restaurants in the UK, including brands such as Café Uno, Garfunkel’s, Deep Pan Pizza and Frankie & Benny’s. The company has more than 500 outlets at sites ranging from high street restaurants, pubs, leisure parks and airport concessions and is listed in the FTSE 250.

The company’s track record over the past decade has been impressive. Its revenues, earnings and dividends have increased in every single year and its growth rate has been close to 10% per year on average. Profitability has also been high with an average return on capital employed (ROCE) of 20% and of course its debts are low, with total borrowings of slightly more than £30m compared to average profits of more than £50m.

The yield at the time of writing is high at 5.1%, so obviously Mr Market is not happy with TRG; you just don’t get a 5% yield from a company with a track record of growing at 10% a year unless the market expects that growth rate to disappear.

In this case TRG has recently mentioned weakening consumer demand and its outlook for next year is for a slight fall in revenues and profits. Whether or not this creates a material risk to the dividend I’ll leave for you to decide, but I will say that I own shares in TRG and currently I’m not overly pessimistic.

XP Power (XPP): Yield = 4.3%; Growth rate = 15%; Debt ratio = 0.5

XP Power is a designer and manufacturer of electrical power controllers which are then fitted inside its customers’ products. Its customers are, for the most part, original equipment manufacturers (OEMs) in the industrial, healthcare and technology sectors. In practice that means its products can be found controlling power for hospital equipment, military equipment, train ticket machines, lifts, elevators and many other places where the control of power is critically important. XP is listed in the FTSE Small-Cap index but is relatively large for a small cap with a market value of almost £300 million.

At first I thought power controllers would be a commodity product – i.e. they’re all basically the same – but apparently that is often not the case for non-consumer electronics. In many cases OEMs have specific requirements for power output (e.g. voltage and other factors which I will not pretend to understand), efficiency, weight, size and various aspects relating to packaging. In these situations off-the-shelf power controllers will not do and this is where XP Power is focusing most of its efforts.

The company’s track record is impressive. Over the past decade it had a growth rate of about 15% a year, although revenue and earnings growth have slowed somewhat more recently. Dividend growth is still going strong though, with the company announcing an 8% increase in its latest quarterly update. Profitability has also been strong with average ROCE coming in at almost 20%; that’s almost double the average of most companies.

Having carried out a brief analysis I can’t see any obvious downsides, or reasons why a company with a dividend which is still growing at 8% would have a yield of more than 4%. Perhaps Mr Market knows something I don’t, but I would say this is definitely a low debt, high yield company which is worth investigating in more detail.

PayPoint (PAY): Yield = 4.4%; Growth rate = 8%; Debt ratio = 0.0

PayPoint is a payment processing company focusing primarily on providing payment terminals to small shops and other retailers. These terminals allow people to conduct a wide variety of transactions in cash, such as paying utility bills, topping up mobile phones or energy meter pre-payment devices and even buying bus tickets. The terminals can also be used to withdraw cash like an ATM or send cash to someone else who can then withdraw it from their local PayPoint terminal.

Historically Paypoint has performed very well. Over the last decade its average growth rate has been almost 8% and its average return on capital employed has been exceptionally high at more than 30%.

However, virtually all of the company’s growth has been on the profit and dividend side of things as revenues have been flat for a number of years. This of course means profit margins have been increasing, but with margins now close to 50% it seems unlikely that they’ll keep going up for much longer. At some point revenue growth must surely return if the company is to avoid stagnation.

Unlike The Restaurant Group and XP Power, there are more obvious reasons why this relatively high growth company has a dividend yield of well over 4%.

As noted in its latest annual results, PayPoint is currently going through some significant changes. Perhaps the most significant impending change is the sale of its online and mobile payments business, where management hope this will lead to a simpler business which is focused on its network of retail terminals. However, simplifying a business can still involve a lot of disruption and change, neither of which are good in the short term.

The company is also just starting the process of replacing its existing and long-running terminal with a new terminal which has the ability to replace existing till systems in many of its clients’ stores. Yet more uncertainty surrounds PayPoint’s parcel collection business, Collect+. This is a 50/50 joint venture with a company called Yodel and the two parties are in discussion over the future structure of this business (or whether it has any future at all).

So all in all there is a lot of uncertainty around PayPoint’s medium-term future, but on the plus side there could be a series of special dividends over the next few years as the company expects to return some excess capital back to shareholders.

UK Mail Group (UKM): Yield = 5.2%; Growth rate = 3%; Debt ratio = 0.3

UK Mail is the UK’s largest independent postal company, delivering mail and parcels for businesses and individuals throughout the UK and across the globe. As you might expect, postal delivery is a very steady business and UK Mail has not disappointed in that regard; its revenues, earnings and dividends barely changed through most of the last decade.

However, that stability came to an end in 2014 as the company optimistically raised its dividend by more than 13% on the back of that year’s good results, which were partly driven by an increase in home parcel deliveries as a result of the continued shift towards online shopping and home delivery. As part of that optimistic outlook UK Mail also began a major new investment programme to create a new and highly automated national sorting hub near Coventry. This hub, through the use of modern automated sortation technology, would be designed to significantly increase the capacity, efficiency and flexibility of the company’s postal operations.

By the end of the 2015 financial year the company had sunk more than £35m into the new hub, which was by then partially operational. A degree of disruption was expected as operations were moved from the company’s old national hub to the new one, but at least the company hadn’t saddled itself with lots of debt in order to pay for this major capital investment (it had instead burned through the vast majority of its not inconsiderable £27m cash pile).

Fast forward to the recently announced 2016 annual results and the dividend has been reduced by 25%, which more than negates the (over) optimistic 13% increase in 2014 and takes the dividend to its lowest level in more than a decade. So why has the dividend been cut? The answer, somewhat predictably, is that new hub.

In the real world it is rare for events to go exactly as planned and in my experience the more critical the event the more likely it is to go wrong. For UK Mail this meant a large number of parcels which the automated sortation equipment couldn’t sort, and that, along with other teething problems, led to lost customers and higher operating costs.

Longer term though the company still expects the hub to be extremely beneficial, and on top of that there is still the continued shift towards everyone buying everything online and then having it delivered. At the time of writing UK Mail’s dividend yield is 5.2%, largely thanks to the uncertainty around its new hub and the stigma attached to dividend cutters. However, if you have the stomach to invest in dividend cutters then this one could be worth investigating further.