Royal Mail delivers a resilient performance

[RobertT]

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Royal Mail has delivered a resilient first half performance, despite intense competitive pressures in the UK parcels business. Total revenue was flat, with strong growth in European parcels offsetting the decline in UK letter revenue. Costs were down over 1%, leading to a better than expected profit performance (adjusted operating profit before transformation costs was flat). The interim dividend has been lifted by 4.5% to 7.0 pence per share. The shares rose by 4% in early morning trading.

Key highlights

UK Parcel volumes were up 4%, helped by a strong performance from Parcelforce Worldwide. However, parcel revenue grew by only 1%, due to changing mix and continued pricing pressure from the highly competitive environment.

Addressed letter volumes declined by 4% (excluding the impact of election mailings), within the group's forecast range of 4-6% declines per annum. Total letter revenue was down 3%, benefitting from price increases in January and March.

European parcels (GLS) continued to perform well with volumes and revenues increasing by 9% and 8%, respectively. Operating margin declines for GLS, due to changes in German minimum wage legislation, are now expected to be at the better end of the 50-100 basis points range.

Outlook

Revenue and volume expectations remain broadly unchanged . Royal Mail is guiding for volume growth in the parcels market of around 1-2% in the short term, reflecting the impact of Amazon using its own delivery network more. UK addressed letter volumes are expected to decline by 4-6% per annum in the medium term. Further action is being taken on costs. There are now some 70 scoped and resourced projects across the group, targeted at avoiding £500m of additional annualised cost by 2017/18. Underlying operating costs in UKPIL (excluding transformation costs) are now expected to be down by at least 1% in 2015-16, as opposed to previous guidance of 'flat or better'.

Our view

UK parcels was supposed to be the growth engine for Royal Mail, with the UK letters business in decline. So it is somewhat concerning that conditions in the UK parcel market look set to remain challenging.

The demise of rival City Link in December 2014 has been followed by a host of announcements from other parcel operators (two within the last week - DX and UK Mail) warning of pricing pressures. Amazon choosing to launch its own delivery network compounds the issue. Overall, Royal Mail estimates that there is around 20% annual spare capacity in the market.

Royal Mail is in a much better position than other postal operators to weather the storm, we feel. It is by far the largest player, with around 50% of the UK parcel market , so can invest more in technology and service. There is plenty of scope to reduce costs, having spent so long in public hands. This should help to support profits, at a time when rivals are seeing margins squeezed.

We think Royal Mail is performing well in a tough environment. The UK parcels business isn't growing much, but nor is it in decline. The European parcels business (almost a sixth of revenues) is performing strongly and costs are being very tightly managed. The group generates prodigious cash flows. The balance sheet is strong and underpinned by a substantial London property portfolio. Growth will probably be hard to come by until market conditions improve. In the meantime there is a yield of 4.6% (variable and not guaranteed) to tide investors over.

All yield figures are variable and not guaranteed.