One turnaround stock I’d sell to buy this unloved 7.5% yielder

It’s often surprising how long it can take for a bad corporate situation to fully unravel. With some companies, there always seems to be another nasty surprise.

I’m beginning to feel that way about defence and aerospace engineer Cobham (LSE: COB), whose shares fell by 4% on Friday morning. The trigger for the fall was a statement announcing a deal to sell the group’s AvComm and Wireless test and measurement businesses to a US buyer for $455m.

I estimate that the sale price is equivalent to perhaps 16-18 times earnings, which seems reasonable. My concern is that this sale is another sign of Cobham’s troubled financial situation. I think there could be more bad news to come.

Why I’m worried

Today’s announcement highlighted two main areas of concern, in my view. The first is that the sale of these firms will reduce the group’s underlying operating profit margin, as they were more profitable than Cobham’s other businesses.

The proceeds from the sale will be used to repay £440m of debt. Doing this will reduce interest costs by around £18m per year, offsetting most of the £25m operating profit these units generated last year. By selling now, Cobham can also avoid the need for future investment in areas which it says are non-core.

However, what disturbs me is that CEO David Lockwood may simply be clearing the decks for another round of exceptional costs. Today’s statement reminded investors that the company still faces “some significant contract exposures and other contingent liabilities”. The full scope of these isn’t yet known, but the wording of today’s news sounds worrying to me.

Cobham shares now trade on a 2018 forecast P/E of 20. The group continues to face unknown liabilities and today’s disposals seem likely to slow earnings growth, at least in the short term.

In my view this stock isn’t cheap enough to reflect the risks. I’m going to avoid this troubled business for a little longer.

A 7.5% yielder I’d buy

In contrast, budget card and giftware retailer Card Factory (LSE: CARD) looks increasingly tempting to me. The group’s shares slumped recently after it warned that full-year profits were likely to fall by around 5% this year.

The slowdown is blamed on the impact of wage inflation and foreign exchange costs, which are expected to total £7-8m in the 2018/19 financial year. Sales performance has also weakened, with card sales apparently flat and sales growth being driven by low-margin non-card items.

This all sounds a bit bleak, but it’s worth remembering that this is still an unusually profitable retailer, with an operating margin of 20% and very little debt. Cash generation is still strong and forecasts for the current year suggest that earnings will edge 21% higher to 19.1p per share in 2018/19.

Given the group’s limited spending requirements, I think this could be enough to support an expected dividend of 14.5p per share. At current prices, this would give the stock a dividend yield of 7.5%.

Card Factory’s share price could continue to drift lower as investors seek new growth opportunities. But the group’s underlying business still looks healthy to me. For income investors, I believe this could be a profitable buy.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

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