Royal Mail shares: why this analyst remains bullish

With their traditional market in decline, adapting to change is vital for the UK postie.

Posties and the investors left out of pocket by the Royal Mail (LSE:RMG) IPO in 2013 have been sent a message that the delivery firm's recent share price recovery may have further to go.

This week's note from UBS focuses on the opportunities for the group's parcel operations to capitalise on the reshaping of the retail sector, with the Covid-19 pandemic and lockdown prompting the likes of John Lewis to close stores in favour of driving up online business.

Self-help measures and a potential reduction in the cost of Royal Mail's universal service obligation (USO), are among other factors leading to UBS forecasting a 3.5% operating margin in the UK division by the 2024 financial year, compared with the consensus of 1.5%.

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UBS reiterated its 'buy' recommendation and 215p price target, but admitted that much will depend on whether ongoing talks with unions avert the threat of industrial action.

The shares hit a low of 124p in early April before a recovery helped them to peak at 194p last month. The former FTSE 100 index stock is still one of the most widely held companies on the London market, including among many of the 140,000 postal workers who were given free shares at the time of the privatisation in 2013.

Retail investors received 227 shares from the heavily oversubscribed flotation, when the stock was priced at 330p and later peaked at around 630p in 2018.

Royal Mail's traditional letters market has been in terminal decline for considerable time, increasing the focus on business-to-consumer parcel operations in the UK. The company also owns the General Logistics Systems overseas parcels business, which is punching above its financial weight delivering parcels in Europe as well as in the US and Canada.

In the first of its updates on trading patterns during the pandemic, the company said today that quarterly parcel volumes at Royal Mail jumped 38% year-on-year — meaning it delivered 117 million more items. Addressed letters, however, were down 33%, or 788 million fewer items.

The company said: “As the UK starts to come out of lockdown we are not seeing any change as yet in customer behaviour. Our customers are wanting more parcels delivered to their homes and are sending fewer letters.

“We are working as quickly as we can to adapt our business to meet our customer needs.”

Recent newsflow has backed UBS's belief that Royal Mail should be able to achieve improved pricing in UK parcels, including the industry expectations that John Lewis online sales will soon represent 60-70% of the company's total versus 40% in the past.

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The bank added that Springboard data showing a 42% fall in mid-July footfall traffic at UK retail destinations highlighted the urgency for retailers to push their online businesses. At Ted Baker (LSE:TED), a trading update today showed that e-commerce sales of £35.2 million for the 11 weeks to July 18 were much higher than expected at more than half of the retail total.

As well as an update on union negotiations due later this month, UBS is also looking out for clues from Ofcom about the regulator's intentions towards the universal service obligation. The one-price-goes-anywhere service has long been seen as a noose around Royal Mail's neck.

Productivity improvements and a gradual reduction in the workforce means UBS sees scope for flat or even declining employee costs in the medium-term. It adds that the sharp volume decline in letters and deteriorating profitability should increase the scope for changes in the USO.