Royal Mail’s 7.2% dividend yield is now under threat

The outlook is changing rapidly for Royal Mail (LSE: RMG). The last time I covered the stock at the beginning of this month, it offered one of the highest dividend yields in the FTSE 250 with analysts projecting a yield of 7.6% this year and 8.3% for 2023 (the firm’s 2024 fiscal year).

The City has been rushing to downgrade its projections over the past couple of weeks.

Refinitiv analysts' estimates now have the company yielding 7.2% this year and 7.8% for the 2024 fiscal year. The stock price has barely moved since the beginning of the month so the lower yield figures reflect a downgrade in dividend expectations.

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And following the company’s latest trading update, it looks as though Royal Mail might even struggle to meet these forecasts.

Royal Mail’s profits are under threat

The company, which was booted out of the blue-chip FTSE 100 index at the end of June, is struggling with surging costs and a dropoff in demand. While parcel delivery volumes surged during the pandemic, generating a billion-pound windfall for the business in the 2021 and 2022 fiscal years, delivery volumes are now reverting to normal levels. At the same time, the group is having to grapple with soaring costs.

Royal Mail is far more exposed to rising costs than other companies as it has a large, unionised workforce. The organisation relies heavily on its 100,000+ employees to deliver the post everyday, and it needs to keep them onside. That means it’s going to have to raise wages as the cost of living increases.

The company has already offered a deal it says is worth “up to 5%” for most of its workers, but this has been rejected. The members of the Communication Workers Union (CWU) have now announced plans to go on strike over the pay offer. The union is holding out for what it calls a “dignified proper pay rise.”

What happens next really depends on what both parties decide to bring to the table.

However, it looks as if Royal Mail’s management is digging in and preparing for a fight. In a trading update published today, (the day after the CWU announced it was planning to strike) the company has warned that it will consider the separation of its two brands, GLS and Royal Mail if “significant operations change” is not achieved at its UK operations.

GLS is the name of the group’s international division, which has been a key growth driver over the past couple of years.

With the international arm booming, Royal Mail is now planning a re-brand. It’s planning to change the name of its holding company to International Distributions Services, which really shows the direction management is looking to take from here. The Royal Mail brand is not a sacred cow, and if it’s not making money, it’s not worth keeping. Management’s intention is to “have clearer financial separation with no cross subsidy.” If that does not scream breakup I don’t know what does.

The UK arm is now reportedly losing £1m a day as its modernisation plan has stalled and sales revert to the mean. Revenue in the three months to June fell 11.5%, leading to an adjusted operating loss of £92m. Revenue at GLS rose 7.8% and the division generated an operating profit of £94m.

Wage discussions will influence Royal Mail’s near-term outlook

The company’s outlook over the next year or two now really depends on its discussions with workers.

With its large unionised workforce, the group is very exposed to inflationary pressures. And in a highly competitive market, that puts the business at a disadvantage. Most of the firm’s competitors pay by the hour (or by the delivery) and the workers have few, if any, rights.

That’s not necessarily a good thing, but it does make it harder for Royal Mail to compete. If workers start striking, customers are going to move elsewhere, which could hit revenue and squeeze profit margins.

And the company is not really in a position to raise prices to offset higher wage bills. Competition is chipping away at prices and regulator Ofcom recently said that it would impose a cap on second-class stamp prices. Unlike other operators in the sector, Royal Mail is subject to more regulation as the UK’s universal service provider. The regulator is also setting “strict” annual delivery targets for the company.

All of the above does not give me much confidence in the group’s ability to weather the current economic storm.

Still, there are some reasons to be positive. Royal Mail has worked out a new deal with its managers to stop strike action that was planned later this week, showing the company is open to changes.

Further, it has the lowest carbon footprint per delivery of any business in the sector in the UK. It plans to push this lower still over the coming years, and has made significant investments in electric vehicles to that end. Management has also introduced barcoded stamps, parcel post boxes, parcel pickups and a new app to help customers pay for and send packages. All of these factors will work in the firm’s favour.

Nevertheless, it faces a huge uphill struggle to get through the current storm.

Rising shareholder returns are no comfort to investors

Royal Mail is facing an uncertain future. While the company's performance over the past two years is impressive, we need to remember that these numbers are backward-looking – they’re not going to tell us anything about the group’s potential over the next 12 to 24 months and beyond.

This is the main reason why I am worried about the outlook for the corporation’s dividend.

The way the City’s outlook for the company’s payout has changed since the beginning of the month illustrates the problem perfectly. The environment for the business is changing rapidly, and investors cannot take its future prospects for granted.

That’s why I’d take even the current figures with a pinch of salt. Royal Mail's growth potential may continue to deteriorate if costs continue to grow. With staff voting for strike action, an increase in costs seems almost guaranteed at this stage.

As such, I would approach Royal Mail’s 7.2% dividend yield with caution.