A hidden high yielder

The hunt for yield looks far from over, even after a three-year run, and there are high-yielding stocks that are either hidden or being ignored by income investors.

There are eight stocks on the S&P/ASX 200 Index with the potential to deliver a 10% gross-up yield or more in 2014-15, but the market is too fixated on Telstra (TLS) and the banks to pay them any heed.

This is perhaps with good reason, as many of these 10% plus yielders have business models that are under considerable stress. Take engineering contractor NRW Holdings (NWH), for example.

It is tipped to be the king of the dividend hill with its 13% yield (including franking credits), but that isn’t enough to win it new fans because of earnings uncertainty stemming from the poor outlook for mining and civil construction projects. (I’ll be writing a more detailed analysis on the stock in the coming weeks).

Macro and company-specific issues also afflict the vast majority of juicy dividend payers in the table above. Indeed, these mouth-watering distributions could turn out to be nothing more than a “dividend trap”, which is a company that appears to have a generous dividend but which will be forced to cut its payout due to declining earnings. High yield is more often than not associated with high risk.

However, there is one hidden dividend gem that should get income investors excited, as I believe it is on a much surer dividend footing. I am referring to STW Communications Group (SGN). The group owns a range of agencies and is the largest advertising and public relations player in the Australian and New Zealand markets.

While it wouldn’t normally be regarded as an income stock given its cyclical earnings, which swing around with the fortunes of the consumer discretionary sector, I do not see much risk around the 9.3 cent a share dividend that I am forecasting for 2015 (STW’s financial year ends December 31). This would imply a yield of 10% once franking credits are added.

That may sound suspiciously high, but it may surprise you to know that it won’t take much for STW to meet this expectation based on my estimates. That’s good news given that advertising spending is under a cloud in this country.

This is one reason why the stock has not made much traction this year. Investors were counting on a clear and sustainable rebound in spending, but the recovery has been patchy at best. This prompted management to warn that it could struggle to meet full-year guidance for mid-single digit earnings per share (EPS) growth, even though the group remains confident that it will report some earnings growth.

But even with next to no bottom-line growth, STW is tipped to see a 49% increase in its cash holdings to $64.5 million. Its previous year’s cash flow was impeded by one-off items, such as timing for tax payments and an unexpected increase in working capital.

The increase in cash will be instrumental in helping the group repay borrowings, with $125 million of its $172.8 million debt facility maturing in 2015.

The savings from interest payments alone is enough to drive a 7% to 8% increase in net profit for 2015 and 2016. Assuming the payout ratio stays around 69%, shareholders can expect to see similar increases to dividends over the same period.

By 2016 STW could deliver a dividend per share of 14.5 cents before franking. In other words, the stock could be yielding around 15% (with franking credits) in two years – and all of this can be fuelled by little more than gross domestic product (GDP) like revenue growth of under 5% a year.

This isn’t to say that STW is a low-risk investment, but conditions will have to deteriorate markedly before STW’s dividend comes under threat, and I am not expecting that. If anything, I believe there is a more room for ad spending to increase than decrease, even though I am assuming near flat real growth for the next few years in my valuation of STW with cost increases slightly outstripping revenue growth.

I don’t usually like “roll-up” businesses, or a company that buys others to become bigger, because there are usually little synergies between the business units. This is largely true for STW, but its track record and dividend growth potential bring enough comfort for me to reiterate my “Buy” recommendation on the stock with a price target of $1.60 a share based on a discount rate of 11.44%.

Earnings growth is nice, but it is not as important for driving share price appreciation. As I wrote in August last year, stocks that can raise dividends for three consecutive years have a 70% probability of outperforming the ASX All Ordinaries index. The median return for dividend dazzlers is 70.2%, compared with 27.3% for the market benchmark.

More interestingly, companies that deliver three consecutive years of earnings per share growth only have a 40% chance of beating the All Ordinaries.

Earnings growth can feel a little overrated.

To see STW Communications’ forecasts and financial summary, click here.