Stockwatch: Consider this 7.8% dividend yield

Is Ladbrokes' 7.8% prospective yield a giveaway or rational pricing for the risks involved? At about 117p, shares in this betting and gaming group are off a recent two-year low of 102p versus 243p in early 2013; and the latest prelims for 2014 included the "intention" to pay the same 8.9p a share dividend in respect of 2015, as for 2014. I use inverted commas as "intention" looks carefully chosen; it falls short of "commitment." Possibly a lawyer or PR considered this wise to rule out the risk of any disappointed shareholders suing. The challenge is therefore to judge whether this extent of payout is realistic in Ladbroke's situation, or a sop to keep shareholders on-side when there are challenges within the results.

According to key financials, the payout is high-risk

For context, Ladbrokes has been engaged in a major restructuring and only expected to return to growth in the second half of 2014 when operating profit recovered 30.4% on H1 - this measure down 9.3% to £125.4 million for 2014 as a whole. Operating profit was also hurt by an "exceptionally high loss" of £8.1 million on Boxing Day football. Bottom-line, the group made basic earnings per share of 11.6p albeit 4.4p after restructuring charges, against 12.3p in 2013. On an earnings basis, therefore, the payout looks imprudent, considering also the market expectation for earnings barely to cover it in 2015 and 2016. In fairness, no indication has been given towards the 2016 dividend.

The end-December balance sheet had £62 million cash against £63.3 million at end-2013, and the cash flow statement shows just over £81 million being paid annually as dividends. Net cash generated from operations fell from £197.4 million to £130.5 million, for cash to net off around £62 million. Such financial dynamics imply the board is rather chancing its arm with a high dividend payout. Better operating performance must follow, to sustain it.

There is an upshot, however, for buyers

As can be seen from the post-results market reaction, Ladbrokes down to 117p from 119p, investors aren't trusting the dividend yet. Ladbrokes is also in a transition phase, searching for a new chief executive. There is possibly some parallel with food retailer Morrisons where the board has parted with its CEO and attempted to sustain a high dividend payout - at least for now. Morrisons' stock has risen in response to a new CEO appointment, showing how investor sentiment can twitch on such news. If a new boss can make a positive impact at Ladbrokes, even re-basing the dividend to some extent, then its stock should rise as investors sense a de-risking. Admittedly the forward price/earnings (PE) multiple appears full, at about 15 times falling to 13, but that's typical in turnaround situations - e.g. with Morrisons on a forward P/E of about 17 times.

Can investment returns overcome tougher regulation?

The crux for value is whether Ladbrokes' strategy and payback from recent investment can counter tougher regulation from social concern about gambling - hence a political response. An increase in Machine Gaming Duty from 1 March also a Point of Consumption Tax means ongoing Ladbrokes betting shop closures: after 89 last year, some 60 this year, prompted also because a majority of leases are up for renewal by 2017. The retail side is still considered "core", being a major source of cash flow, the football business seen as a means to off-set the decline in horse betting. More self-service betting terminals have been deployed, also Clarity gaming machines, although net revenue slipped 0.7% to £811.5 million with operating profit down 10.9% to £119.3 million. The context of higher duties and further shop closures makes it hard to be enthusiastic about genuine recovery yet.

The digital side has done well, however, in a "pivotal" year with operating profit up 70.7% to £14.0 million on revenue up 22.9% to £215.1 million. Its progress appears significantly due to migration to new systems, enhancing the betting and gaming experience on mobile devices, hence staking by mobile sportsbook increased by 110% for the year. Further innovations are ongoing.

So, it was disappointing, the chief executive's review did not explain how a £8.1 million Boxing Day loss came about, "Ladbroke's worst on record across all of our platforms." The best interpretation is that all the technology advances in the world cannot insulate from exceptional event loss. The worst is Ladbrokes not managing its sportsbook properly. More positively it is the kind of thing a capable new chief executive should guard against.

An update on 2015 trading didn't exactly inspire either: revenue growth of just 1.5% and mention of "adverse industry-wide football results in weeks 3 and 8" but overall trading is cited in line with expectations. A niggle is provided by way of "significant headwinds" in duties although management says it is confident of generating continued underlying growth. Note "underlying."

Slight downgrades in the pipeline, as a result?

Mind it will likely take a few days for any profit downgrades to factor into the market consensus estimate, but I would expect to see them - say by about 5%. This doesn't really change the investment rationale, based on a yield that could likewise be modestly cut and yet still act as a prop, compensating investors until a (hopefully vigorous and capable) new chief executive is confirmed this year. This stock rather demands a leap of imaginative faith for such a scenario, but it implies scope for a progressive re-rating - initially some rise like with Morrisons if the new boss is respected, then over time if fresh actions invigorate the business. So I would continue to draw attention like I did last October at 116p after Ladbrokes' chairman spent nearly £48,000 buying shares at 119.7p.

For more information see ladbrokesplc.com.