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Is There Value Left in Royal Mail Shares?

15 Mar 2018, 20:16

http://www.morningstar.co.uk/uk/news/16 ... hares.aspx

After a sustained period of being out of favour, Royal Mail shares have bounced back; up 50% in four months

As the Premier League season nears its end, all eyes will be on the teams that fall out of the division - and whether they re-gain their top-flight status next year. Sunderland have shown it’s not easy to bounce back, though local rivals Newcastle United have found the task much simpler.

Companies relegated from the FTSE 100 face similar challenges to return to the blue-chip index; some being promoted relatively soon, while others languish in the 250. Royal Mail (RMG) has proved more Newcastle than Sunderland since slipping out of the FTSE 100 in September. It returned in March, just six months later.

A national institution, Royal Mail’s time as a listed entity has been tumultuous. Its flotation at 330p back in October 2013 grabbed retail investors’ imaginations. By close of play on its first trading day, it had climbed a third to 455p. By mid-January 2014, it had surged to a high of 618p.

Rookies enticed by the household name must have thought making money was easy. But things went stale rather quickly. The stock had slipped to 389p by the following January. By early November 2017, it had slipped to 368p on fears over UK politics and its pension fund deficit.

But it now seems the stock's fortunes have turned. Led by Moya Greene, one of only eight female FTSE 100 chief executives, Royal Mail has instituted a remarkable comeback. It has cut costs and, importantly, struck a deal with the Communication Workers’ Union on the pension deficit.

Value investors decided early 2018 was the time to buy, with the stock “very much out of favour”, according to Laura Foll, co-manager of the Morningstar Silver Rated Lowland Investment Trust (LWI). They’ve been proven correct thus far, and the stock has rallied 50% to 552p. So, for investors now, is there scope for further re-rating?

It’s no secret that the letters side of the business is in structural decline. That’s something that was noted at flotation, says Foll. It’s likely to continue to decline at a mid-single-digit percentage. However, Royal Mail “is still a business in growth, rather than decline”, continues Foll.

The reason for that is its parcels business. Almost half of Royal Mail’s value comes from parcel delivery both in the UK and its European GLS business. “Parcels are growing really strongly because of people like me that order everything online and have it delivered to their desk,” Foll says.

Steve Magill, manager of the UBS UK Equity Income Fund, says the GLS business, which is the market leader, is particularly attractive and has different characteristics to the UK business.

“There are more elements of value and more levers that management has got than people think,” Magill says. “People see the headlines of strikes and that people don’t send letters anymore and ignore the underlying characteristics of the business.”

Ken Wotton, manager of the LF Livingbridge Multi-Cap Income Fund, says one factor the investment case hinges around is whether that structural growth in parcel delivery will outpace the decline in their traditional letters business. “That seems to be playing out,” he says.

The other factor is regarding the pension deficit, but Wotton thinks deficits in general are a function of the low interest rate and bond yield environment we’ve been in since the end of the financial crisis. “I just don’t find it credible to believe that’s going to persist for sufficiently long that those deficits are going to remain forever.”

While there’s a lot more to the business, “these are the two factors most likely to affect their profits, cash and ability to sustain the dividend”.

Dividend Proves a Boon
That dividend has become a key tenet of the investment case. At a forecast 24p for the year to March 2018, the payout has grown 20% since IPO and that 2018 payment translates to a yield of over 4%.

While you are clearly taking on some problems, Foll says she thinks the business looks attractive at around 12 times forward earnings, and the dividend, which is well covered and looks sustainable, is paying you to wait until things truly turn.

The management team is another key positive and is “genuinely excellent”, according to Foll. “They have invested a lot in automation on the parcels side, which has allowed them to be competitive.”

The threat of a Jeremy Corbyn general election win looms large, though that looks like a problem for further down the line. “It’s something that we obviously think about and it would certainly affect the share price if the perception was that that would happen,” says Magill.

Neither he, Wotton nor Foll believe Royal Mail will be re-nationalised. Any Labour Government would have plenty more things to accomplish before setting out down the road of mass nationalisations.

James Henderson, Foll’s co-manager, says: “You don’t want to be paying out greedy shareholders to nationalise it when you need to be writing cheques for the NHS. It could be in manifestos and still not happen; but it’s definitely a worry in the share price – and rightly so.”

Foll also points out that the GLS business has been ring-fenced so it can’t be nationalised, meaning it would have something of substance to salvage from the wreckage.

Magill feels the stock has further to run. While he’s already made good gains from the stock and has been trimming his position, that’s a result of the stock becoming a larger position of the overall fund. He still sees further upside.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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