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We reluctantly turn bearish on the transport group as a major setback changes the investment case
Thursday 04 Oct 2018 Author: Daniel Coatsworth

Investors who have been drawn to Royal Mails (RMG) shares as a source of generous income may soon be in for a shock unless the business sees a radical improvement with its efficiency plan.

A major profit warning on 1 October has seen the share price fall by 23% to 368p over two days. Analysts have had to significantly downgrade earnings forecasts because of lower than expected productivity gains and cost savings.

The reduction in profit is expected to result in lower free cash flow, thus questions are now being asked over whether it can afford to pay dividends at current levels.

Prior to the profit warning the shares yielded a prospective 5.2% yield based on a 477.1p share price and consensus forecast 24.87p dividend payment for the year to March 2019.

The prospective yield now stands at 6.8% based on the same dividend forecast. That looks too high given its situation. Liberum analyst Gerald Khoo says management committed to dividend growth on a conference call following the profit warning. Khoo has reduced his dividend forecast to 24.4p to show token growth of 1.5% per year.

‘Even at this level, we see the payout being barely covered by earnings and cash flow this year, admittedly with adverse timing distortions on cash flow this year, and underlying cover deteriorating in later years.

‘Management has stated that it would not pay dividends out of increases in debt, so we see the dividend as highly vulnerable to any further deterioration in trading.’

Royal Mail say its UK productivity performance is ‘significantly’ below plan at 0.1% in the six months to 23 September, down from a target of approximately 3%.

Unfortunately, this has had a knock-on impact on cutting costs with the target cut from £230m to £100m in 2018-2019.

Productivity improvements are vital for Royal Mail's future as it needs to drive earnings and fight back against fierce competition.

In a triple whammy of bad news, addressed letter volumes have dropped 7% amid declining marketing mail as structural decline, business uncertainty and GDPR data protection rules made an impact.

Royal Mail has a unique market position in the UK and its overseas business is growing fast. Unfortunately its near-term future from an investment perspective is clouded by margins and cash flows coming under significant pressure.

For those latter reasons, we reluctantly switch to a ‘sell’ rating on the stock in anticipation that the shares have little chance of recovering until management can provide evidence of higher productivity gains. (DC/LMJ)

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