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Why Seven Group Holdings Limited shares may offer a huge dividend yield

In 2010, Seven Group Limited merged with the WesTrac Group to form Seven Group Holdings Limited (ASX: SVW), a diversified media, mining, energy and investment conglomerate.

Seven Group Holdings holds the exclusive distribution rights for Caterpillar’s mining equipment in the Asia Pacific region, alongside a controlling interest in Seven West Media Ltd (ASX: SWM) and a $1.1 billion dollar active investment portfolio in energy and property assets. 

When Seven Group Holdings formed in 2010, it issued Seven Group Holdings Transferable Extended Listed Yield Shares (ASX: SVWPA)(“TELYS4”) which is a redeemable convertible preference share that entitles holders to preferred, semi-annual dividends. With TELYS4 trading at a significant discount to its face value of $100, the current 10.8% gross yield makes for an attractive investment proposition.

What is TELYS4?

TELYS4 was issued to roll forward (former) Seven Group Limited’s convertible preference shares into the newly merged Seven Group Holdings. TELYS4 ranks behind all creditors, but has priority over ordinary shareholders in relation to distributions and winding up. Unlike similar instruments, TELYS4 does not have a maturity date, meaning it continues in existence until Seven Group Holdings determines to redeem or convert the shares (at its discretion).

In return, TELYS4 pays a semi-annual, fully-franked dividend at a gross margin of 4.75% over the 180-day bank bill swap rate (BBSW). The 180-day BBSW currently sits at 2.22%, implying investors in TEYLS4 receive a gross dividend yield of approximately 6.97%. Importantly, this yield is measured against the face value of $100, and with TEYLS4 trading close to $64.60 (at the time of writing), the effective yield is closer to 10.8% (inclusive of franking credits).

Therefore, provided Seven Group Holdings can maintain the TELYS4 dividend, investors will be rewarded with a solid income stream that trumps all other bank deposits. There is also potential for TELYS4 to be redeemed for $100 by Seven Group Holdings, meaning investors could receive a windfall capital gain in the process.

What are the risks?

Of course, a risk-free return does not exist in the market, and TELYS4 is no exception. It’s fortunes are inextricably linked to the success of Seven Group Holdings which is why the TELYS4 share price has dropped 26% from earlier this year. 

With Seven Group Holdings experiencing a tough 2015, underlying profit came in at $203 million for the financial year, down 19.3% from prior year. It’s core divisions of mining, media and energy all took a hit, with the company warning that underlying earnings (EBIT) are likely to fall a further 10% in the 2016 financial year.

Accordingly, the TELYS4 share price has been under pressure with concerns mounting over Seven Group Holdings’ ability to weather the current slowdown and continue paying dividends. You see, TELYS4 dividends rely on Seven Group Holdings’ ability to generate sufficient cash to pay the dividend. With the mining and energy downturn persisting, investors fear Seven Group Holdings’ underperformance will result in it cancelling the TELYS4 dividend, making TELYS4 shares virtually worthless.

The silver lining

Noting this key risk, the silver lining lies in the way TELYS4 is structured. TELYS4 contains a dividend stopper which prevents Seven Group Holdings from paying all ordinary dividends for 12 months in the event it does not pay a TELYS4 dividend. This means Seven Group Holdings must pay a TELYS4 dividend if it wishes to pay its semi-annual dividend which it has a “proud history of paying”.

In 2015, Seven Group Holdings generated operating cash flow of $287 million and undertook a $40.3 million share buy-back, indicating the company is sufficiently capitalised to meet its obligations through free cash flows. Even with earnings expected to fall 10% in 2016, Seven Group Holdings’ strong cash generation ability, alongside the dividend stopper, should protect the current TELYS4 yield given management would be loathed to cut or stop the Seven Group Holdings dividend.

Foolish takeaway

With the TELYS4 dividend effectively underwritten by the dividend stopper, TELYS4 offers a market-beating income stream with potential for solid capital growth. Although the latter requires Seven Group Holdings to turnaround its performance, TELYS4 shares trade at a significant discount to face value, providing an attractive option for investors seeking exposure to Seven Group Holdings.

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Motley Fool contributor Rachit Dudhwala has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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