UK Mail - Is the super high yield sustainable?

I’ve written a lot lately about big cap, solid growth companies like Vodafone, BHP Billiton and MITIE, and I guess that some people who read this might think, “What sort of value investing is that?  Where are the obscure, the unloved and the unfashionable?”. I’m not sure I can stretch that far, but the next company under review is UK Mail (LON:UKM).  It’s no world leader or mega-growth story; in fact they’ve barely grown earnings per share in a decade.  They operate in a commodity market (where nobody has any pricing power) with barriers to entry that are relatively low and customers that don’t give a damn who they deal with. They are however, the leading independent, integrated postal group in the UK.  In plain-speak that means they deliver things like mail, parcels, packets and palletised goods either inside the UK or internationally, for next day or not.

So what’s so good about a zero growth company in a market so competitive it looks like a war zone?

The irresistible lure of a high dividend yield

The yield.  It’s all about the yield.  With a share price of around 200p and a dividend of 18p, the yield currently sits at almost 9%. Usually when a dividend yield is that high it means the odds of the dividend actually being paid are low.  That’s why it can be so dangerous to invest just on the basis of yield.  The dividend often gets cut or suspended and all you’ll have to show for your investment is some shares in a crummy business on the road to nowhere. On the flip-side, the benefits of a high dividend yield (if it actually gets paid) are obvious: You get a whacking great dollop of cash just for holding the shares.

This is really useful, especially in the longer term as you are realising returns all through the holding period.  This means you’re not as dependent on the share price (and therefore capital gains) to actually make you any money. The problem with being dependent on capital gains for all of your returns is that Mr Market is a fickle fellow; there’s no way of knowing how he’s going to value your holdings, regardless of how well the company actually does.  For example:

Scenario 1 – Company doubles in size, retains ‘no dividend’ policy and share price halves.  It’s possible and more likely than you’d think, especially if you overpaid to start with.

Scenario 2 – Company doubles in size and doubles the dividend.  That’s possible too and you’d almost certainly be in profit after a few years if you bought with a sensible starting yield.

For example, if the yield was 5p when you bought the shares at 100p you’ve got a 5% yield.  If the dividend goes up to 10p over the next 5 years you’ll have received around 35p in dividends.  With the new dividend of 10p the share price is unlikely to stay at the original 100p, let along drop by 35p to 65p, which would be required to negate your dividend profits.  At 65p the 10p dividend would be a yield of over 15%, which just isn’t going to happen in a sustainable business.

A high yield helps to support a minimum price for the shares

Most investors love a good dividend.  If the price falls the yield goes up and sucks in more buyers which, assuming the company is sound, will help to reduce further falls.  Of course the price can still fall off a cliff, but across a diversified portfolio of high yielders the downside protection may help you sleep easier (as will the cash rolling in while you sleep).

The search for a sustainable dividend

I don’t go looking for high yield shares first as that’s controlled by the price of the shares.  The first thing I look for is a quality company.  “A-ha!” you might say, “where is the quality in UK Mail if they have barely grown earnings in a decade?”. Good point, but sometimes I like to lower the growth bar and just look for companies that have stood their ground for a decade or more; in other words:

Look for a business which is not declining

This means I screen for companies that have at least the same revenue, earnings and dividends as they did 3, 5 and 10 years ago. UK Mail just about ticks those boxes. You’d be surprised at how many companies – especially in the current economic climate – haven’t kept revenues, earnings and dividends above where they were 3, 5 and 10 years ago.  Many companies don’t even have a 10 year history. By starting with just this minimalist standard of quality and durability I can say that any companies making it over the hurdle have been around a while and are at least not going down the pan.  Not exactly the glamour of 20% plus growth per annum; more like the dirty foot soldiers of capitalism, grinding out the results through grit and ingenuity. Check out Game Group.  In many ways they could be a good value investment and they’re yielding almost 20%.  Will it get paid?  Perhaps, but for the last three years revenue and earnings have been on the slide and the expectation (from the ‘experts’)  is currently that they’ll keep going down. Perhaps they can turn things around, but that’s not the sort of company I want in my portfolio.

Look for a company with low debt

There’s no point buying a high yield share if the company goes out of business 5 minutes later.  That’s why it’s important to check the company’s debt levels, the basics of which I covered in 5 Ways To Measure Debt. If the company has low debt and reasonable liquidity then the odds of it surviving whatever issues have caused the share price to drop are, in most cases, greatly increased.

A defensive industry can be a bonus

Another aspect to a company’s survival is the sort of business it’s in.  One problem for game group is that (without having looked into it too deeply) they sell computer games to kids.  If the kids haven’t got any money (because they’re NEETs, or because their pocket money dried up) then they can either just stop buying the games or more likely download the things from the internet for free – which I guess would be illegal. With UK Mail, it delivers mail, parcels, packets and palletised goods (and a few other things besides).  People aren’t going to stop sending mail because of the recession.  If anything they may send more parcels as they start buying everything on eBay.   The same goes for businesses; they can’t just stop posting things out because times are hard.  Well okay, they can to a small extent but so far UK Mail has offset any reduction in demand by shutting a depot or two.

Is a 9% yield ever sustainable?

I hope not. 

My assumption is that if the dividend is paid next year then by that time the share price will have appreciated such that the yield is back into ‘normal’ territory, i.e. 5% or so.  This requires a share price of around 350p which, somewhat handily, is what Investors Chronicle said was fair value back in 2010.  It’s also well below the 700p investors thought the shares were worth back in 2004. It’s my expectation that UK Mail’s market leading position as the low-cost provider of choice, the defensive nature of their industry, their low debts and their ability to keep growing revenue through innovative products (like iMail and their iPhone postcard app) will be enough to keep the dividend in place.  Only time will tell. I have added UK Mail to my model portfolio at 210p (therefore yielding 8.7% – down from 9% due to the bid/ask spread on this slightly illiquid small cap share) as well as my personal pension.