Questor share tip: Royal Mail on track for income

The maiden set of results as a listed entity for the postal group underline the long term investment case, says Questor

Royal Mail
565p+32
Questor says HOLD

QUESTOR was an early backer of the Royal Mail flotation as we encouraged people to apply for shares that have since soared by more than 70pc. Crucially we also said investors should hold the shares for the long term and this maiden set of results as a listed company shows exactly why.

Profits are rising, debt levels are falling, and the postal company is moving closer to an agreement with the unions that could greatly reduce the risk of industrial action.

The political debate surrounding the flotation valuation is detracting from the minor miracle that is taking place at the centuries old postal service. Royal Mail has more than doubled profit before tax in the first-half of the year to £233m when compared to the same period last year, and putting that in context the company made a full year loss of £258m as recently as 2011.

Digging beneath the headline number Royal Mail said that the first half profits were flattered by a one off government tax break and the timing of redundancies. Still, adjust for these and profits are still heading strongly in the right direction.

Questor believes the profits should carry on rising as what we are now seeing are the fruits of a long process that started back in February 2003. That was the date Adam Crozier joined as chief executive, at the time describing his role as the “biggest corporate turnaround programme in the UK”.

A turnaround of a public sector giant like Royal Mail usually means job losses, and these are expensive. That said, after 10 years most of the pain has now been taken. Royal Mail reported £195m in transformation costs for the year ended March 2013, this number is expected to fall to £165m in the current year, and settle at between £100m to £120m for future years, adding almost £100m to profits.

The company reported like-for-like operating profit margin of 5.2pc and analysts believe this will rise towards 8pc in the next three years, in line with European postal sector peers.

The company is now also generating more cash and this reduced debt levels by £183m, leaving net debt of £723m at the end of September. Analysts expect debt levels to fall by a further £220m in the second half.

Revenues are expected to be stable at about £9.3bn for the full year as parcel revenues increased 9pc and offset falling letter volumes down 6pc in the first half.

The threat of industrial action remains a risk to investors. The company is set to complete discussions with its workforce and unions next week. However, they are still talking which must be taken as a positive.

On the plus side there is the value of the property portfolio that could be worth between £500m to £1bn, or 50p to 100p to the share price.

However, Royal Mail shares are now looking expensive. They trade on a price earnings multiple of 15.7 times forecast earnings, compared to a sector average of 14.5 times. The closest comparable company, Belgian operator Bpost, for instance trades on a P/E ratio of 12 times forecast earnings or a 24pc discount.

Royal Mail also looks expensive in terms of its forecast dividend yield of 3.7pc, compared to a sector average of 5.1pc.

The postal group is a solid long term bet and has made a strong start to life as a listed company. However, we downgrade the shares as much of the good news and some more is now in the price. Hold.