There are currently only a handful of stocks in the FTSE 250 that support dividend yields of 5% or more. One of these companies is Royal Mail (LSE: RMG). At the time of writing, shares in Royal Mail support a dividend yield of 7.8%, which looks highly attractive compared to the index’s average of 2.9%.
Many investors consider incredibly high dividend yields to be a sign of distress. Therefore, it’s often best to avoid companies with yields more than twice the market average. On this basis, Royal Mail looks to be in distress, but should investors really be worried?
One of the fastest ways to figure out if a dividend is sustainable is to look as cash flow. Dividends are paid out of cash resources. If a company isn’t generating enough free cash from operations to cover the payout, then it will either have to borrow money or cut the distribution.
In its last financial year covering the 12 months ending 31 March 2019, Royal Mail recorded operating cash flow from operations of £493m and capital spending for the year of £364m. That suggests total free cash flow for the year of £129m.
Unfortunately, the group’s total dividend distribution for the year amounted to £242m. This implies the company paid out more than it could afford in its last financial year. With this being the case, it’s no surprise management decided to cut the postal service’s distribution by 40% in May 2019.
This cut should have helped improve dividend sustainability, but there’s another problem. City analysts expect the company to report a 57% decline in earnings per share in its current financial year. A further reduction of 26% is expected for fiscal 2021.
If Royal Mail’s dividend looked unsustainable in its 2019 financial year, even a 50% dividend cut might not be enough to save the distribution if net income slumps as much as analysts are expecting over the next two years.
In the past, the company has been able to produce extra cash by cutting costs and selling off assets. However, it can’t continue to do this forever.
Royal Mail has always had a fractious relationship with its workforce. Therefore, further cost cuts to help shareholders, at the expense of employees, could only lead to further industrial action.
At the same time, group borrowing has increased as management has tried to fill the gap between cash coming in and cash flowing out of business. Net debt was £1.4bn at the end of the company’s last reported period. In fiscal 2016, net debt was just £244m.
We won’t know what management wants to do about Royal Mail’s dividend until the company announces is its full-year results in the middle of 2020. Still, considering all of the above, it seems highly probable the organisation will cut its dividend further.
As such, it looks as if the Royal Mail share price’s 7.7% dividend yield cannot be trusted.
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Rupert Hargreaves owns no 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.