RM - Trading enviroment remains challenging

[RobertT]

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Royal Mail's first quarter results show a broad continuation of the trends reported last year with a solid performance from UK Letters and European parcels, offset by competitive pressures in UK Parcels. Overall, group revenue was flat as a 2% decline in UK Parcels, International and Letters (UKPIL) was offset by a better than expected performance from the European parcels business (GLS). The full year outlook remains unchanged, with the shares down slightly in early morning trading.

Our view:
Royal Mail shares have been volatile since their IPO. Having almost doubled from their initial launch price of £3.30, the shares fell to around £3.90 in the second half of 2014. In recent months they've staged something of a recovery, but still remain well below their peak.

This volatility has stemmed from concerns over intensifying competition, which has seen growth in the UK Parcels business stall. Amazon's entry into the UK delivery market reduced Royal Mail's addressable market by about 3%. The demise of competitor City Link, in late December, illustrates how fiercely competitive the UK parcel market is, and Royal Mail expects conditions to remain challenging.

The outlook for the UK Letters business may be improving. Rival Whistl (was TNT) has announced it is suspending its 'end-to-end' delivery service, and has commenced an "extensive review" of its feasibility. Royal Mail had previously warned that growing competition from direct delivery operators such as Whistl could reduce its revenue by over £200m in 2017-18. The issue has not gone away (the regulator is still keen to promote competition and is currently reviewing access pricing), but this is clearly a welcome development for Royal Mail.

The European parcels business continues to perform well and the group appears to be making good progress with its cost saving initiatives. Having spent so long in public hands there is little doubt efficiency savings are there for the taking, which could help drive margins higher. Cash generation is also strong; property disposals from the large London property portfolio contributed £100 million of net cash flow in FY15 and further disposals are likely over the coming years.

Those strong cash flows enable Royal Mail to pay healthy dividends, underpinning a prospective yield of 4.2% (variable and not guaranteed). Following today's 5% rise, the group has said it remains committed to growing the dividend.

If Royal Mail can succeed in reducing its operating costs and improve the growth rate for the parcels business, then future dividend growth prospects ought to be encouraging, given the strong cash flows already being generated.

Key highlights:
UK Parcel volumes and revenue increased by 3% and 2%, respectively, against weak comparatives. Royal Mail had some success in targeting new sectors and also benefitted from longer network opening hours, but the pricing environment remains very competitive, particularly for Parcelforce Worldwide and export parcels.
Addressed letter volumes declined by 5% (excluding the impact of election mailings), within the group's forecast range of 4-6% declines per annum. Total letter revenue was down 4%, as letter price increases in January and March were partially offset by declines in higher Average Unit Revenue products.
The European parcels business, GLS (almost a fifth of group revenues), continued to perform well with volumes and revenues increasing by 9% and 8%, respectively. Royal Mail continues to expect margins for this division to decline by around 50-100 basis points this year due to changes in German minimum wage legislation.

Outlook:
Royals Mail's outlook and guidance remain unchanged from that reported at the full year stage. Back then it guided for volume growth in the parcels market of around 1-2 per cent in the short term, reflecting the impact of Amazon using its own delivery network more. UK addressed letter market volumes are expected to decline by 4-6 per cent per annum in the medium term. The group continues to target flat or better UKPIL underlying costs for 2015-16.

Moya Greene, Chief Executive Officer of Royal Mail commented:
"In the first three months of our financial year we have seen a continuation of the overall market trends we saw last year. We have benefitted from the parcel initiatives that took effect in the second half of last year and a good performance from GLS. Our trading environment remains challenging and we are stepping up the pace of change to drive efficiency, growth and innovation, while maintaining a tight focus on costs."