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TEMPUS

Few positives in a second-class stock at Royal Mail owner IDS

The Times

Ask any one of the dwindling bulls on International Distributions Services what is the attraction of remaining invested in the beleaguered stock and they will point to GLS, the highly profitable international parcels delivery business.

The trouble with unlocking any of that value? Royal Mail, the problem child that represents about half of the FTSE 250 group’s revenue and is in the middle of a lengthy and costly dispute with its workers. Now the Communication Workers Union is understood to have been told that a failure to reach an agreement risks tipping Royal Mail’s lossmaking regulated delivery business in Britain into administration.

But Royal Mail isn’t like most businesses. To put it into administration, for example, government approval would be required. The practicalities and time frame for when any separation could be achieved are opaque. Politically, an administration without International Distributions Services putting any more cash into Royal Mail could prove unpalatable, given that the group balance sheet is not in distress and GLS remains highly profitable. IDS declined to comment on the reports, save for the fact it was doing “all we can to get agreement” with the union.

As JP Morgan Cazenove points out, debt covenants seem unlikely to be breached. At the half-year point IDS had cash and available debt facilities of £1.7 billion. Its £975 million loan facility has a condition of net debt not exceeding 3.5 times adjusted profits. Under the terms used for covenant testing, the group was in a £307 million net cash position at the end of March last year. On that same basis, the American broker reckons it will shift into a net debt position of £197 million at the end of this financial year, which would equate to a leverage multiple of 0.7.

That hardly makes losses any easier to swallow. Analysts have forecast a pre-tax loss of £279 million for this year, or an adjusted operating loss of £182 million. That reflects an anticipated loss of £500 million this year for Royal Mail, worse than the guidance of between £350 million and £450 million.

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Trading guidance for Royal Mail inevitably is laden with caveats. True, there has not been industrial action during the fourth quarter of IDS’s financial year, one condition of losses being held at the level suggested in January. But it does not include the cost of voluntary redundancies, which might be “significantly lower” than the 5,000 to 6,000 previously announced but still has not been accounted for. The threat of fresh strikes could obfuscate guidance for the next financial year.

What about GLS? Profit here is expected be €380 million to €400 million this year, but it is not immune from the economic pressures buffeting Royal Mail. Delivering parcels across borders is a growing market, but GLS has suffered an easing in demand since lockdowns ended. Delivery volumes declined by 2 per cent over the first nine months of the financial year, even if price rises helped to keep revenue in positive territory. Cost inflation is biting and the adjusted operating margin is expected to decline by one percentage point to 7.5 per cent. In the long term, GLS is operating in a highly competitive market, against operators without the cash drain of a legacy business.

The shares have fallen by more than a third over the past 12 months. In a sum-of-the-parts valuation, Liberum has put a £3.4 billion enterprise value on GLS. Based upon IDS’s present market cap and debt, that estimate implies investors value Royal Mail at about £200 million. Even that could prove too generous.

ADVICE Avoid

WHY Industrial action and the continuing decline in letters make it likely the stock will continue to disappoint

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Essentra

Shedding less profitable divisions doesn’t mean Essentra is home and dry. True, the industrial manufacturer and distributor is left with a higher-margin components business and a cleaner balance sheet, but it still faces wider economic pressures that mean sales volumes are expected to be flat, at best, or, at worst, down 2 per cent on last year.

Lockdowns in China and customers running down stock levels in the United States have weighed on orders. Last year revenue growth was inflated by price inflation, which pumped up revenue by 9.5 per cent at a constant currency level, offsetting negative volumes. The question is this: if inflation eases this year as expected, to what extent can Essentra repeat the trick? Analysts at Numis expect more muted revenue growth of only 1 per cent this year.

Post-restructuring, the shares trade at 17 times forward earnings, a slight discount to industrial manufacturing groups with a better proven record, such as DiscoverIE or Diploma. The real test is whether the FTSE 250 group can deliver on a five-year plan to triple operating profit and pump up the margin to 18 per cent, from 12.7 per cent last year. It intends to do that by accelerating revenue growth to a compound rate of more than 10 per cent, from a historic rate of about 4 per cent. That’s quite a jump.

Scott Fawcett, its boss, reckons more than 6 per cent of that will be organic, pinning some hopes on a new transaction management system helping Essentra to price better and operate more efficiently. Relatively fixed operating costs mean there is a degree of operating leverage within the business. The rest of the revenue growth is set to come from mergers and acquisitions.

After shareholder returns of £150 million of proceeds from the sale of the packaging and cigarette filters businesses, leverage is due to stand at about 0.5 times adjusted profits, below a near-term target ceiling of one. Together with the £60 million in cash the remaining business typically churns out, that leaves enough room for more bolt-on deals.

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Then again, there are also share price discounts on offer for better-quality industrial names.

ADVICE Hold

WHY Other industrial companies have proven more resilient to the macroeconomic pressures

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