Royal Mail (LON:RMG) could offer a 9% dividend yield

At the start of 2022, Royal Mail (LON:RMG) was flying high. The company had reported near-record profits for the two years of the pandemic and appeared to have recovered both its profitability and its mojo following a boardroom shake up.

Unfortunately, events this year have suggested that Royal Mail’s postal business still has the same problems with modernisation, workforce relations, and declining letter volumes that dogged it before the pandemic.

Royal Mail Group shares are now back at pre-pandemic levels:

Recent trading: The group’s first-quarter trading update revealed that revenue fell by 11.5% year-on-year in the Royal Mail postal division, leading to a Q1 operating loss of £92m. The postal operator hopes to break even at an adjusted operating profit level over the full year.

This was a notable contrast with RMG’s other division, international parcel operator GLS, which owns Parcelforce. GLS reported a 3% fall in volumes but said that revenue rose by 7.8% during the quarter, including acquisitions.

Inflationary pressures are putting last year’s 8% operating margin under pressure at GLS, but management still expects this business to generate an operating profit of €370m-€410m this year.

Royal Mail Group chairman, Keith Williams, says that the problem at Royal Mail is that efficiency improvements have stalled and the postal workers’ union won’t accept changes to working practices. He’s planning to end cross-subsidy between GLS and Royal Mail and has threatened to consider splitting the two businesses if no solution can be found.

I can’t predict how all the human and political elements of this situation will turn out. But I can see some reasons to believe that the shares offer value at current levels, however the situation evolves.

Stockopedia’s algorithms appear to share this view. Royal Mail is badged as a contrarian stock at the moment.

That suggests a mix of good value and quality, but poor momentum. In other words, the shares could be cheap if earnings stabilise:

Let’s take a closer look.

Great value?

Royal Mail is often talked of as a value stock due to its large property portfolio, cash generation and apparently modest valuation.

Book value: Royal Mail does indeed have plenty of fixed assets. The group’s property, plant and equipment (PP&E) was valued at £3.6bn on the most recent balance sheet. Debt is still low.

However, the price/book ratio above is distorted by a more unusual balance sheet entry. Unlike many large employers, Royal Mail’s pension scheme is fully funded. In fact, it’s in surplus – to the tune of £2.7bn. This is shown as a non-current asset.

Management warns that this surplus is an accounting entry only and “could not be recovered by the group”. So when considering the equity value available to shareholders, we need to discount this surplus.

Stripping out this pension surplus gives me a net asset value of £2,611m or 274p per share for Royal Mail Group. That means the last-seen share price of 230p represents around 0.85x book value. That’s still attractive, I think, but not such a large discount as suggested by the headline figures.

A P/E of 3 and a 9% yield? RMG shares look extremely cheap relative to last year’s earnings and dividends:

• P/E: 3.3
• Dividend yield: 8.7%
• Earnings yield (EBIT/EV): 20%

The problem here is obvious enough. The group earned exceptional profits over the last two years, but these are expected to moderate going forward:.

It looks like GLS profits will help to offset a possible net loss for Royal Mail this year, leading to a positive but much-reduced group result.

However, I think what’s most interesting here is the possibility that the dividend will be maintained. Royal Mail’s dividend policy is for a progressive payout that keeps net cash broadly at zero.

Last year’s ordinary dividend of 20p is unlikely to be covered by group earnings this year. But Royal Mail reported net cash excluding lease liabilities of £307m at the end of March. That would be enough to cover last year’s ordinary dividend of 20p 1.5 times.

Maintaining this payout for FY23 would give the stock a forward yield of 8.7%. Any increase could push the yield to 9%.

If the company can ride out one bad year and return to a more sustainable level of profitability in FY24, then I think Royal Mail shares could offer attractive value at current levels.

Quality: a mixed picture

Why doesn’t Royal Mail have any debt? Such prudence is unusual in large companies. But there is a good reason, which the company answers in its own results:

Given the high operational leverage in our business, we will continue to keep low levels of financial leverage.

Operational leverage refers to the effect a small change in revenue has on a company’s profits.

Royal Mail’s claim of high operational leverage reflects the very high fixed cost base of this business. The vast majority of its daily operations are fixed, regardless of whether mail volumes rise or fall.

What this means is that when volumes rise, as they did during the pandemic, profits can rise very quickly. Unfortunately, we’re now seeing the opposite effect.

In my experience, it’s quite rare for a company to explicitly flag up this risk. It suggests that profits could always be uncertain and volatile, based on factors outside management control. It’s certainly something I’d want to consider when reviewing Royal Mail’s quality metrics.

At first glance, these seem acceptable, if rather average:

However, I think it’s worth bearing in mind that these ratings are based on near-record results. Looking back over the last few years, what strikes me is how volatile Royal Mail’s margins have been:

One of the factors the QualityRank looks for is consistent profitability. This isn’t present here.

However, I think that the results we saw during the pandemic suggest that Royal Mail has the potential to deliver attractive profitability, if it can modernise its operations and introduce a little more flexibility into its cost base.

Dire momentum could turn positive

Despite the current deadlock with the CWU, City analysts remain more positive about the medium-term outlook for Royal Mail Group. They’re forecasting a sizeable bump in earnings next year:

If this materialises, RMG shares could be trading on just 6.5x FY24 forecast earnings, with a covered 9% dividend yield. Given the group’s general record of cash generation and low leverage, I can see some attractions here.

However, I think it’s prudent to consider the known unknowns in this situation.

We don’t know how the current dispute over pay and working conditions will be resolved, or how long it will take. Positive news could trigger an upwards re-rating – but a protracted deadlock with ongoing strikes could have the opposite effect, while also hitting profit expectations.

In addition, we don’t know how cost inflation and economic activity might change over the coming year. Although Royal Mail hedges most of its commodity-related costs, GLS doesn’t. High costs plus a broader economic slowdown could hit parcel volumes and cause profit expectations to be revised.

Finally, I think it’s worth remembering that the technical trend here is still very weak:

From a technical perspective, the only glimmer of hope I can see here is that volumes have risen over the last two weeks, relative to the three-month average. I guess it’s too soon to say whether this marks the start of a rally, but it might be worth watching.

My view: Royal Mail Group’s MomentumRank of 2 is dire by any standard. In my experience, investing in stocks with such poor momentum requires patience and can be an expensive mistake.

Conclusion

Leaving aside Royal Mail’s problematic industrial relations, I think that a key question is whether Royal Mail Group’s financial position has worsened during the first half of the year. This might provide some clues as to whether a dividend cut will be needed.

There’s also the question of whether strikes could cause havoc over the key Christmas trading period.

RMG’s accounts for the six months to 30 September are due in November. Until then – at least – I suspect the shares will remain volatile and apparently cheap.

I dislike investing in situations where there’s so much political and regulatory risk. But on balance, I think there’s a good chance the shares do offer value at current levels. If I was a died-in-the-wool value investor, I’d certainly do some more detailed research into RMG.