Why Royal Mail is the ul­ti­mate con­trar­ian play

We ex­plain the is­sues fac­ing the UK parcels and let­ters de­liv­ery group and why the stock is still at­trac­tive

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The strikes fac­ing par­cel de­liv­ery ser­vice Royal Mail (RMG) are just the lat­est in the se­ries of prob­lems drag­ging on the com­pany’s per­for­mance.

Ap­prox­i­mately 111,000 postal work­ers will go on strike be­tween 19 and 21 Oc­to­ber over pay and pen­sions. This is de­spite Royal Mail al­ready pay­ing staff above-in­dus­try rates and gen­er­ous pen­sion con­tri­bu­tions.

The prof­itabil­ity of the com­pany is highly sen­si­tive to small changes in wage in­fla­tion as­sump­tions. Con­cerns over com­pe­ti­tion and dwin­dling let­ter vol­umes have also weighed on the stock.

Shares in the postal ser­vice have taken a beat­ing this year, down 17% to 381p. That’s higher than the 330p price at which it joined the stock market in Oc­to­ber 2013 but well be­low the all-time high of 604.5p seen in Jan­uary 2014.

Many an­a­lysts are neg­a­tive on Royal Mail as an in­vest­ment – yet we be­lieve a large amount of bad news has al­ready been priced in and that now is a good time to buy while sen­ti­ment is so poor to­wards the busi­ness.

To its credit, the busi­ness con­tin­ues to be­come more ef­fi­cient and flex­i­ble and is rapidly in­creas­ing its po­si­tion over­seas.

Fur­ther­more, many ri­vals on the par­cel de­liv­ery side have de­vel­oped a poor rep­u­ta­tion for ser­vice, cre­at­ing an op­por­tu­nity for Royal Mail to win back lost cus­tomers.

HOW DAM­AG­ING WOULD A STRIKE BE?

RBC Cap­i­tal Mar­kets an­a­lyst Damian Brewer thinks the forth­com­ing strikes risk ma­te­rial dam­age to Royal Mail. He be­lieves com­peti­tors might take ad­van­tage of the strikes to steal market share ‘that might never re­turn’.

WHY ARE POSTIES STRIK­ING?

Royal Mail wants to re­place its de­fined ben­e­fit pen­sion scheme which pro­vides a guar­an­teed in­come in re­tire­ment with a dif­fer­ent scheme that gives em­ploy­ees a cash lump sum linked to the value of their con­tri­bu­tions.

Work­ers are also un­happy with pay, which Royal Mail hopes to ad­dress through a

SHARES HAVE BEEN WEAK BUT ARE STILL TRAD­ING ABOVE THEIR IPO PRICE

5% in­crease over two years that is par­tially de­pen­dent on much-needed pro­duc­tiv­ity im­prove­ments.

Out­side these is­sues, the com­pany is strug­gling with ‘busi­ness un­cer­tainty’ in the UK and de­clin­ing let­ter vol­umes as elec­tronic com­mu­ni­ca­tion such as emails and texts con­tinue to re­place ‘snail mail’.

UBS an­a­lyst Do­minic Edridge is pes­simistic that Royal Mail can con­tinue to grow due to its lack of mod­erni­sa­tion. An ex­am­ple of which is the high pric­ing for heav­ier parcels as they have to be man­u­ally sorted.

WHERE IS ROYAL MAIL IN­VEST­ING MONEY?

The com­pany is work­ing on di­ver­si­fy­ing its busi­ness by fo­cus­ing on e-com­merce, in­vest­ing in tech­nol­ogy and ex­pand­ing its over­seas di­vi­sion, GLS.

Rev­enue from GLS in­creased 18% in the three months to 25 June, with sales growth de­liv­ered in all main mar­kets. This is promis­ing al­though GLS only ac­counted for circa one fifth of group rev­enue and profit in the last fi­nan­cial year.

Un­der its over­seas ex­pan­sion plan, Royal Mail ac­quired Golden State Overnight in the US last year, which is cur­rently per­form­ing in line with ex­pec­ta­tions.

In April, Royal Mail made fur­ther progress with its strat­egy through the ac­qui­si­tion of US overnight par­cel de­liv­ery firm Postal Ex­press for $13.3m.

WHY SHOULD IN­VESTORS STICK WITH ROYAL MAIL?

The stock was a big hit when it floated four years ago as it was priced on a low rat­ing and paid a gen­er­ous div­i­dend.

Cur­rent fore­casts im­ply a prospec­tive yield in the re­gion of 6.3% and the po­ten­tial for a bit more div­i­dend ev­ery year.

In May, the div­i­dend was lifted 4% to 23p per share and In­vestec an­a­lyst Alex Pater­son thinks the div­i­dend per share will con­tinue to rise, fore­cast­ing 24p in the year to 31 March 2018, in­creas­ing to 25p and 26p in 2019 and 2020 re­spec­tively.

De­spite the trou­bles cloud­ing Royal Mail’s out­look, he re­mains ‘op­ti­mistic that sig­nif­i­cant ef­fi­cien­cies can be achieved over time’ but con­cedes that this may take longer than ex­pected.

Pater­son also flags that trad­ing in the three months to 25 June was bet­ter than fore­cast; par­tially driven by a strong per­for­mance over­seas.

Liberum an­a­lyst Ger­ald Khoo fore­casts EBITA (earn­ings be­fore in­ter­est, tax and amor­ti­sa­tion) will grow in the GLS over­seas di­vi­sion from £164m to £188m in the year to 31 March 2018.

The group as a whole cur­rently trades on 9.3 times fore­cast earn­ings per share for the cur­rent fi­nan­cial year. That is far too cheap in our opin­ion for a com­pany with such a strong market po­si­tion. Yes, it de­serves a dis­count for labour is­sues and com­pet­i­tive threats – but not to such a dra­matic level.

It is easy for in­vestors and an­a­lysts to over­look Royal Mail’s qual­i­ties given the head­winds it faces. How­ever, we be­lieve its prob­lems can be fixed and in­vestors are be­ing re­warded for their loy­alty with a gen­er­ous yield. (LMJ)

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