Stockwatch: can the parcel boom offset letters’ fall for Royal Mail?

The pandemic wave of large items sent in the post could end after lockdown, posing several questions.

A sharp jump in profit ahead of expectations affirms the key point of operational leverage when I advocated Royal Mail (LSE:RMG) as a ‘buy’ last September at 230p.

At 450p currently, this £4.3 billion company has been expected to make annual revenue of around £12 billion, albeit on a low single-figure operating margin (see table) that went as low as 1.3% in the financial year to end-March 2020. On a seven-year historic view, the group margin has slumped from 18%, but five months ago there were some positive signs - such as a margin over 8% from GLS international parcels. 

A series of positive news towards margin recovery 

My case was, so long as early signs of the workforce co-operating on efficiency improvements, continued, it would only need a modest rise in the margin to leverage attractive profit. Meanwhile, net tangible assets of 468p a share (last March) offered comfort as to downside.  

The stock began to re-rate from early November – as many did, on Covid-19 vaccines’ success – then the 19 November interims cited 10% revenue growth as parcels more than offset letters’ decline.

Tightening Covid-19 restrictions, then the formal lockdown from early January, has reinforced a bonanza period not only for online shopping deliveries but also PPE gear, test kits and vaccination letters. 

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Then, on 22 December, an agreement was reached with the Commercial Workers Union on the future direction of Royal Mail, operational change, pay and job security. It was reinforced by 3 February news of union members voting 91.5% in favour, after which the stock tested 420p. 

It rose to 470p, before settling around 450p after yesterday’s trading update cited the busiest three months in Royal Mail’s history (to end-December). Around 496 million parcels were handled and 11.7 million delivered on the busiest day, which was 32% higher than the peak day during the first lockdown in 2020.  

In respect of nine months in the group’s year to end-March 2020, revenue rose 14% over £9.3 billion, within which parcels raced ahead 37% to £3.8 billion while letters fell 16% to £2.6 billion. The GLS international parcels business rose 24% to nearly £3 billion. 

Adjusted operating profit guided over £500 million 

Various positives have therefore come together for this exceptional performance, and the key question is how median revenue will trend in years ahead. Certainly for the next few months it appears that high volumes will persist, and Public Health England is today reported as saying Covid-19 restrictions must remain until all the population has been vaccinated. 

By the end of October, management intends to have revised Royal Mail’s network and technology to improve customer service and productivity. Hence, the stock’s break-out is justified by efficiency gains along with a revenue boost.  

Adjusted operating profit guided over £500 million for the current year to end-March affirms my hunch last September that Royal Mail is at an inflection point. Consensus last November had been for £200 million net profit and earnings per share (EPS) of around 16p.

At the time, it had a forward price-to-earnings (PE) ratio of 20x, which I suggested “is justified if the group has turned the corner, in context of annual revenues already set to be over £11 billion”.

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One needs to beware the exact definition of ‘profit’ when numbers are bandied around.

Current consensus (which may reflect the recent update) looks for £246 million net profit in the year to March 2021, rising to £350 million the next year. Whereas, at the start of this month, analysts at Citigroup forecast underlying profit of £289 million for the 2021 year, rising to £410 million in 2022.

If circa £400 million is realistic then it implies EPS around 47p – i.e. a PE multiple of 9.6x despite the stock nearly doubling since last September.  

Curiosity of a resumed dividend, forecast 

Interestingly, Citigroup also reckon on a dividend to be declared in respect of the current financial year. That is despite last November’s interims not expecting one for the 2020-21 year, just the ambition to resume pay-outs in 2021-22.

That seems as close to the bone as is wise to go, when simultaneously pushing through operational efficiencies with a workforce. 

Meanwhile, at BT (LSE:BT.A), a group of Openreach staff have voted 86% in favour of strike action – in a dispute on the employment of new engineers on different grade and pay structures.

Although I was positive on BT at 102p last November, my ‘buy’ case cautioned about the risk of strike action. This was mostly as the interim results had guided for a resumption of dividends in the financial year to March 2022, plus a progressive payout policy commencing with 7.7p a share.

That implied a whopping 7.5% yield at 102p a share, hence why BT was undervalued. The stock rose to 147p by early January but has retreated to 123p. I am not surprised, as it promised a big payout when job cuts and working practice changes are being made. 

In due respect, Royal Mail’s set-up is broadly cash generative. The interims showed a 24% rise in net cash from operations, to £359 million. However, cash reduced from £1.6 billion to £1.1 billion over the six months’ period – as a result of eliminating short-term bank debt to leave just under £1 billion long-term debt. There are also £1.1 billion lease liabilities and a £345 million pension deficit, albeit in context of £3.9 billion net tangible assets.  

Royal Mail - financial summary
year end 31 Mar

Source: historic company REFS and company accounts

Short interest has completely unwound  

After soaring from owning 1.6% of the total share capital in mid-2019, to 9.6% last August – hence one of London’s most-shorted stocks – hedge funds have correctly anticipated the shift in Royal Mail’s fundamentals, to reward prevailing over risk.

Moreover, the stock continues to trade at a discount to net tangible assets per share of 456p (as of end-September). The short position very rapidly unwound to just below 2% at end-September then to nothing by mid-November. 

While this means the stock now has to perform entirely according to fundamentals (rather than technical support from shorts closing) it represents a unilateral view among hedge funds that Royal Mail’s risk/reward profile lies neutrally or to the upside. 

Potentially still a ‘buy’ on a long-term view 

A relentlessly upward chart since last September can be seen both as reason for caution after a strong run, yet also a genuine break-out after a broad decline from over 600p in early 2014. It takes the stock back to a 2015-2018 trend-region. 

Royal Mail had floated at 330p in October 2013 with the stock surging 40% on its first day (showing how it is wise to beware initial excitement over flotations like exists today). 

On a two to three-year view, the stock can go higher as the parcels side – including international – strengthens.

A key question, however, is the extent to which parcels’ handling may ease along with Covid-19 restrictions in due course, reverting investor attention to letters’ decline. This makes Royal Mail’s future tricky to project, although I believe a turning point has been established by the better mood of industrial relations enabling cost efficiencies. 

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Dividends are also challenging to predict, but I would pencil in at least 10p a share for the coming financial year, implying a 2.2% yield or better. If it recovers to more than 20p then Royal Mail would be seen as an attractive income stock – yielding over 4.5% - however such payouts from 2014 to 2019 were unsustainable.  

Covid-19 has been quite a saving grace for the company, despite its tragic challenges, and we need to see how trading settles on a one to two-year view before assuming much about the extent of dividends. 

This may be overly cautious, but I temper my near-term stance to: ‘hold’. 

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