Edmond Jackson's Stockwatch: Is Royal Mail's growth prospect limited?

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After controversy over whether shares in the UK postal service operator Royal Mail Group were sold too cheaply last October, financial results for the year to end-March 2014 now help to judge their intrinsic value.

At 527p the FTSE 100 shares trade at a near 60% premium to their 330p offer price. In the New Year, Royal Mail effused as high as 617p, turning volatile briefly in a 560p to 605p range, then dropped from 560p to below 500p in April amid concerns the regulator Ofcom may get tougher on Royal Mail in regards to access rights for direct delivery.

TNT Post UK lodged a complaint and investors suspect it may take Ofcom a good while to deal with the issue; meanwhile it has called on Royal Mail to improve efficiency. The resulting uncertainty has meant more share price volatility, to an extent the forecast dividend yield of about 4% seems quite irrelevant versus the changing market value. Bluntly, the possibility of a 4% payout a year hence, isn't really a prop.

Royal Mail plunged by nearly 10% after its prelims as the outlook statement adopted a theme of "increasing challenges" with more intense competition in parcels and letters. Direct delivery is having "an adverse financial impact" and "without timely regulatory action, could undermine the economics of our universal service and our ability to generate sustainably a 5 to 10% earnings before interest and tax (EBIT) margin in our reported business."

This was a sharp dose of reality versus the bullish case for Royal Mail made by Barclays (a co-leader of the flotation).

The bank argued that its status as provider of a universal postal service should ease regulatory constraints.

Fair enough on a separate point: That taxpayers' picking up the bulk of the group's pension liability had helped clean up the balance sheet.

Another aspect of uncertainty is widely differing interpretations of (trends in) earnings per share (EPS), just when this is becoming a crux for valuation. Moreover, the board has made clear that dividend growth will be commensurate with earnings.

Increased competition

While Company REFS has just published "normalised" EPS of 149p for the year to end-March 2014, the results release highlighted EPS of 23.3p excluding specific items, which is up 25.2% on such a normalised basis.

Adding more variety the brokers' consensus entertains 42.4p for the current financial year and 48.8p in 2015/16, which if a realistic measure would see the price/earnings multiple reduce from 12.4 to below 11 times. But the company's highlighted view of EPS implies a multiple of 20 times which looks high considering the underlying business dynamics.

In the last financial year, parcel revenue has increased 7% to £7.79 billion due to higher size-based pricing while volumes were flat. Royal Mail is the market leader but recognises it needs to do more in certain segments as competition and capacity increases - which potentially caps scope for margin improvement.

Strikes must be avoided otherwise customers will be prompted to switch. New initiatives include the Sunday opening of selective delivery offices, Sunday parcel deliveries within the M25 and Parcelforce will launch Sunday deliveries for online shoppers.

Encouragingly there has been a 7% revenue rise at General Logistics Systems a pan-European parcels business, which at £1.65 billion represents 17.5% of group revenue. This is worth watching but it remains to be seen what extent of growth parcels can provide as a result of online shopping - the growth carrot held out at flotation.

"One to watch"

Letter revenue including marketing mail has slipped 2% to £4.62 billion while a 4% decline in addressed letter volumes was at the "better" end of a 4-6% range anticipated. I have added to the table, higher revenue growth from recent years. Additionally the group operating margin has slipped from 4.4% to 4.2%.

Such an operations profile, with investment needs reducing and free cash flow up 19.2% to £393 million, makes Royal Mail look more like an income share with limited growth prospects albeit useful cash distributions. But Royal Mail's price has traded too high to offer an attractive dividend yield, even assuming earnings cover of about two times.

On this interpretation the likely outcome is a share price of 450p or lower, where a yield of 5% compensates for risks to growth, with Royal Mail becoming less volatile once more stable income investors dominate the register. Royal Mail is therefore "one to watch" as a potential yield play, waiting for the shareholder base to settle down as growth investors exit.

Such a reading of Royal Mail also explains why investment banks leading the flotation sold the business at a "knock-down" price to build in a margin of safety to ensure a successful float.

The current example of Saga which is drifting from its 185p pricing (even at the lower end of a range) shows how investors can get spooked when a new issue doesn't start trading well; although Saga's prospective yield is only 2-3% whereas Royal Mail's was near 7% at the 330p flotation price.

Despite crowd sentiment affecting popular flotations, the status change in price appears significantly influenced by what dividend yield is appropriate to compensate shareholders for holding risks. You have to assume that forecasts supporting Royal Mail's annual payouts of over 20p a share are fair, although the market may want a better implied yield than 4% now risks are perceive as rising. Until Royal Mail proves its earning power the share price may therefore edge lower to enhance yield.

For more information see royalmailgroup.com/investor-centre.