Royal Mail (LSE: RMG) recently suffered the ignominy of being relegated from the FTSE 100 after its share price shrank more than 25% in the past year alone. But with the value of its shares now hovering only slightly above their IPO price, the company’s dividend yield is up to a whopping 6% and is still covered 1.9 times by earnings. So is Royal Mail an unbeatable option for income investors at its current valuation of 10 times earnings?
Well, the problems the company faces are very real. First up is the steady decline in letter usage that is almost assuredly going to continue indefinitely. In fiscal year 2017 letter volumes shrank 6% year-on-year (y/y) and revenue fell 5% to £4.3bn.
However, the company is making up for the decline in letter usage by shifting resources into parcel shipping and this business is booming thanks to e-commerce. Last year, parcel revenue rose 3% y/y to £3.3bn in the UK and European operations recorded a 9% y/y revenue uplift to £2.5bn. While this is a fiercely competitive market, even if the company only grows sales slightly ahead of the market it will be hugely beneficial for the bottom line.
Management is also in the midst of a dramatic transformation programme that involves trimming operating costs, investing in more efficient sorting facilities and selling off high-priced London real estate that isn’t being fully used. The positive effects of this programme are now beginning to pay off with earnings per share last year rising to 27.5p from 21.5p and cash flow rising substantially.
That said, prospective investors should be cautious right now as the company is embroiled in a fierce fight with unions over phasing out its current defined benefit pension scheme. From an investor perspective this makes sense as management expects costs related to funding annual pension payments to rise from £400m to over £1bn in the coming years. But with the workers’ union threatening a strike, I’d wait to invest in Royal Mail until both sides come to an agreement and its financial effects are made public.
A falling knife to catch?
Another high-yield stock that’s been battered recently is replacement window and door manufacturer Safestyle (LSE: SFE), whose share price is off by over 25% in the past year. This has been caused by a couple of profit warnings due to falling consumer demand across the industry earlier this year.
However, this problem hasn’t affected its ability to pay out a dividend that analysts expect to yield 6.6% this year. In fact, although H1 earnings per share fell 11.7% to 8.3p, this still safely covered the interim dividend of 3.75p. And with operations still generating impressive cash flow and net cash of £17.7m on the balance sheet, the full-year dividend in the 11p range should be very safe indeed.
This industry-wide downturn is also a blessing in disguise for Safestyle. The company has a major leg up over competitors from owning its factory, which significantly lowers costs and lead times for getting new products to market. This means it can sacrifice on pricing and temporarily reduce margins to take market share from competitors, something it has done very successfully before. Safestyle isn’t without risks but its healthy yield, bundles of cash and attractive valuation of 11 times forward earnings has me very interested.
But if Safestyle is too expensive for your taste, I recommend checking out the Motley Fool’s free report on one Top Small Cap trading at under eight times forward earnings. This bargain valuation doesn’t mean low growth though, as management has increased earnings by double-digits four years in a row.
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Ian Pierce has no position in any of the shares mentioned. The Motley Fool UK has recommended Safestyle UK. 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.