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Royal Mail looks like the proverbial falling knife

09 Oct 2018, 16:08

https://www.proactiveinvestors.co.uk/co ... 30118.html

The year started off well for Royal Mail PLC (LON:RMG) but turned sour in a hurry once October arrived.

A landmark agreement towards the end of January with the unions on productivity and the defined benefit pension plan sent the shares up from 466p to an all-time high of 611.4p in May.

Irrational exuberance started to dissipate after the full-year results were released in May and the shares had drifted down to 477.1p by the end of September.

A profit warning on October 1 sent the shares plunging as low as 322p but hardly anyone in the broking community seems to think they are cheap even at the current price.

Liberum Capital Markets stuck with its ‘sell’ recommendation and slashed its target price to 250p.
Citigroup cut its rating on Royal Mail to ‘sell’ from ‘neutral’ with a target price of 300p.
UBS slashed its price target to 354p from 528p and reiterated its ‘neutral’ stance.
HSBC downgraded to ‘hold’ from ‘buy’ after what it called a “productivity bombshell” and slashed its price target to 379p from 552p.
RBC Capital Markets tried to confuse us all by switching its rating to “UP” but that is just impenetrable broker-babble for “underperform”; seeing as its previous rating was ‘sector perform’ you can mark that down as another downgrade. RBC’s price target was chopped to 315p from 500p.

Do not try to catch a falling knife

Many investors will be familiar with the aphorism, “don’t try to catch a falling knife”, and it seems to apply in spades (to mix metaphors) with Royal Mail.

The aphorism generally works as good advice because experience tells us two things.

After a shock such as Royal Mail’s profit warning, no one really knows what the true value of the shares is.
With crisis-hit companies, things usually get worse before they get better (there’s another adage that profit warnings come in threes).
Some might argue that Royal Mail is not in the midst of a crisis and there is some merit in this view.

The company said it expects group adjusted operating profit before transformation costs for the current financial year to be in the range of £500mln to £550mln on a 52-week basis, so it is still making money.

With the likes of Amazon.com and Deutsche Post muscling in on its patch in the more profitable parcels delivery side of the business, that’s not to be sneezed at but if it wants to grow profits (and finance the all-important dividend) then it needs to become a leaner operation.

The deal with the unions was supposed to be a big part of that drive to become more efficient but this month’s trading statement not only revealed that productivity improvements have not been as high as hoped, there have barely been any improvements at all.

HSBC suggested that while the Communication Workers Union’s (CWU) negotiators might have been satisfied with what many saw as a pragmatic agreement to head off industrial action and release the company from its costly commitments to sustain the pension plan, the rank and file appear not to have been so pleased.

In this regard, the exorbitant pay deals enjoyed by successive Royal Mail chief executives will not have gone down well. New boss Rico Back was offered an annual salary of £640,000 that was £100,000 higher than that enjoyed by his predecessor, Moya Greene, and her remuneration had been regarded as obscene in many quarters (not to mention her £900,000 pay-off after her retirement).

Never mind profits growth, dig that crazy dividend
Without the wholehearted commitment of its workforce, Royal Mail may well struggle to overhaul the business in the time-frame originally envisaged by management. That will put a crimp on profits growth but then very few people have Royal Mail (or any postal outfit) down as a growth stock.

What matters to most shareholders is the dividend. The shares currently yield around 7%, which is a level that in most companies would signal a dividend cut is on the way.

In the case of Royal Mail and its global peers, however, a yield of 7% or higher is considered to be a requirement in order for investors to hold the shares as the sector in which they operate is considered to be one with limited growth opportunities.

On the one hand, the rise of online shopping has dramatically increased the parcels deliveries workload but on the letters side, apart from junk mail, parking fines and that birthday card from dear old Auntie Sylvia, what else is there in this age of digital communications?

Happily for those still holding Royal Mail shares – Vince Cable and a few other forgetful old codgers, presumably – the dividend looks safe but that assertion comes with a caveat, which is that it only looks safe it brokers’ current assumptions prove to be on the money.

RBC Capital Market’s calculations indicate that the company can continue to grow the dividend by a penny a year.

It reckons investors who hold shares in delivery companies typically demand a very high dividend yield and thinks a yield of around 9% is about right for Royal Mail; in the absence of a significant hike in the dividend, the only way it can offer a 9% yield is for the shares to fall further.

UBS reckons the current yield of 7% is “reasonable” for Royal Mail.

“We see limited risk to the dividend in the short-term, given it costs £243mln, implying that RMG [Royal Mail] needs to generate adj EBITDA [adjusted underlying earnings] of ~£850mln to cover it on a cash basis: in FY2019 we are forecasting £960mln,” the Swiss bank said.

“This risk of a cut is only likely if margins in UKPIL [UK Parcels, International & Letters] take another sustained step down, at which point a regulatory review would be likely, given EBIT margins would be significantly below Ofcom's 5-10% desired range,” UBS said.

Jeremy Corbyn to the rescue?
So, according to UBS, if things get so bad for Royal Mail that it can’t sustain the dividend, the government will step in and make life a bit easier for the group rather than face the wrath of those who stagged the flotation back in October 2013.

Those who bought Royal Mail shares in October 2013 are sitting on a measly profit of about 11p per share, although they have trousered dividends of around 20p per share or more each year.

If the shares (again) fall below the flotation price of 330p, might the Labour Party consider renationalising it if it gets into power?

Possibly, although if it is serious about taking privatised industries back into public ownership it probably has bigger fish to fry, such as the utility companies.

Could the shares become cheap enough for nationalisation to be a possibility?

There are certainly enough reasons to suggest that the shares have further to fall from here.

With a capitalisation of £3.4bn, Royal Mail is comfortably the lowest-valued member of the FTSE 100 (the next lowest is Rightmove at £3.9bn).

That makes it vulnerable to ejection from the index. The highest valued FTSE 250 stock is John Wood Group, with a market capitalisation of £5.2bn so ejection from the Footsie looks very likely for Royal Mail, which would prompt all the FTSE 100 index-tracking funds to sell the stock.

Then there’s the pension issue. It closed its defined benefit (aka “final salary”) pension scheme in March to avoid an expected increase in cash contributions to about £1.2bn per annum and is working closely with the CWU to secure the introduction of the UK's first Collective Defined Contribution scheme.

If, as HSBC suspects, the rank and file are royally cheesed off, these negotiations may not have the happy ending Royal Mail’s management is hoping for and that would be a (penny) black day for the company’s shareholders.

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