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Liberum thinks Royal Mail will unlikely be able to sustain its current dividend policy due to poor cover, profits and cash flow as well as limited earnings visibility
Royal Mail Group PLC (LON:RMG) took the market by surprise with a 4% hike to the interim dividend in a bid to lift investors’ spirits after a disappointing financial performance.
But shares have fallen 6.8% to 324p in morning as investors appeared to shrug off the bigger payout and instead pour over a weak set of first-half numbers and the absence of a fresh strategy that was expected to be released by new boss Rico Back.
READ: Royal Mail shares drop as it posts slump in profits and makes investors wait for new strategy
Back, who has been chief executive since June, said he would announce his strategy for the next five years at the company’s capital markets day in March.
“A hike in the first-half dividend is something of a surprise at Royal Mail and looks like a sop from the delivery firm’s newly installed management to keep investors on side while they await a big strategy announcement in March 2019,” said AJ Bell investment director Russ Mould.
The dividend was raised to 8.0p from 7.7p last year despite profits slumping, debt rising and significant cash outflow.
Dividend policy 'unsustainable', says Liberum
The increase in the dividend was in line with the company’s policy, which analysts at Liberum see as “unsustainable”.
“We view the current dividend rate and policy as unsustainable, given poor cover and earnings and cash flow, and inappropriate in light of limited earnings visibility and the lack of long-term earnings growth,” they said.
“Our recommendation remains ‘sell’, with a discounted cash flow-based target price of 250p.”
Profits more than halved to £33mln in the six months to September 23 after the postal operator failed to cut costs as quickly as hoped due to poor UK productivity.
Revenue edged up 1% to £4.9bn as growth in parcel volumes offset another decline in letters.
Debt rose to £470mln from £382mln last year while the cash outflow was £308mln.
Royal Mail had pre-warmed investors about missing its cost savings target and declining letter volumes in a trading update last month.
Poor UK productivity impedes cost savings target
It said full-year adjusted operating profit before transformation costs would be in the range of £500mln and £550mln, well below the £694mln posted last year, and cut its cost avoidance target to £100mln from £230mln.
The group had hoped that an agreement reached with the Communication Workers Union over pensions, pay and working conditions in January would improve productivity but this was not the case in the first half.
UK productivity fell 0.2% over the period and is now expected to be “significantly below” the company’s original full-year estimate, which was towards the upper end of 2% to 3% growth.
“The new agreement with employees, reached earlier this year, avoided industrial action, but it’s proving difficult to deliver the improved working conditions and cost savings at the same time,” said Nicholas Hyett, equity analyst at Hargreaves Lansdown.
“That’s no great surprise, and it’s only likely to become more difficult from here. An organisational restructure looks like it’s on the cards as the group tries to get back on track and, while we’ll have to wait for next year’s strategy day to get the details, that kind of thing is expensive and risky.”
Labour cost pressures and tough competition weigh on parcels
The group’s European parcels business Global Logistics Systems (GLS) was also hit by higher labour costs, dragging the division’s profit margin lower in the first half.
Royal Mail said it would raise prices and review discretionary spending to offset the labour market cost pressures, which are not expected to ease in the short term.
The company also acknowledged that the competition for parcels is tough as rivals like Amazon, DPD and Hermes continue to expand their delivery networks. That means it will become harder for Royal Mail to improve margins and grow volumes enough to mitigate ongoing weakness in the letters business, which has been hit by the internet age and less marketing mail following the introduction of General Data Protection Regulation (GDPR) rules.
“For the new management, the task is still a tough one and the industry continues to face many challenges,” said Helal Miah, investment research analyst at The Share Centre.
“Competition within the delivery business is getting ever more intense while Royal Mail, unlike its rivals will still be distracted by having to deliver letters even though this is a slowly dwindling market. We take a cautious view on the stock and can still only recommend a ‘hold’ at best for investors seeking a balanced return and willing to accept a medium level of risk.”