Are National Grid and Royal Mail shares top buys for income?

National Grid and Royal Mail recently increased their dividends, but saw their share prices fall… There are trade-offs between dividend yield and payout sustainability!

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Recent results from National Grid (LSE: NG) and Royal Mail (LSE: RMG) were released on a bad day for global stock markets. The UK’s FTSE 100 index, for example, fell 1.8%.
 
National Grid, which had made an all-time high the previous day, dropped 3.1%. Royal Mail fared worse, crashing 12.4%, making it the Footsie’s biggest faller.
 
However, both companies declared dividends in line with market expectations. Could they be top income buys for me today?

Social compact

As a starting point, it’s worth mentioning that for many years the assets and operations of both businesses — and a number of others — were considered so important to the UK that it was thought best they be ‘owned by the nation’.
 
Today, they’re owned by shareholders, and there’s an implicit social compact. In return for investing in the assets and operational efficiency of former state-owned infrastructure, regulators allow a company to make reasonable returns.
 
On paper, this should lead to resilient and predictable cash flows for the company, and sustainable dividends for its shareholders.

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Regulated and reliable

Most of National Grid’s businesses, in the transmission and distribution of energy in the UK and north-east US, are regulated. The company is currently pivoting to an increased focus on electricity infrastructure to help move to a greener, net zero world.

Asset sales and acquisitions, and a massive five-year £30bn-£35bn investment programme, are in progress. Management is also targeting £400m cost efficiencies by March 2024 to help deliver supply at the lowest possible cost to customers.

The firm reported good headway on all fronts in its latest results, and its numbers were in line with market expectations. A sign of confidence in the long-term cash-generating capacity of the business is that the group has multiple lenders, and that maturities on some its borrowings extend as far out as the 2080s.

Structurally challenged

Royal Mail is the UK’s Designated Universal Service Provider. It’s required to deliver a one-price-goes-anywhere service on a range of letters and parcels to any location within the UK.
 
However, the letters market is in structural decline, due to increasing digital communication. Offsetting this is parcels. Royal Mail has a lot of competition — both domestically and in its expanding international network across Europe and the US — but the overall parcel market’s growing, thanks to the rise in online shopping.
 
Unfortunately, while the company’s latest dividend was in line with market expectations, its profit wasn’t, because cost savings fell short of target. Management also highlighted challenges ahead. Namely, the weakening economy, growing inflationary pressures, and pay negotiations with the Communication Workers Union.
 
The company’s net debt more than doubled over the course of last year, and the longest maturity on its borrowings is 2026.

Contrasting dividend records

National Grid has a long record of annual dividend increases. For its latest financial year, ended 31 March, it declared a dividend of 50.97p. This was a 3.7% increase, consistent with its policy of raising the dividend in line with the increase in the year’s average UK CPIH inflation.
 
Royal Mail’s dividend record is less robust. For its 2018/19 year, the firm paid a 25p dividend. However, it announced it intended to ‘rebase’ the dividend to 15p the following year. It said it needed to make additional investment in its UK business, and that it expected lower cash generation in the early years of the plan. However, the dividend was suspended altogether when the pandemic struck.
 
Payments have now resumed. The board declared a dividend of 20p in its results for the year ended 31 March. It also paid a special dividend of 20p during the year. This was recompense for the absence of distributions during the pandemic, and the board isn’t proposing any further special dividends.

Trade-offs

On the back of the results, National Grid’s running dividend yield was 4.2% and Royal Mail’s was 6.7%. The difference in the yields suggests the market sees National Grid’s dividend as likely to be more reliable than Royal Mail’s.

On the one hand — while always remembering no dividend is guaranteed — National Grid’s record of growth could make it a top buy for income. On the other, if the market’s concerns about the sustainability of high-yield Royal Mail’s payouts prove unfounded, it could be a more lucrative income buy.

In practice, a well-diversified income portfolio — avoiding an over-reliance on just a few companies — will inevitably contain a range of trade-offs between a higher yield and a higher level of confidence in the sustainability of the dividend.

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G A Chester has no position in any of the shares 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.

Should you invest the value of your investment may rise or fall and your Capital is at Risk. Before investing your individual circumstances should be considered, so you should consider taking independent financial advice.

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