Questor share tip: Hold Royal Mail for income

Royal Mail
519p-56
Questor says HOLD

SHOULD Royal Mail investors return their shares to sender after the company warned on increasing competition in the parcel delivery market? Questor thinks there is more going on beneath the surface at the national postal service and this first set of full-year results as a listed company show why shareholders should hold on.

The long-term investment case remains. Revenue increased 2pc to £9.46bn, and pre-tax profits jumped from £283m to £1.67bn. Even adjusting for a £1.35bn pension benefit this year the adjusted pre-tax profits were still up by more than a fifth to £363m, from £304m.

There was a mixture of good and bad news in the detail. There was disappointment in parcel delivery. This is important for the share price because profit from parcels is seen as the big opportunity for the business as more people shop online.

Royal Mail remains the UK market leader in parcel delivery but warned of “intense” competition. Despite this, volumes are forecast to increase by about 5pc next year.

Letters, on the other hand, delivered an encouraging performance. Most in the industry accept letters are in long-term decline. The volume of letters sent was down 4pc to 16.5bn this year, but revenue was only down 2pc as stamp price increases offset lower volumes.

UK Parcels, International and Letters (UKPIL), the core Royal Mail division that generates 82pc of revenue and 72pc of profits, reported profits up £15m to £309m. So, not exactly breathtaking, and the profit margin slipped from 3.9pc to 3.5pc, but still a steady profit performance. Revenue in the core division is split about 60/40 between letters and parcels.

The European parcel delivery business called General Logistics Systems (GLS) makes up the balance of revenue and profits. The results here were again solid with revenue up 7pc to £1.65bn and profits 4pc higher at £128m. Royal Mail warned revenue growth would be more muted this year.

The annual results revealed an increase in redundancy-related costs from £195m to £241m. But a large part of this was Royal Mail preparing for the loss of 1,300 management roles. These changes are expected to save £25m by March 2015, rising to £50m next year.

Questor was more interested in the performance below the surface. Free cash flow was better, up £64m to £398m. This strong performance meant net debts were lower than expected at £555m. Both these factors reduce risks for shareholders.

Dividend payments look fairly comfortable. The final dividend proposed is 13.3p, ex-dividend July 2, payable July 31. Royal Mail only floated part way through its full financial year, so there was no interim payment. Adding this in for the current year will equal about 21p, representing a yield of 4pc.

There is still the potential of a cash inflow from the sale of Royal Mail’s properties. The company’s sites at Mount Pleasant, Nine Elms and Paddington are all prime London property. There is no way of knowing if or when they will be sold, but in total they have been valued at up to £500m, which works out at 50p per share.

Questor was an early supporter of the Royal Mail flotation. On September 27, we advised “Get in quick and buy Royal Mail” at 330p. The shares have since returned gains of more than 62pc. We downgraded the shares last year (565p, November 28) as the rating got ahead of itself at 17 times forecast earnings. The shares fell more than 7pc yesterday.

Cost-cutting and revenue growth are expected to increase the adjusted earnings at Royal Mail to about £500m in the year ended March 2015. The closest European sector peers are rated on about 9.5 times adjusted earnings, which gives a share price of 475p.

Throw in about half the property, and the shares around 500p look reasonable. Royal Mail issued a cautious outlook, proving life in the private sector is tough, but Questor believes they remain a solid investment for the long term. Hold.