The Royal Mail (LSE: RMG) share price fell below its 2013 flotation price of 330p on Thursday, after investors took a dim view of the group’s half-year results.
The postal operator’s shares fell by 5% after the firm reported a 7% fall in letter volumes during the six months to 23 September. Although parcel volumes rose by 6% over the same period, this wasn’t enough to prevent the company’s underlying operating profit falling by 25% to £242m.
There was also mixed news from the group’s GLS international parcel business, which owns Parcelforce. Although revenue from this division rose by 9%, driver shortages and other cost pressures pushed profit margins down from 7.5% to just 5.7%.
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Despite these headwinds, chief executive Rico Back has left the group’s guidance for full-year underlying operating profit of £500m-£550m unchanged. The interim dividend will also rise by 4% to 8p, in line with previous years’ growth.
Dividend looks under pressure
Ahead of today’s half-year results, analysts’ forecasts suggested that Royal Mail would generate adjusted earnings of 28.3p per share this year. A full-year dividend of 24.7p is expected, giving earnings cover of just 1.2x.
These figures indicate that the company expects to pay out about 87% of its accounting profits in the form of dividends. That’s uncomfortably high, in my view. I’d normally look for a figure of less than 70% for a mature business like this.
Still generating cash
One of Royal Mail’s strengths since its flotation has been its strong cash generation. This has allowed the business to keep debt levels low despite heavy spending on modernisation and generous dividends.
My sums show that free cash flow over the last 12 months was £375m, excluding acquisitions. This is still enough to cover the £240m dividend bill, but it’s substantially less than the £596m of surplus cash generated by the firm last year.
The main reason for the drop in free cash flow was a £101m payout relating to the back-dated pay award received by Royal Mail staff earlier this year. I expect cash flow to improve during the second half, but this is an area I’ll be watching closely.
What needs to change?
Mr Back said today that he’s planning a rethink on strategy. Information about the firm’s “direction for the next five years” will be shared with investors in March. However, I think that two recent management changes give us some clues about the problems faced by Royal Mail.
The head of the UK post and parcels business, Sue Whalley, has now left the business after 12 years’ service. Mr Back plans to take over Ms Whalley’s role himself, but he’s appointed a new deputy chairman to the board to help him. Keith Williams was the executive chairman of British Airways until 2016, so he has extensive experience of industrial relations.
These changes suggest to me that Mr Back believes much greater changes to staffing and working practices will be required to manage the continued decline of letter volumes. Persuading the group’s unionised workforce to accept such changes is unlikely to be easy.
Could the shares hit 300p?
At current levels, Royal Mail shares trade on about 12 times forecast earnings, with a 7% dividend yield. If profits continue to fall, I think the shares could have further to slide.
In my view there’s a real risk the stock could hit 300p before any recovery gets under way.
