Stockwatch: profits slide at Royal Mail – but what happens next?

by Edmond Jackson from interactive investor |

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Profits plunge but revenue rises at the postal institution. Can management change continue, and industrial action be avoided?

How should we interpret the rise in the share price of Royal Mail Group (LSE:RMG) versus its mixed interim first-half results yesterday?

Group revenue is up nearly 10%, but according to what costs you want to treat as exceptional the group has yet to definitively tip into profit. Pre-tax profits fell 90% to £17 million.

Yesterday, the price rose 10% to 312p in response, the chart suggesting an uptrend since August/September remains intact. By the close, however, the gain had eased to 3% at 296p as the mood turned more cautious generally, and today it has opened at 285p.  

The progress of coronavirus vaccines has turbocharged many stocks by 10% to 30% or more since Pfizer (NYSE:PFE) kicked off the good news from 9 November, but a difficult winter and huge logistical challenge lie ahead.  

Does Royal Mail merit a 300p support level currently? 

Perhaps this is the best way to figure if the rise is deserved or should be sold into. Barely two months have passed since I set out a “buy” case at 230p, saying that trade unions would more likely recognise sober realities during Covid-19 than engage another disruptive strike.

The interims cite voluntary redundancy costs of £147 million, with an annualised £130 million cost benefit from the next financial year to March 2022.

The company also continues to “target £200 million savings over two years in non-people costs and have a strong pipeline of initiatives with £70 million savings delivered to date”.

The near-term dilemma, however, is higher costs of handling more parcels until greater automated capacity is in place, as well as Covid-19 costs persisting into the 2021-22 year.  

Otherwise, if management can improve its operating margin from a measly 1.3% in a context of annual revenue projected to approaching £12 billion in the next two financial years, major opportunity exists to leverage profit.  

Obviously, this would require delicate industrial relations and adeptly managing the decline in letters versus growth in parcels.

When Royal Mail achieved a 3.5% operating margin in 2017 it generated normalised earnings per share (EPS) of around 57p, and free cash flow per share of 37p, which paid a 23p dividend.

It may be vague benchmarking in a mercurial revenue mix since then but implies a price-to-earnings (PE) ratio of exactly 5x and just over 8% yield at the current share price. 

So yes, the market is justified to anticipate scope for better reward when judging Royal Mail’s risk profile. It all depends whether management can deliver and unions allow profit/dividends recovery without disrupting it.  

Full-year revenue upgrade is the interims’ key upshot  

When I wrote in September, the broad sense of yesterday’s results was apparent in a trading update for the first five months of the financial year.

Parcels were doing better than expected, albeit the costs involved – of diverting handling capability from letters – had tempered a return to UK profitability 

Figures now show total revenue growth in the six months to 27 September at 10% to £5.7 billion, of which parcels represent 60% of this versus 47% like-for-like.

Domestic parcels leapt 51% and tracked parcels by 72%, like-for-like. A switch to online shopping helped, also collection/delivery of tens of millions of Covid-19 test kits and PPE items. Total letter volume fell 21%.  

GLS international parcels is a star performer: revenue up 22% - albeit described as “exceptional” - on a 9% margin, hence operating profit soaring 84% to £166 million. For the full year, 21% to 23% revenue growth is projected on an 8% margin.    

All things considered, it has meant a full-year group revenue upgrade from “75 million to £150 million higher” to “£380 million to £580 million higher”. The parcels element rose from 22% expected growth to 31%, with the group achieving adjusted operating profitability. Letters’ decline has mitigated slightly, from 17% to 16% down. 

Rising costs and charges have confused genuine profitability 

Manual sorting of more parcels has cost £95 million. There were £85 million costs linked to Covid-19 and £32 million extra international conveyance costs due to capacity shortages. Some of that could be regarded as exceptional during Covid-19, as could a £147 million voluntary redundancy charge affecting some 2,000 roles.  

If you want to “see through” to what the group can reasonably achieve, however, certain costs are required to get there.  

The interim results are not well presented in this regard, citing a reported operating loss of £20 million (encouraging, given a raft of what seem mostly exceptional costs) and in the headlines’ table at least, an adjusted operating profit of £37 million.

The release then goes to cite £147 million redundancy and £32 million international conveyance costs as contributing to a £129 million “adjusted” operating loss. Even if you respect the £37 million profit figure, it is down 78% like-for-like. 

