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Royal Mail - extra costs unravel parcel boom

Nicholas Hyett, Equity Analyst | 8 September 2020 | A A A
Royal Mail - extra costs unravel parcel boom

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Royal Mail PLC Ordinary GBP0.01

Sell: 482.80 | Buy: 483.20 | Change -5.20 (-1.06%)
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A short trading update accompanying the group's AGM has Royal Mail's revenues up £139m in the first five months of the year. That reflects very strong growth in parcels, offset by weakness in letters.

However, costs associated with the transition from letters to parcels and coronavirus related expenses mean profitability in the UK Royal Mail business continues to decline. That has been partially offset by improvements in the international GLS business.

The shares rose 6.0% in early trading.

View the latest Royal Mail share price and how to deal

Our View

The huge increase in online shopping has seen a rapid increase in the number of parcels making their way to our doors. Royal Mail's played a key part in that process and that's boosting revenues both home and abroad.

However, the group hasn't escaped coronavirus unscathed. Letter volumes have collapsed, led by a dramatic decline in advertising mail. Extra costs associated with servicing the unexpected parcel demand make increased revenues as much a burden as a blessing in the short term. Combine all that with a potentially painful recession and we expect significant losses next year.

While a pandemic might have been unforeseeable, the current crisis is highlighting long suspected weaknesses. The group's been over reliant on the shrinking letters market and underinvested in parcels infrastructure. Those problems go back years and haven't been helped by a highly unionised workforce and watchful regulator that have, at times, made it difficult to introduce change.

The contrast between the smaller international GLS business and the core Royal Mail operation is stark. Not only are GLS revenues rising, but an operating margin of 8.1% is many multiples of what's being achieved in the UK.

Getting the UK business up to scratch will be top of the agenda for the new CEO when he/she is appointed. In the meantime recently appointed Chairman, now executive Chairman, Keith Williams has set out his short term priorities.

The former British Airways executive has experience dealing with a heavily unionised workforce, and plans to cut 2,000 roles suggest he is prepared to make unpopular decisions. Other operating costs are also under microscope - although the deadline on efficiency and profitability targets has been pushed back from 2024 to a yet to be determined later date.

Cost discipline should pay dividends long term but it must be accompanied by considerable investment in technology.

Royal Mail is looking to automate its UK sorting operations - with a particular focus on improving efficiency in parcels. Along with existing spending plans, that was expected to see the group invest £1.8bn in the UK postal system over 5 years. Those investments might be delayed or trimmed now, but it's still a sizeable commitment.

The combination of short term uncertainty and long term investment demands have led the group to cut its dividend. That will be unpopular with shareholders but we think it's the right decision. Royal Mail's balance sheet may be in relatively good shape now, but with several years heavy investment to come it won't stay that way.

It's hard to overstate the challenges that face Royal Mail at the moment. Shrinking the cost base, investing in technology and adding to international acquisitions are, in our opinion, the right answers. However, coming up with answers and executing them are very different things, and Royal Mail's track record doesn't inspire confidence.

Royal Mail key facts

  • Royal Mail is expected to be loss making this year, and as a result there is not currently a valid PE ratio
  • Average Price/Earnings ratio since listing: 11.3
  • Prospective yield: 1.2%

Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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AGM Trading Update

Royal Mail reported a 34% increase in parcel volumes in the first five months of the year, representing 177m more parcels, with parcel revenues up 33.1%. Addressed letter volumes fell by 1.1bn letters, or 28%, with letter revenue down 21.5%.

Total revenue in the UK business is expected to rise £139m. However, costs associated with shifting towards parcels are expected to be £85m, while coronavirus related costs were £75m.

As a result Royal Mail is still expected to make a material loss this year. That's despite £200m of operating cost savings planned in the division this year, and a further £130m in 2021-2022. The group has also reduced planned capital expenditure by £250m over the next two years.

GLS volumes rose 19% in the first five months of the year, with revenues up 18.6%. The group reported an operating margin of 8.1%. Growth was driven by continued expansion in B2C parcels, with particular improvements in the previously struggling markets such as France, Spain and the US.

The group has updated guidance for the full year, and now expects Royal Mail revenues to be £75-150m higher than in 2019-20 compared to £200-250m back in June. Total transition/COVID costs are now expected to be between £260-280m compared to £250m expected in June. However, the outlook for GLS has improved, with revenues expected to rise by 10-14% compared to 5-7% back in June and expected operating margins rising from 6% to 7%.

The group continues to discuss operational and regulatory changes with staff, the regulator, government and parliament.

Find out more about Royal Mail shares including how to invest

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.