This FTSE 100 stock is cheap – but can it deliver in a post-Covid environment, asks our companies analyst.
What to make of the conundrum that is Royal Mail (LSE:RMG) Group?
Its FTSE 100 stock plunged 35% in value from 527p in mid-January to 340p on 7 March; and the fact that it fell below 400p in February means the drop was not chiefly the market reacting to war in Ukraine.
This was despite a resilient Christmas period update on 25 January, tinged only by a restructuring charge to streamline management.
Currently, it has recovered 8% to around 360p, in line with the wider market. If consensus forecasts are fair, this implies a 12-month forward price/earnings (PE) ratio of just over 6x and a yield of more than 6.5% covered up to 2.5x by projected earnings.
Moreover, the historic table shows earnings are well-backed by free cash flow, making the business conducive to shareholder returns.
The stock appears cheap, and therefore due for mean reversion upward: for example, a recovery to 500p seen late in January would imply a seemingly fairer yield of 5.5% based on a circa 28p dividend.
That is unless you believe that the 30%-plus increase in parcel volumes over the last two years will abate now that Covid lockdowns seem to be a thing of the past, and especially if there is a recession. Royal Mail does face quite stiff competition in parcels and the number of letters posted is in steady decline.
A wide dispersion of market views
Among bank/broker analysts: Barclays has just recently targeted 640p with an ‘overweight’ rating; Peel Hunt is on ‘buy’ with a 625p target; and Berenberg has re-iterated ‘buy' targeting 650p. Others are similarly bullish and 650p implies a 10.8x PE based on consensus for earnings per share (EPS) around 60p; also, a circa 4.3% yield. If the forecasts are fair, this target hardly seems a stretch.
Credit Suisse is a contrarian, however, this month cutting its stance from ‘neutral’ to ‘underperform’ and its target to 345p.
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The short position – sellers of borrowed stock over the 0.5% threshold for disclosure – has this year risen from zero to around 3.4% of Royal Mail equity. Blackrock, GLG Partners, Citadel Partners and Marshall Wace are involved, although the latter two have now slightly trimmed their shorts. While this can be seen as an amber light, it helps explain stock weakness.
Ironically, Blackrock is also a disclosed holder making some odd shifts: raising its stake from sub-5% to near 5.2% on 4 March, then dropping to 4.1% on 8 March. Given it is one of the world’s largest investment groups, its various fund managers could simply have differing views.
It appears short sellers have taken a medium-term view, given the fact that from early last January there was a definite shift from ‘growth’ to ‘value’ stocks. Moreover, after the 18 November interims, the stock actually rose from around 425p to over 490p, so it was not as if the verdict on Royal Mail’s last full commercial disclosure was negative.
The 25 January “transformation and trading update” affirmed in-line trading. An operating profit downgrade to around £430 million reflected a £70 million restructuring charge that sceptics could say is a genuine cost, but there was nothing adverse as regards the business.
Resilience in parcels has supported healthy cash flow
In the March 2021 financial year, revenue from parcels rose 39% to represent 72% of group revenue; however, a 13% decline in letters revenue trimmed the group advance to 17%.
At the interim 2022 stage, group revenue rose 7%, although Covid has confused precise like-for-like comparisons in the last two years. Management cited a structural shift in parcels, with UK volumes down 4% but GLS (Royal Mail’s international operation) up 8%.
This, together with cost measures, meant a £404 million interim adjusted operating profit –up from £37 million – and £298 million operating cash flow, despite higher capital expenditure.
Besides a 6.7p interim dividend, £200 million is currently being returned via share buybacks, and there was also a 20p special dividend. Consensus is for a circa 29p total dividend in respect of the year to 28 March 2022.
Despite this strong ‘special’ element, I doubt that management would have ramped up returns at the interim stage if they were at all tentative about cash flow.
Moreover, they “believe that both Royal Mail and GLS will be able to fund their investment pipelines from future cash flows”.
With an improving group revenue profile absorbing a circa 20% decline in letter volumes, the interim numbers and narrative thus came across as a modest inflection point for the business.
Royal Mail - financial summary
year end 31 Mar
|Turnover (£ million)||9,357||9,328||9,251||9,776||10,172||10,581||10,840||12,638|
|Operating margin (%)||18.3||3.1||2.7||3.4||1.5||2.3||1.3||5.8|
|Operating profit (£m)||1,712||293||251||337||157||239||141||728|
|Net profit (£m)||1,277||325||241||272||259||175||161||620|
|IFRS3 earnings/share (p)||128||32.5||21.4||27.3||25.7||17.5||16.1||61.8|
|Normalised earnings/share (p)||54.7||57.3||74.6||56.5||86.1||47.2||29.7||57.4|
|Operating cashflow/share (p)||80.7||76.2||72.4||75.7||90.0||49.3||95.1||117|
|Capital expenditure/share (p)||41.0||42.0||45.9||38.8||35.8||36.4||34.2||34.5|
|Free cashflow/share (p)||39.7||34.2||26.5||36.8||54.2||12.9||60.9||82.4|
|Covered by earnings (x)||9.6||1.6||1.0||1.2||1.1||0.7||2.2||6.2|
|Net Debt (£m)||575||295||244||358||6.0||320||1,153||478|
|Net assets per share (p)||253||399||446||500||444||462||563||481|
Source: historic company REFS and company accounts
£500 million profit in the March 2022 year still good progress
While down on £702 million achieved in the exceptional year of 2021, it is a re-rating on the circa £150 million to £350 million range over 2015 to 2020 (see table).
Sceptics might say that Royal Mail’s recent third quarter benefited, as it had at the end of the March 2021 year, from Covid testing kits being sent out (this time after Omicron struck). Yet the latest update cited test kits as constituting only a mid-single digit percentage of parcel volumes over nine months.
Despite upward cost pressures, a respectable 8% operating margin was guided for. Returns on equity/total capital improved from mid-single-digit to double-digit percentages in the 2021 year and the consensus is looking for mid-teens going forward.
Obviously, elevated fuel prices will bring fresh challenges for delivery costs, but these are faced by the entire industry.
The chief risk appears to be a stagflation scenario worsening to recession, as a knock-on from war. Competition from likes of DPD, Hermes and Yodel might require compromises on Royal Mail’s margin.
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Additionally, there is always a chance that the unionised workforce pitches for a keen wage demand as inflation rises, although it has also recently shown realism towards modernisation changes.
A dilemma for cyclical comparisons is the lack of data to cover Royal Mail’s performance in a recession.
Looking back to its October 2013 flotation prospectus, consolidated income statements only covered 2011 to 2013, showing a linear trend in normalised operating profit from £210 million to £635 million. We really need to see the dynamics from 2007.
Net debt including leases is around 40% of net assets and the net interim finance charge was covered 12x by operating profit. Rising interest rates could affect this, but the group does not look exposed.
The long-term chart offers no real clues
The chart is not clear as to whether the recent fall may go further or has reached trend-level relative to the April 2020 low near 130p.
In November 2019 I thought it best to avoid at 220p due to strike threats, then in September 2020 I shifted stance to ‘buy’ at 230p on the basis that the unionised workers would compromise on achieving cost reductions.
That worked out in the short term, with the stock testing 570p in June 2021; however, the trend has since been a volatile downtrend.
In the news recently was a 10p rise in the price of first-class stamps to 95p, with second-class up by 2p to 68p. Given a 60% decline in letters since 2004 and a 20% drop-off since the start of the pandemic, perhaps some investors see this as a bad sign.
But I think letters are less relevant to the investment stance than parcels. If you think the UK can escape recession, buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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