At first glance, the Royal Mail (LSE: RMG) share price looks like an excellent income investment. At the time of writing, the stock offers a prospective dividend yield of 6.4%, compared to the broader market average of 3.5%.
However, when you dig into the company’s prospects and cash flows, it looks as if this distribution is on shaky ground.
Falling earnings
Since 2016, Royal Mail’s net income has halved, falling from £325m in 2015 to £175m for 2019. City analysts are expecting this trend to continue for the next two years. Analysts have pencilled in a 55% decline in earnings for 2020 and 31% for 2021.
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Based on these projections, Royal Mail’s dividend cover looks set to fall from 1.4 times in its current fiscal year to under one by 2021. A dividend cover ratio of less than one implies that the company will not be earning enough money from its operations to cover the dividend. That’s a big red flag.
If Royal Mail does not have enough cash coming in from operations to meet its projected dividend, then the company will either have to sell assets or borrow money to meet the payout. The next option is a dividend cut.
That’s why I think investors would be better off avoiding the Royal Mail share price for the time being.
Cash cow
Instead of Royal Mail, I’d buy FTSE 250 income champion PayPoint (LSE: PAY). This year, PayPoint is expected to distribute 84p per share to investors in dividends, giving a yield of 8.3% on the current share price.
Its dividend is also uncovered by earnings per share, but there are two reasons why I believe this distribution is more secure than that of Royal Mail.
Firstly, the group’s balance sheet is much stronger. At the end of its 2019 financial year, PayPoint reported a net cash balance of £38m on its balance sheet, compared to Royal Mail’s net debt position of £320m.
Secondly, there is its cash generation. For fiscal 2019, the company generated £50m of free cash flow from operations, roughly covering its dividend to investors. To put it another way, after spending £11m on capital projects, the firm returned all excess cash to investors.
High quality
Another reason why I like PayPoint over Royal Mail is the fact that the company is what I like to call a high-quality business.
Over the past six years, the group has produced an average return on invested capital (a measure of profit for every £1 invested in the business) of 64%, compared to the market median of just 4%!
This number tells me that PayPoint is a highly profitable enterprise. As the company provides the vital service of payments processing for tens of thousands of businesses and customers around the world, I reckon this should continue for many years to come.
That’s why I’d buy this 8.3% yielder over Royal Mail any day.