An ongoing reduction in letter volumes meant this operation lost £180 million “and demonstrates the need for change in the Universal Service”. Time will tell what can be achieved. 

Where Royal Mail will be in a few years’ time, therefore, remains highly speculative: its extent of success with parcels as Covid-19 eases, versus letters’ liability. Yet letters have put it in a strong position as the UK’s leading delivery group. 

Royal Mail group - financial summary

year end 31 Mar 2014 2015 2016 2017 2018 2019 2020
               
Turnover (£ million) 9,357 9,328 9,251 9,776 10,172 10,581 10,840
Operating margin (%) 18.3 3.1 2.7 3.4 1.5 2.3 1.3
Operating profit (£m) 1,712 293 251 337 157 239 141
Net profit (£m) 1,277 325 241 272 259 175 161
IFRS3 earnings/share (p) 128 32.5 21.4 27.3 25.7 17.5 16.1
Normalised earnings/share (p) 54.7 57.3 74.6 56.5 86.1 47.2 29.7
Operating cashflow/share (p) 80.7 76.2 72.4 75.7 90.0 49.3 95.1
Capital expenditure/share (p) 41.0 42.0 45.9 38.8 35.8 36.4 34.2
Free cashflow/share (p) 39.7 34.2 26.5 36.8 54.2 12.9 60.9
Dividend/share (p) 13.3 21.0 22.1 23.0 24.0 25.0 7.5
Covered by earnings (x) 9.6 1.6 1.0 1.2 1.1 0.7 2.2
Net Debt (£m) 575 295 244 358 6.0 320 1,153
Net assets per share (p) 253 399 446 500 444 462 563

Source: historic Company REFS and company accounts

‘We need to speed up the pace of change’ 

Management layers are being reduced and activities prioritised that generate quicker payback. Capital expenditure in support of marketing and efficiency is said to aid revenue growth and generate £330 million of operational cost savings. Capital expenditure is, however, reducing this year and next.  

Parcel automation seems a modest 30%, although a hub in the North West is due to come into operation next January and a Midlands hub scheduled to complete in 2023, with capacity to process more than a million parcels a day. 

Stockbrokers appear to be swallowing this carrot: the consensus of those analysts was already for a current year anticipated net loss of around £90 million, to become a £200 million profit for normalised EPS around 16p.

That implies a forward PE near 20x, but is justified if the group has turned the corner, in context of annual revenues already set to be more than £11 billion. 

Industrial relations appear more positive 

Another key upshot is progress in talks with the Communication Workers Union (CWU), which have recently intensified. The company said: “With the improved revenue performance, we have focused on how we can deliver efficiency and productivity in a growth environment that will enable the business to see benefits of operational leverage.” 

The CWU tweeted yesterday to re-iterate this theme of progress, but also that “on the basis of the company’s half yearly results, we now anticipate an improved offer on pay”.

Time will tell whether this is a potential stumbling block or braggadocio by the union to justify its existence.  

Some investors might say dividend yields are higher risk where the workforce is well-unionised.  

Interim balance sheet ought to mitigate downside risk 

Net debt is declared cut 27% to just over £1 billion, and the cash flow statement does show a £700 million repayment.

Within the balance sheet however, “debt” includes £949 million lease liabilities, given there is £1.1 billion cash and £957 million long-term bank debt and some derivatives’ liabilities. 

The £3 billion of assets constitute property, plant and equipment and there are quite modest £925 million goodwill/intangibles.  

Note also a £3 billion pension fund surplus, whose £59 million net interest can be seen as ensuring £17 million reported pre-tax profit, down from £173 million.  

Net tangible assets per share work out at 391p, hence despite no yield currently. There is downside protection. 

A complex risk/reward profile

It is tricky to estimate, especially quantify, the “reward” element here, which demands faith that management can continue advancing change and workers will co-operate.

As Covid-19 drags on, they may be less likely to rock the boat. I adjust my stance from “buy”, albeit more after its sudden price rise than intrinsic downgrading. 

If a perceived satisfactory Brexit trade deal is secured, Royal Mail would be a domestic stock likely to benefit, in which scenario rates a fresh “buy”. 

All things considered: “Hold”. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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