Stockwatch: is now the time to buy into Royal Mail?

Delivery titan has benefited from extra parcels being sent during the pandemic, but unions and declining letter use pose issues.

Is it time to buy into Royal Mail (LSE:RMG)? From over 600p two years ago, its mid-cap shares fell as low as 125p in March, then recovered to trend sideways around 175p during the summer.

Yes, there was a sense that it must be benefiting from more parcels being sent during lockdown, but the short position soared to an all-time high of 9.6% of the issued share capital barely a month ago.

While short sellers may copy each other, I suspect doubts over a latent parcels group still compromised by periodic strikes and a shift away from letters.

Last Tuesday, however, the stock enjoyed its biggest-ever one-day rise of 25%, currently around 230p, in response to a trading update for the first five months of the current financial year to March 2021.

Royal Mail is potentially at an inflection point both for its fundamentals and the chart, although be aware the jump is currently accentuated by short sellers closing.

Parcels growth and cost-cutting drive the ‘buy’ case 

The key upshot is parcel deliveries are doing even better than expected, although in the UK the costs of coping with this – re-arranging from letters – is tempering a return to profitability.

What is gained on parcels is lost on letters. But so long as industrial relations do not break down again, a £200 million cost-cutting programme appears on track.

According to an update from the Communications Workers Union last Friday, negotiations on productivity improvements are making progress, although an agreement is yet to be reached. 

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There is speculative appeal because Royal Mail enjoys group revenue approaching £11 billion, hence the operating margin only needs to recover for profits to kick in.

The seven-year table shows it collapsing from 18% near 1% in respect of the 2019-20 year, within which the GLS international parcels business now enjoys a margin over 8%. While there remains some risk that a global recession could compromise parcels, Covid-19 may have given a permanent boost to online ordering.  

The goal is evolution from “a loss-making UK-focused letters operation that also delivers parcels, to a profitable international parcels business also delivering letters in the UK”.

Much appears to rest on whether the unions co-operate, also on pay in the longer term if and when shareholder payouts resume. There is also a legal requirement for Royal Mail to deliver letters six days a week, with Saturdays currently dropped due to Covid-19.     

The table shows historic earnings per share (EPS) roughly in the 50p region, hence the stock is conceivably on a single-figure forward price-to-earnings ratio.

Meanwhile, net tangible assets of 468p a share last March offer some comfort as to downside. The risk/reward profile therefore looks exciting, if costs can be cut. 

Sudden cut in the short position has skewed the rise 

This week’s disclosures show that on 8 September - i.e. in response to the update – three of the four disclosed institutions short of Royal Mail bought back nearly 2% of its issued share capital.

This reduced total equity shorted to 4.38%, probably as much as could be achieved in one day.

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Notably, BlackRock axed its near -4% short position to 2.37%, as if its negative conviction is lost. On 9 September, Adelphi Capital continued to trim its short 0.1% to 0.85%, hence the total to 4.28%. 

The “sell” case is now muddied by Covid-19 invigorating parcel demand and governments’ stimulus measures helping economies out a second-quarter 2020 trough. Another complication is negotiations with the Communications Workers Union appearing more constructive.

Possibly unions now recognise that with unemployment rising it is not in their members’ interests to try to dictate terms. 

Valuation model involves stark contrasts  

No final dividend was paid in respect of the March 2020 financial year and none is expected for the current year, the hope is to restore payouts in the 2022 year. 

Assets are strongly backed by £3.1 billion property/plant/equipment. But a sceptic might say their value is solely what they earn, because Royal Mail is not going to be shut down with its depots sold on for property development. 

Thus potential longer-term earnings, and their rating, are chiefly where the intrigue lies, backed by a good record on free cash flow (see table) despite significant capital expenditure.  

Consensus had been for a £184 million net loss in the current year to March 2021 and negative EPS of 18p, then a £99 million profit for the 2022 year and EPS of 8p. Upgrades are creeping in, with EPS of minus 16.4p and 9.1p now targeted, hence the stock rising also in a sense of “less-worse than feared”.  

Mixed progress, if better than expectations 

GLS, the international parcels group, is enjoying strong growth from e-commerce and business-to-business deliveries. Its recent update cited 19% revenue growth on an 8.1% operating margin.

It is a leading provider in Europe, the US and Canada, and trading better in France, Spain and the US, which had been problem areas. For the full year, revenue is guided upwards from 5-7% to 10-14%. The margin was also increased, from 6% to 7%.  

In the UK – reported as “UKPIL” – parcel revenues are up 33% on 34% volume growth, while letter revenues have fallen 21.5% on volume down 28%. This change in emphasis has meant £85 million costs so far this financial year, versus guidance previously for £70 million over six months.  

Group revenue is thus also guided up for the full current financial year, albeit with higher costs on the UKPIL side offsetting better margins at GLS. Covid-19 related costs are now expected to reduce by £20 million for £120 million for the full year, hence slightly lower group losses than previously expected. 

Management warns that Royal Mail “will not become profitable without substantial business change” – as if making the position plain for ongoing industrial relations talks. After previously guiding for a £130 million restructuring benefit kicking in from the March 2022 year, £200 million savings are now targeted. 

Mind that parcels are not a one-way bet, perhaps in the event of a second wave of Covid-19 this winter and governments being unable to keep adding to their debts. The UKPIL side is also exposed to changes in international postal rates if an EU trade deal collapses. 

Royal Mail: financial summary

Source: historic company REFS and company accounts

A closer look at the end-March 2020 balance sheet 

Management speaks of its “strong” balance sheet on grounds of £1.9 billion total liquidity, including undrawn facilities. Investors need to look more broadly though. 

Alongside £3.1 billion of property/plant/equipment is a quite reasonable £948 million of goodwill/intangibles relating, for instance, to acquisitions made at a premium to their net asset values.

However, the working capital profile includes my bugbear about a skew towards trade payables – 1.6x trade receivables – hence uncertainty as to whether delayed payments may bolster the income statement. 

As to debt structure: £700 million is near-term and £935 million long term, additionally there are £1.1 billion of lease liabilities. Yet £1.6 million cash fully covers Royal Mail’s bank debt.

The income statement still shows a net £50 million interest cost swamping £55 million normalised operating profit.

More positively a “viability statement” cited the directors’ reasonable expectation of “not breaching any covenants under any drawn facility over the period to March 2023”.

‘Buy’ if you reckon unionised workers will co-operate 

At 220p last November, I suggested investors “avoid”, chiefly due to strike threats, but was aware of potential upside.

At around 230p, it now chiefly depends whether cost reduction plans get implemented. On a disciplined investment view, you would continue to hold or await more evidence, but for those willing to take the risk, trade unions now recognise sober realities in a Covid-19 environment: “buy”. 

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