Stockwatch: buying this small-cap for its 9% dividend yield

Are companies genuinely on the cusp of better prosperity from lower interest rates? Or is the short to medium term, curdled not only with belated effects of higher rates but also a new Labour government likely to raise taxes and regulation?

A week ago, interim results from retailer Card Factory (LSE:CARD)surprised investors with a 40% plunge in pre-tax profit, said partly to be due to “substantial increases in National Living Wage plus freight inflation”.

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This week has kicked off with four profit warnings for varying reasons: supply chain issues and weaker Chinese demand, hurting Aston Martin Lagonda Global Holdings Ordinary Shares (LSE:AML); a tough outlook for floor coverings (discretionary spending) at Likewise Group (LSE:LIKE); weaker revenue for automotive brake discs at Surface Transforms (LSE:SCE); and wage pressures plus good ol’ British wet weather at Brighton Pier Group (The) (LSE:PIER).

A mix of factors is involved yet they share effects of tighter monetary policy after two years, and lately higher wage costs. Employee pay awards are running relatively high in the UK, especially in services, which are the backbone of the modern UK economy. It therefore seems unlikely that the Bank of England will proceed with rate cuts near the pace expected for the US Federal Reserve.

Such warnings, and also the possibility of inheritance tax relief being lost for AIM stocks, put into question a “risk-on” approach, for October at least. High dividend yields in particular need a kick of the tyres, especially where smaller companies are involved.

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An apparently strong dividend prospect

So it is timely – and after its own update – to re-consider Duke Capital Ltd (LSE:DUKE), a £138 million provider of finance to unlisted companies, which offers an 8.5% yield, assuming a 2.8p per share dividend is sustained in the year to March 2025. If recent guidance is fair, this should be covered around 1.4x by earnings and possibly nearer twice by free cash flow, given that there is no real capital expenditure. Net asset value at the year-end last March was close to 39p, which offers an element of comfort relative to the current price around 32.5p.

I drew attention as a “buy” last February at 31p, and the price twice hit 34p in July, otherwise the share has been sideways-volatile – not untypical of high-yield stocks where the market wonders if there really is sustainable upside.

Duke Capital - financial summary
Year end 31 Mar

Source: company accounts.

Founded in 2015 and listing in 2017, Duke’s business concept is providing hybrid credit and equity capital to small and medium-sized enterprises. The “hybrid” aspect links to royalty re-payments based on growth of those businesses’ revenues.

Its portfolio of interests – which has appeared to be around 15 situations but needs specifying more regularly, and also to show the balance of industries in portfolio weightings – grew to over £100 million by the March 2020 year-end but Covid meant non-cash write-downs totalling over £15 million that year, hence a £9 million annual net loss.

This was quite a dramatic example of what can happen to balance sheet values when unlisted companies hit a downturn; and why investment company shares related to private equity also tend to trade at a discount to net assets.

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Moreover, Duke has adjusted its approach to take equity stakes selectively, compared with royalty-based financing where the business owners retain full control. This addresses concern that the stock otherwise has no capital growth appeal, but does then make it rather hostage to economic cycles.

After the price plunged from 46p to below 20p in early 2020, there was a robust recovery; then expectations for higher interest rates to cool inflation sent the stock back down to 30p by September 2022, and it has traded sideways-volatile since:

Source: TradingView. Past performance is not a guide to future performance.

While the company has paid out around £50 million to shareholders since inception, dividends took a “scrip” or share-based form in 2021 to retain as much cash as possible. That could happen again, I believe, in another sharp recession.

The financial dynamics proclaimed at full-year results on 27 June did, however, show Duke’s business model as plenty effective. Total cash revenue soared 38% to over £30 million, with the recurring element up 12% to over £24 million. Three successful and profitable exits generated £23 million of additional liquidity and £46 million been deployed including new situations: £9 million in a management buy-out of a US designer and installer of custom glass, and £14.5 million for development of care homes in South-East England.  

A latest update in respect of Duke’s first quarter to 30 June cites nearly £3 million applied to Bay Broadcasting, an Irish radio operator. A total £6.8 million equivalent was being generated from the sale of another Irish business, in education, and a further £3 million applied to the US glass-maker – taking that equity stake to 74%.

A focused yet balanced portfolio of interests

Client companies are in the UK, Ireland, Canada and the US, which spreads risk away from reliance on the domestic economy – the classic risk with small-cap stocks.

Yet this update sustained a relatively flat near-term profile, especially adjusting for inflation. Recurring revenue rose 5% to £6.3 million, with guidance at £6.4 million for the second quarter (just closed), which would be only a 3% like-for-like increase on the same period last year. Total cash revenue has shown a spark of growth by way of £10.2 million in the fourth quarter of last year but is necessarily lumpy given that it includes disposals.

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It was insufficient to inspire investors yesterday – the balance of trades apparently weighted to “sell”, albeit on modest volume of 325,000 shares. The wider market was down, if consolidating after last week’s surprise of major Chinese stimulus rather than concern about economic prospects.

I believe the chief risk is recession along the lines that Mark Spitznagel, the US hedge fund manager, predicts – as if economies face a pre-determined downturn after tighter monetary policy, although you could argue that “he would say that, wouldn’t he” given that his fund effectively offers investors insurance for macro risks. I think the odds less likely, but I respect the view.

Even the likes of JP Morgan Chase have lately raised the probability of a recession from 25% to 35%, and if the US falters it would be felt in Europe and elsewhere. Who knows if China’s stimulus will actually work, and where current military escalation in the Middle East will lead.

Such fears are friendly to income investors

They keep selective stocks priced usefully for yield, if we can be reasonably sure the risks do not outweigh the rewards.

Looking at assets on Duke’s 31 March balance sheet, its equity component in client firms rose from £13.3 million to £15.9 million; and credit finance investments from £158.5 million to £177.6 million. This was assisted by a near 30% rise in total debt to £70.4 million, generating (presumably net) finance costs up 29% to £7.4 million – despite material cash on the balance sheet, which reduced from £9 million to just below £3 million.

So, the equity exposure is just shy of 10% of Duke’s own net assets. Management has had no write-offs for failures, just a small loss related to a Dutch riverboat operator hit by Covid, in context of the £15 million write-down for carrying values back then.

It is impossible to be sure of the macro outlook, but I think Duke remains a useful example for income investors of how well run small-caps can offer attractive risk/reward. Dividend guidance so far is for a 0.1p rise to 2.9p a share for March 2026, constituting a 9% yield. I therefore retain: Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.