One beaten-down income share I’d buy and one I’d sell

Drax train

The share price of power generator Drax (LSE: DRX) is down around 12% over the past six months as the group, which operates what used to be the UK’s largest coal-powered station, struggles to find its path forward in a carbon emission-conscious world. But with analysts expecting the company’s shares to kick off a very nice 3.7% dividend yield this year, should investors buy into its turnaround?

I certainly won’t. One of the issues stopping me from doing so is that the company has dived head first into switching to producing energy from burning wood pellets imported from the US. In 2015 the government contributed £450m in subsidies since biomass energy is considered a renewable source of power. However, the government’s stance towards financially supporting this form of power generation has since become much murkier and Drax won’t be helped by the decision to leave the EU and its potential subsidies behind.   

To cope with this, the company’s management has had to change strategy yet again and is moving forward with plans to add four gas-burning generators to its array of coal and wood pellet-burning ones. In addition to diversifying its generating capacity, the company has also moved into selling power directly to businesses through the £340m purchase of Opus Energy last year.

This move may work out in the end but the skill set necessary to run a utility versus that needed for operating a power generator are substantially different. This branching out was also costly as net debt in H1 rose from £85m to £372m year-on-year. This isn’t a major problem yet with EBITDA of £121m recorded in the same period and remains within management’s target of net debt of two times full-year EBITDA, but is worth keeping an eye on.  

That said, moving away from its core competencies, the cloudy outlook for future subsidies for biomass energy, and a dividend yield far below regular old utilities is enough to scare me away from buying shares of Drax today.

Temporary setback? 

I’m much more interested in shares of Topps Tiles (LSE: TPT), which after shedding 25% over the past year now trade at 10.5 times forward earnings and offer up a 4.5% dividend yield.

The cause of investors’ increasingly negative outlook towards the flooring retailer is like-for-like (LFL) sales that contracted by 4.7% in Q3. This was the second straight quarter of negative LFL movement and suggests to many investors that the UK housing market, or at least the refurbishment segment, may be heading downhill.

However, at today’s valuation I believe investors may find Topps Tiles a very impressive income option with surprisingly decent growth potential. This comes from the company opening new outlets to serve both retail and trade customers. At the end of H1 the company had 359 stores and had set itself a medium-term target of 450.

And while slipping LFL sales are a worry, the company is still highly profitable with operating margins stable at around 10% and its dividend is very safe with full-year earnings expected to cover it 2.25 times. I reckon investors who believe the domestic economy will continue to grow in the coming years will find Topps Tiles a very attractively valued income stock with considerable prospects for long-term capital appreciation due to expansion.

But if you’re looking for a value stock with better growth prospects, you’ll probably love the Motley Fool’s Top Small Cap of 2017. The company’s stock trades at eight times earnings despite four consecutive years of double-digits earnings growth.

To discover this under-the-radar value and growth stock for yourself, simply follow this link for your free, no obligation copy of the report. 

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Ian Pierce has no position in any 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

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