Since the government put Royal Mail shares on the market in 2013, investors can be quietly happy with their returns.
Investors who bought in at day one at a price of 330p a share would have seen a return of just over 35% to date, excluding dividends.
With good dividend stocks at decent prices hard to come by in the FTSE, I thought I’d take a closer look at Royal mail.
With an attractive growing dividend, this may be one for dividend growth investors to look out for.
What makes Royal Mail so interesting is that it’s a former state-owned monopoly which is still in transition from public ownership to private ownership.
The company still holds an effective monopoly in the letters market but are battling heavy competition in the parcel market.
Royal mail operates under two main divisions;
UK Parcels, International & Letters (UKPIL)
UKPIL operates in the United Kingdom collecting and delivering parcels and letters through approximately two main networks, the Royal Mail Core Network and Parcelforce Worldwide
General Logistics Systems (GLS) .
A brief history;
In 2006 Royal Mail lost its monopoly on the UK parcel market when it became open to competition from companies such as UKMail, DPD and Hermes.
Although Royal Mail also lost its monopoly on letters in 2005, competitors just don’t seem interested in this ever shrinking market. The withdrawal of Dutch competitor Whistl in 2015 left the company effectively unopposed.
In 2013 Royal Mail was offered to investors for 330p a share, thus privatising one of the last surviving state owned companies in the UK.
The overall postal market
Royal mail’s two markets can be defined by the following statements;
Declining letter volumes and increasing parcel volumes.
In 2013, Royal Mail commissioned a review into future volumes from Pwc. The results can be seen below;
As the graphs clearly indicate, the UK has an increased demand for parcel services but a decreasing demand for letter services.
These trends are also clear in other developed countries and there are no signs of a reversal.
With a decline in mail volume, Royal mail is rightly positioning itself for the growth in parcels and cutting costs.
The parcel market and Royal Mail’s positioning
As we can see from the chart below, Royal mail continues to enjoy the lion’s share of the UK parcel market
Source: Royal Mail PLC 2015-2016 results
But, this dominance is declining year on year as is evident above.
The overall parcel market grew 6% growth in 2015 and Royal Mail estimates a further 4% volume growth moving forward. This growth has allowed Royal mail to grow parcel volumes despite its declining market share.
Whilst focus on the parcel market appears to be a winning strategy significant hurdles exist that I’ll outline below.
The problem with Royal Mail’s strategy is the intense competition they face in the industry.
This is evident from the meager 1% revenue growth achieved from a 3% increase in parcel volumes. This is a worrying sign of declining margins to come.
If this trend is to continue then clear challenges await for the company;
2016 results show that the 1% increase in parcel revenue was offset by a 2% decline in letters revenue.
With the majority of Royal Mail’s revenue coming from its letters division this continued decline will slowly erode the balance sheet unless growth in other areas (mainly parcels) pick up.
As we can see from the above table taken from the company’s 2014-15 trading results Total letters accounted for £4,567mn of revenue as opposed to £3,190 for parcels.
The continued decline in letters revenue (although less than expected) as evidenced in the company’s 2015-16 trading results above creates a pressure on the company to deliver on parcel growth.
Even as the parcel market grows and parcel revenue increases it seems tough for Royal Mail to make a net gain on their overall revenue due to declining letter revenue.
Another revenue worry I have moving forward is the Royal Mails obligation to offer a universal service which means delivering to some very rural areas without the ability to charge more.
This is in stark contrast to competitors who can simply cherry pick the most profitable urban regions and rely on Royal Mail for ‘the last mile’ delivery. Royal Mail has hit back by ramping up the charges for this service but competitors have complained to the regulator Ofcom. With such murky legal waters ahead this certainly casts a shadow over the business.
Profit on the other hand looks promising if we strip transformation costs with profit up 5% in 2015.
Royal mail has done an outstanding job of turning the company’s finances around.
Debt is down significantly since 2012 and the company continues to make significant efficiency savings;
(Source: Ft Markets, Royal Mail Plc)
The group has also managed to shed 3,500 jobs since 2015 whilst also increasing productivity by 2.4%. These are promising signs for a company that needs to shed costs fast in order to maintain margins (especially in parcels) in a competitive market.
The company’s cash flow looks worrying at first glance;
But when you consider the transformation costs the company has occurred the weak cash flow becomes understandable.
Transformation costs in 2015 were £191mn, and the company projects further costs of £160mn in 2016-2017.
Most impressively is the operating profit margin now being achieved by the company as a result of these transformation costs with the profit margin jumping from 4.7% in 2014 to 6.1% in 2015.
Royal mail offers a tempting dividend yield of 4.2% and sits comfortably at a payout ratio of 54% from results filed in May.
With room for movement in the payout ratio the company could continue to increase its dividend payments even if earnings disappoint.
The company is also committed to a ‘progressive dividend policy’ meaning that dividend investors can be confident of continued dividend increases in the future.
Due to the scale of transformation costs it’s difficult to efficiently value the shares based on EPS. Transformation costs in 2016-2017 are expected to come in at around £160mn.
Instead, I decided to use a dividend discount model to value the company’s shares.
As revenue is going to be difficult to expand in such a competitive market (and relative to management’s past performance) I see cost cutting measures as the main source of EPS growth for the company moving forward.
After a big dividend jump from 2014-2015 I expect dividend growth to stabilize at around 5% due to the above mentioned factors.
I factored in a 10% discount rate to account for the risk of our capital
The dividend discount model gives me a fair value of 442p a share. Meaning that this stock appears 15% overvalued by this metric.
Royal mail management is doing all it can to streamline the business moving forward, yielding impressive results with productivity and margins on the up due to a successful transformation strategy. But, there is only so far that transformation can go before the company is unable to continue to make large savings through efficiency.
The worry from then on would be the poor increase in parcel revenue relative to parcel volume achieved as this metric tends to point towards narrowing margins.
There’s too much uncertainty for me to buy the stock at this price but if the company goes on to continue to dominate the parcel shipping sector, investors should be handsomely rewarded with dividend growth and capital gains.