Is it time to pile into the Royal Mail share price?

The Royal Mail  (LSE: RMG) share price has plunged and the valuation looks low, so let’s explore the potential investment opportunity now.

I’ve been bearish on the letter and parcel delivery service provider for some time. And in an article published during March, I asked the question: “Is Royal Mail’s 10% dividend yield safe?”

Dividend carnage

My conclusion back then, and for a long time previously, was that the dividend yield was precarious. The business had been struggling because of declining demand in the letter business and fierce competition in the parcel business. It was obvious earnings only covered the dividend payment a little over once, which I described as “an uncomfortably low level.” My argument was that it would be sensible for management to “cut the forward dividend by around 50%.”

And so, it came to pass – well, almost. With the release of the full-year results report in May, the company revealed that it plans to rebase down the forward dividend for the current trading year onwards to “not less than” just 15p per share, down from 25p, and representing a cut of 40%.

The plan is to keep that minimum level for the dividend set until the trading year to March 2024, “regardless of [the] Group’s annual earnings or in-year trading cash flow.” Hmm, that’s a strange thing for the directors to say. Imagine running a corner shop like that. “I’m going to keep taking my spending money out of the business regardless of how much cash comes in from selling Mars Bars or whether I make any profits at all.” Sounds like a recipe for getting into financial trouble, to me.

In fairness, the directors went on to say in the report that they expect the rebased dividend to be covered by “cumulative trading cash flow over both three and five years.” Nevertheless, I think it’s nuts for any company to make dividend promises at all.

Fighting to turn the business around

Generally, I reckon shareholders are savvier than directors tend to give them credit for. My guess is that many holding the shares of companies on the stock market see themselves as part owners of the enterprise and would rather the directors base their dividend decisions on what’s right for the business over the long haul.

If cash inflow and earnings don’t support a dividend payment in any particular period, it seems unwise, to me, to pay money out in dividends because the payment will either likely drain cash reserves or add to borrowings. And it’s not as if Royal Mail occupies a comfortable trading niche allowing it to wallow in torrents of incoming cash flow. Instead, the firm is in full turnaround-mode, doing its best to cut costs, restructure, redesign its strategy, and generally do all it can to survive, let alone thrive, in what is a horrible, low-margin and stupidly competitive sector.

Indeed, Royal Mail’s valuation looks low with a forward-looking price-to-earnings ratio running close to just below nine for the current year on much-reduced earnings. But my goodness, the firm has earned its low valuation, and I continue to see the stock as risky. So I won’t be piling in, even if the share price starts to go up for a while.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Motley Fool UK 2019