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Five reasons Royal Mail could fail to deliver for investors

02 Oct 2018, 16:45 ... 06195.html

Royal Mail is grappling with a number of challenges at the moment as well as fierce competition from rivals at home and abroad

Royal Mail's UK parcels division is performing well, unlike its letters business

Royal Mail PLC (LON:RMG) shares have shed around a quarter of their value in the last day after it warned on full-year profit and said crucial productivity improvements had failed to materialise.

The post and parcels delivery firm this week reported that trading conditions in the UK had been extremely challenging, leading its letters volumes to drop by 7% in its first half. Given these factors, the company slashed its annual profit guidance to £500mln - £550mln - well below the £694mln it reported last year.

Worryingly, it also hinted that all is not well at its parcels business - it's strong growth has offset declining letter volumes in recent months.

The company’s recent woes have compounded a range of other ongoing issues which the postal group is struggling to shrug off.

On the plus side, its shares now offer better value and confidence can perhaps be garnered from the company’s refusal to cut the full year dividend ahead of the peak Christmas season, which may provide some short-term upside relief.

Boardroom uncertainty

The postal group needs some stability in its boardroom if it is to navigate through the choppy waters it finds itself in, but the picture is currently anything but stable.

The company’s chairman, Peter Long, resigned last month after being accused of 'over-boarding' – holding too many seats on boards – by investors. Long, who is also chair of travel firm TUI (LON:TUI) and estate agent Countrywide (LON:CWD), had been chair of Royal Mail for three years and was replaced by Les Owen, a board member and former chief executive of insurer Axa Sun Life.

This followed a major revolt by shareholders against the pay package awarded to new CEO Rico Back – the former chief of its European subsidiary GLS - who replaced well-regarded predecessor Moya Greene last month. Back was awarded a deal worth up to £2.7mln a year, subject to certain targets being met, plus a £6mln ‘golden hello’ for leaving GLS.

Seventy-percent of Royal Mail's shareholders opposed the award but failed to stop it. Unions, meanwhile, slammed the award and said that Royal Mail staff were angry about the size of the pay package, given that they had agreed to changes in their pensions to help save the company money last year.

Productivity failure

The postal service, which floated in late 2013, said it would miss its target for improving productivity – it was up just 0.1% in the first half, compared to an aim of 2-3%. This means it will also fail to hit its targeted £230mln of cost savings this year, with the company now expecting to achieve around £100mln in savings.

The productivity targets were a key part of a deal it struck with unions earlier this year in which the firm reduced working hours in exchange for changes to working practices. However, these changes are “taking longer than expected” to deliver, the company said.

“Following the conclusion of the agreement with unions, the company had expected cost savings and efficiencies to ramp up in the second quarter and then accelerate through the third and fourth quarters,” Citigroup analysts said in a note to clients, adding that the lack of efficiencies delivered in the second quarter “cannot be achieved” in the second half.

The company is trying to introduce what it called “a challenging agenda” of new working conditions, new technology and digitisation, and growth initiatives.

It remains to be seen if its long-running modernisation plan will bear fruit and improve productivity at all or if the initiative will merely fade into the background as the company tries to plot a course through its many challenges.

Parcels worries

Growth at Royal Mail’s international parcels business, GLS, has offset declines in letter volumes more than once in recent years. And while the company sees first-half revenues at GLS rising 9%, the outlook for the unit is ominous.

Royal Mail said that labour market and other cost pressures were impacting margins at GLS “more than anticipated” which clearly doesn’t bode well. Add fierce competition from rivals such as DPD and Hermes, as well as the threat from the growth of Amazon (NASDAQ:AMZN) in the UK, and the challenge looks even tougher.

“We would hope that the parcels and GLS business can continue with their rapid growth. A stalling here, caused by perhaps industrial action or competitive pressures, will surely result in further troubles for the group,” said Helal Miah, investment research analyst at The Share Centre.

Despite this, its UK parcels business performed well: revenues and volumes up 6% in the first half, with the full year outlook looking positive.

Letters not delivering

The FTSE 100 company said UK letter volumes had fallen 7% in the first half after being hit by ongoing structural declines, business uncertainty and General Data Protection Regulations (GDPR), which have deterred many businesses from sending junk mail.

The company said in July it had seen a 7% fall in letter volumes between March and June, showing that the picture failed to improve in the second quarter.

Analysts at Liberum expect letter volumes to remain under pressure and forecast a 7% year-on-year fall in the full year and a best-case recovery to a 6% fall in 2020 – the upper end of management’s previous guidance.

Deutsche Bank analysts believe Royal Mail is trying to shift its business model away from mail to the growing parcels space but is being hindered by the high levels of operating leverage within the business.

Dividend commitment

On a conference call following its profit warning, management reaffirmed its commitment to continued dividend growth. While this may be viewed as a positive factor by some, analysts are sceptical as to whether Royal Mail’s forecast earnings can cover the proposed handout to shareholders.

“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,” Liberum analysts wrote in a note to clients, adding that it had trimmed its dividend growth target to 1.5%.

“Our view is that dividend cover of around 1x is wholly inadequate for a business with limited forward earnings visibility, facing structural challenges and with the high operational gearing and earnings volatility exhibited by Royal Mail in recent years,” they added

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