The current Royal Mail (LSE: RMG) share price of 265p is 20% below its flotation price of 330p in 2013. And getting on for 60% down from its all-time high of 631p made less than a year ago.
However, we’ve seen a bit of a rally of late, following a record low of 234p on 26 March. Is the tide turning, and is now the perfect time to buy in for a big recovery? Here, I’ll explain why I think Royal Mail could struggle to deliver for investors.
Cheap
City analysts expect the company to post a 42% fall in earnings per share to 26.3p for its financial year ended 31 March when it releases its results in May. A further fall of 5% is pencilled in for the year to March 2020, followed by a 4% recovery in fiscal 2021.
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We’re looking at a price-to-earnings ratio of just over 10, which is pretty cheap. So there’s potential for a re-rating — maybe to 12-14 (20-40% upside) — over the next couple of years. This is if we see earnings recover as forecast, and the business looking like it’s moving towards sustainable growth. In addition, there’s currently a running yield of just over 9% on a 24p dividend.
Stretching targets
Everyone’s agreed Royal Mail’s letters business is in structural decline. Management is working on a medium-term outlook of annual contraction of 4-6%. However, it’s expected to be 7-8% for the year just ended, following a worrying 10% drop in Q3 (the Christmas quarter). Furthermore, management has said volumes for fiscal 2020 will also be outside the predicted medium-term range.
It strikes me there’s a risk here that contraction will trend at a faster rate than management is banking on. For a company with a large fixed cost base, this would be terrible news for profits. As it is, management’s productivity targets already look overly ambitious to me, if not in tatters. A gain of just 0.1% looks on the cards for the year ended March, meaning the company has to conjure up an 8% productivity gain in fiscal 2020.
The group’s parcels businesses, at home and abroad, are having to work hard just to offset the malaise of letters. However, its European and North American parcels delivery networks are facing cost pressures, with the division’s operating profit margin dropping nearly 2% to 5.7% in the first half of the financial year. Furthermore, looking to fiscal 2020, the company has said it expects slowing volume growth, as it focuses on trying to protect its margins.
Doubts about dividend delivery
Putting it all together, I see considerable downside risk to current revenue, earnings and cash flow forecasts. This brings us back to the 24p dividend and running yield of over 9%.
If the business does fall short in fiscal 2020, and the dividend is reduced, I bet you a pound to a pinch of snuff it’ll be cut by more than the 6% to 22.5p currently showing as the City consensus forecast. This is because many analysts are going for a maintained dividend, while a minority have pencilled in a hefty reduction — 33% in one instance, albeit not quite as severe as the recent cuts by Marks & Spencer (40%) and Saga (56%).
However, due to the downside risks to revenue and earnings, and the potential rebasing of the dividend, I’m not at all confident Royal Mail will deliver for investors. As such, it’s a stock I’m happy to avoid.
