Royal Mail shares have fallen by 17pc so far this year as competition increases and parcel volumes suffer a slowdown. Questor accepts the share price may be weak for the next 12 months but the long-term investor should focus on the growing dividends, strong cash flow and dominant market position of the UK postal service.
The shares are falling as the outlook for parcel delivery worsens. Parcels are the major growth opportunity for the group and generate much of the profits. In the final quarter of last year parcel growth slowed to 4pc, almost half the rate reported during the first nine months.
Rival UK Mail said it also expects the volume of parcels delivered to slow throughout the rest of the year when it updated on first quarter trading this week. Competition has also got tougher after Amazon, the largest parcel customer, started developing its own distribution network.
The parcel operation delivered revenue growth of 7pc during the full year, but volumes delivered were flat. Management expect to grow parcel revenue by more than 5pc a year, but analysts have trimmed the outlook for revenue growth to 4.8pc in light of the challenges.
Letter volumes are in structural decline and the market for Royal Mail just got tougher. Letter volumes are expected to fall between 4pc and 6pc a year, but stamp price increases that are inflation linked are offsetting this. Letter volumes fell by 4pc in the year ended March, which was at the top end of expectations and letter revenue only declined by 2pc to £4.62bn during the year.
The market got tougher when logistics group TNT opened up a new mail delivery service focused on West London. Royal Mail faces the prospect of fighting to keep its lucrative city delivery customers while still having to service the much less profitable countryside deliveries.
Royal Mail is fighting back. In May the company said it would trial a Sunday delivery service. This move also hints at the Communication Workers Union (CWU) being on side with changes that are needed to fight the competition.
The group is enjoying a solid performance in overseas delivery. Royal Mail’s overseas parcel delivery service General Logistics Systems (GLS), reported 7pc growth in revenues and operating profits during the full year.
That means the UK Parcel, International and Letters business, responsible for 82pc of revenue and three quarters of profits, is profitable and cash generative despite the challenges. The strong cash flow reduced net debts – total borrowings less cash – to £555m at the end of March, some £50m better than expected, and a sharp fall from £903m a year earlier.
Royal Mail position in UK parcels (based on revenue). Source: Royal Mail prospectus
Free cash flow is forecast to be about £250m in the year ended March 2015, rising to £300m two years later. Dividend payments are covered twice by adjusted earnings per share, and the 22p forecast dividend for the current year, which provides an income yield of 4.6pc, is forecast to increase by an average of 15pc during the next two years.
The shares currently trade on 13 times forecast earnings of 37p per share, falling to 11 times next year. That compares to European rival Deutsche Post DHL on 15 times forecast earnings falling to 14 times next year.
If parcel growth slows further ,Questor can envisage a double whammy on the earnings forecast and the rating. As an example if we take about 10pc, or 4p, off the earnings growth forecast to 33p, and apply a lower growth rating, or 12 times earnings, we get an estimated share price of about 400p.
Then there is the hidden value in the London Development property portfolio, which some have estimated could be worth between £600m to £1bn, or 60p to 100p per share. Royal Mail has a net assets value of £2.4bn, or 240p per share.
We have been consistent and clear on Royal Mail. Questor was an early supporter of the Royal Mail flotation. Back on September 27, we advised “Get in quick and buy Royal Mail” at 330p. The shares have since returned gains of more than 44pc. We still like the long-term strength of the business and the dividend income, with the shares offering a forecast yield of 4.5pc.
We downgraded the shares when they looked expensive last year (565p, Hold, November 28, 2013) and have maintained our position that they are a good long term income investment (519p, Hold, May 22, 2014).That advice remains, hold.
WHAT IS ROYAL MAIL?
Royal Mail has two main businesses UK Parcel, International and Letters (UKPIL), responsible for 82pc of revenue and employing 150,000 people and General Logistics Systems (GLS) responsible for 18pc of revenue.
UK Parcel, International and Letters (UKPIL)
UKPIL is split between letters, parcels and marketing mail. The letter industry is in structural decline with overall volumes falling between 4pc to 6pc every year. However, Royal Mail has a monopoly over letter delivery in the UK. This gives them pricing power and two years ago the company was freed from revenue controls and stamp price increases were allowed. Letter operations revenue declined by 2pc to £4.63bn on volumes down 4pc in the year to March 31.
Parcelforce is the Royal Mail’s branded parcel delivery company and it is providing exciting growth. Royal Mail with 53pc of UK parcels has a market leading position. The rise and rise of internet shopping is boosting home delivery. The Parcel operation increased revenue by 2pc to £7.79bn as it delivers more than 3 million parcels every day. However, this business does face stiff competition from the likes of DHL, Fedex, UK Mail and now Amazon.
Marketing mail operations are subdued due to a depressed advertising market. Marketing operations delivered a solid performance with stable revenue. However, any recovery in the advertising market will boost business here.
General Logistics Systems (GLS)
GLS operates as a parcel delivery operation across Europe. Competition in this region is tough and profit margins slipped to 6.5pc from 6.7pc in the year ended March 31. The division generates 16pc or £1.65bn of group revenue and around a quarter of operating profits.
