Royal Mail is a High Income Stock, says Jupiter

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Emma Wall: Hello, and welcome to Morningstar. I am Emma Wall and I am joined today by Alastair Gunn, manager of the Jupiter High Income Fund to give his three stock picks. Hi, Alastair.

Alastair Gunn: Hello. Wall: So, what's the first stock today? Gunn: The first stock is Royal Mail (RMG), and the reason I like Royal Mail is that dividends are big risk across the market generally and Royal Mail has a very strong looking balance sheet. It's got virtually no debt. It's got a big pension fund surplus today. It has a lot of surplus property on its balance sheet and the dividend is round about two times covered at the moment. On a cash basis, it's less covered than that at the moment, but that builds very rapidly over the next couple of years.

Wall: It was quite controversial stock when it listed, and there were sort of headlines that suggested that shareholders had perhaps being swindled because the price was so high. It was a national asset and we should have got more for it. Obviously, their share prices come down quite a lot since then. Do you think it's on fair value? Is it undervalued?

Gunn: No, I think it's very definitely undervalued at the moment, but when it was floated, it was floated with the seven-year regulatory framework and it was within that framework. It was going to be allowed guaranteed returns and the returns today are much lower than the allowable returns in the future and that was to allow for investment in automation and to live with the fact that there is universal service requirement.

Everybody in the country is entitled to a mail delivery service. And yet particularly in the more remote areas of the country that basically is a loss-making service.

So, you got to fund that some way. And what's happened recently is we had a regulatory review and that cost into some uncertainty whether the current framework will last or not.

Now, to my mind it will last. I think that will be cleared up later this year. And that means that we'll have a much securer future in terms of growth in earnings going forward. And the reason I think it's going to be unaffected is because now delivery costs in the U.K. are amongst the lowest in Europe, service standards are amongst the highest.

And if you are a regulator, what are you trying to do? You need to make sure that that universal service obligation can be delivered and only sort of two, three year ago before Royal Mail was privatised, it was on its knees financially. It was in danger of going bust.

So, in order to provide a viable future for Royal Mail, it has to have a framework similar to one that we have before and I think will be reconfirmed later this year. -