This stock’s dividend yield is scarily high. Is a big cut on the way?

Many investors look for income from their portfolios, whether it’s to reinvest back into the market — which we at the Fool UK would heartily recommend if you’ve still got many years before retirement ahead of you — or used to supplement the rather meagre State Pension. But this strategy is clearly not worth the effort (or cost) if the stocks selected don’t have the capacity to pay out cash to their loyal shareholders.

How do you spot such companies? Two indicators are a simply too-good-to-be-true dividend yield, and dwindling dividend cover (the extent to which profits cover the total payout, where twice is ideal). 

With this in mind, here’s one firm I think faces the real possibility of being forced to substantially cut its dividends.

Punctured profits

Halfords (LSE: HFD) is a household name. Then again, the same thing can be said about Thomas Cook. Familiarity is nothing without decent profits to back it up. And having now issued a number of warnings, it’s clear the bike retailer and auto repair operator is now struggling to pull in as much cash from consumers as it used to. 

In this month’s trading update for the 20-weeks to 16 August, the company said strong sales growth online and B2B had been “more than offset by the impact of the challenging retail backdrop and tough weather comparators year-on-year.” In other words, fewer people were buying bikes and motoring accessories due to things like Brexit and the fact that last year’s sweltering summer motivated more of us to get outside. All told, like-for-like revenue was down 3.2%. 

To make things worse, Halfords’ management was rather downbeat on trading going forward.“The impact of the uncertain economic environment remains an ongoing risk to big-ticket discretionary purchases in the second half,” it said. Underlying pre-tax profit is expected to come in somewhere between £50m and £55m. 

Cheap… for a reason

Investors have been bearish on Halfords for some time now. From hitting a peak of 388p a pop back in May 2018, the shares have tumbled 56% to just 171p. The company now has a valuation of just £340m, leaving it firmly in small-cap territory. 

Of course, some might argue its lack of popularity among investors now makes this retailer a great contrarian bet, in the same way Pets At Home once was. Based purely on a forecast price-to-earnings (P/E) ratio of just 8, Halfords presents as a bargain. At 9.5%, the dividend yield looks mighty tempting too.

But the latter is a red flag, in my opinion. With profits only likely to cover the payout around 1.3 times, the 16.3p per share cash return forecast by analysts will surely be questioned if the business fails to stabilise earnings. And while we might only be talking about a cut here, this doesn’t actually solve Halfords’ biggest issue. Its lack of an economic moat.

What’s to stop someone testing a bike in store and then going home to order online from a (cheaper) competitor? What makes Halfords’ mechanics better than rivals? Management’s talk of offering a “differentiated, super-specialist shopping experience” isn’t sufficient, as far as I’m concerned. And the fact the company is still to launch an integrated website — combining both its retail and autocentre operations — speaks volumes. The winding road ahead looks long and tough.