What should investors do with these Neil Woodford dividend favourites?

Following AA’s dividend cut, should you be concerned about the income safety of these two Woodford stocks?

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Neil Woodford’s reputation as a star fund manager took another knock this week as roadside assistance company AA announced a shock profit warning and slashed its dividend. It’s the latest in a series of high-profile losses in his struggling equity income portfolio, following on from Capita and Provident Financial.

With this in mind, today I’m taking a look at whether some of his other high-yield picks could also be at risk of cutting their dividend payouts.

Falling profits

Fashion retailer Next (LSE: NXT), which had until recently been a consistent performer, is another one of his holdings that is struggling to deliver bottom-line growth. While the company reported a stronger-than-expected set of sales figures for the Christmas period, management only lifted its full-year central guidance for underlying pre-tax profits by a mere £8m from its earlier estimate of £717m, to £725m.

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As such, underlying pre-tax profits are on course to decline for another year running, from £790m in its previous financial year. I reckon there’s no end currently in sight to the company’s declining bottom-line performance, with the unexpected cold weather leading up to Christmas only giving its sales trend a brief reprieve from long-term structural headwinds affecting the retail sector.

Free cash flow

Next’s shrinking bottom-line will no doubt hurt its free cash flow going forward, shrinking its capacity to pay dividends. But as ordinary dividends add up to just 158p per share last year, and account for just 47% of its total dividends over the past 12 months — that is the combined value of both ordinary dividends and special dividends — the company can avoid a cut in its ordinary dividends.

With Next on course to generate £300m in free cash flow after ordinary dividends for the full year, down from £330m in the previous year and £372m in the year before that, the company looks set to reduce the size of its special dividends. It won’t be considered as a dividend cut, per se, but it would still be a reduction in total shareholder payouts.

Special dividends

Barratt Developments (LSE: BDEV) is another of his top positions, and accounts for 2.8% of his LF Woodford Equity Income Fund. Like Next, the housebuilder pays special dividends on top of ordinary dividends, giving it the flexibility to cut shareholder payouts whenever trading conditions become less favourable.

However, in contrast to Next, Barratt has made clear its intentions to maintain its special dividends at last year’s level of £175m for both 2018 and 2019. This gives shareholders clarity over future dividend payments, demonstrating its strong financial position.

Cyclical risks

The profitability of housebuilders have soared in recent years, but there’s growing concern that we’re approaching the cyclical top of the property market. Housebuilding is a very cyclical industry and, as such, earnings and dividends can be volatile.

The latest results should calm investor nerves, though. Despite an overall cooling in the property market, Barratt’s average selling price continues to increase, with buyer interest remaining strong. Its forward order book is also growing faster than many of its peers, with forward sales up 2.0% to £3,078m.

City analysts are sanguine, too, and expect the housebuilder to report underlying earnings growth of 5% and 6% over the next two years. This should mean there is little risk of a cut to shareholder payouts any time soon.

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Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Jack Tang has a position in Capita plc. 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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