Why Royal Mail is the ultimate contrarian play
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
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 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.