Extreme dividend yields are often a sign of deeply rooted issues in the company and business model behind the dividend-paying stock. For some investors, that's a deal-breaker. For others, it's a call to action. Some of those troubled businesses could come back swinging, unlocking a spring-loaded turnaround play -- and you can still enjoy sky-high effective yields on the low buy-in prices you locked up.
How can you tell the strong turnaround ideas apart from truly doomed underperformers, where the high yields really are red flags? That's the question we posed to a panel of dividend investors here at The Motley Fool, asking them to share some insights that could save ordinary investors from yield-hunting heartbreak.
Read on to see why they would recommend taking a second look at Seagate Technology (STX), GameStop (GME -6.77%), and Medley Capital (PFX 2.51%). All of these companies have their issues, but they also seem poised to make a strong comeback.
Game over or game on?
Keith Noonan (GameStop): It's not hard to see why shares of GameStop trade at low multiples. Most known for being the world's largest specialty video game retailer, the company depends on new and used software sales as its key earnings drivers; however, these profitable revenue streams are drying up as consumers increasingly buy games digitally.
Last year saw roughly 10% more games purchased through digital channels compared to the year prior, which means GameStop doesn't have a shot at making those initial sales or selling those units used. Last quarter, new and used games accounted for roughly 52% of sales and 51% of gross profit, and both of these product categories will almost certainly decline over the long term.
So GameStop is certainly facing some big challenges, but packing a 7.5% dividend yield and trading at just 6 times forward earnings estimates and 0.2 times forward sales, the company looks like a worthwhile value play for risk-tolerant investors.
On the video-game front, GameStop has caught a favorable break with the success of Nintendo's recently launched Switch gaming console, and new mainline hardware refreshes from Sony and Microsoft are likely to arrive within the next few years. Those performance catalysts should help keep its video-game business solid in the near term as it works on building its growth businesses. With momentum behind its push to become a bigger player in the pop-culture merchandise space and solid growth for its mobile hardware and wireless service sales, the company's transformation has credible avenues to success.
GameStop's stock might not be the absolute steal that its multiples imply, but its turnaround potential is on sale.
Let's explore some ideas old enough to be new again
Anders Bylund (Seagate Technology): Hard-drive manufacturer Seagate offers a juicy 6.9% yield today, on the heels of a strong first-quarter earnings report. That report triggered a quick 17% share price boost, but it's only a brief respite from a long-term slide that has sliced Seagate's market value in half since the start of 2015.
Some of Seagate's market troubles are certainly justified. Top-line sales have fallen 25% over the last three years while free cash flows took a 53% haircut. Some would also question the company's future prospects as the computing industry moves away from traditional spinning magnetic discs and deeper into SSD territory -- a space where archrival Western Digital (WDC -2.93%) has a solid long-term plan and Seagate is struggling to find a foothold.
Seagate bulls would argue that the company is carving out a new market position, focused on large-capacity storage with a special emphasis on enterprise customers. As Western Digital and others fight for small slices of the growing SSD pie, Seagate can double down on low-cost drives addressing large and long-term storage needs. As a bonus, the company is not exposed to the risk of SSD prices suddenly plunging if and when the supply-and-demand balance in that sub-market changes.
And meanwhile, Seagate is spending just 64% of its trailing free cash flows on dividend checks today. This gives the company the freedom to buy back shares at low market prices while planning for dividend payout boosts in the future.
Seagate's critics make sense in many ways, but so do its supporters. If nothing else, the stock looks like a solid play for value-conscious income investors.
A pile of trash could be someone else's treasure
Jordan Wathen (Medley Capital Corporation): Hold your nose and consider this deeply discounted business development company, which yields 11% based on its most recently declared dividend of $0.16 per share, per quarter.
To be frank, there isn't much to like about Medley Capital as it sits today. Its underwriting record has destroyed hundreds of millions of dollars in value, and its dividend has been cut multiple times as it culled its portfolio to pay off shrinking credit facilities. So, what's the good news? Things are so bad I think the end game is drawing near.
In my view, it's likely Medley Capital eventually finds itself under the management of a new team, and it could happen relatively quickly. Leveraged to the hilt, partly to buy Medley Capital stock, Medley Management (MDLY) may have every reason to put the management contract on the auction block.
We saw how that played out for shareholders of Fifth Street Finance, who enjoyed a return of about 45% in roughly four months as Oaktree Capital Group (OAK) stepped in to pay up to be the Fifth Street BDC's new manager. If Oaktree was willing to deal with Fifth Street Asset Management (NASDAQ: FSAM), there is a suitor willing to deal with Medley Management.
Medley Capital's 33% discount to last-reported book value allows for things to get worse before they get better, but this isn't a "widows and ophans" stock by any means. It's very cheap because investors know it's likely to underperform without a change in control at the management company.