It’s been a long road but, finally, the FTSE 100 has reached 7,500 points. This may prompt worry among some investors, since it could mean the index is overvalued and there is a lack of investment opportunities on offer. Risks such as Brexit, the general election, Trump’s Presidency and numerous others could weigh on the UK’s main index.
Likewise, those risks may fade and leave investors in an even more bullish mood. Therefore, in my view there is limited value in attempting to predict the short-term price movements of the index. During bull and bear markets, opportunities to buy and sell nearly always exist – no matter what the index’s level.
One such opportunity at the moment could be Royal Mail (LON:RMG). The company offers a very low valuation, high yield and a business model which has the potential to improve. Although risks do exist, the rewards suggest Royal Mail has investment appeal regardless of how the FTSE 100 performs in future.
A struggling business?
Royal Mail is essentially a two-speed business. Its traditional UK operations account for 78% of revenue and have been struggling for some time. For example, in its full year to 26 March 2017, it recorded a decline in underlying revenue in its UK business of 2%. This was largely due to a continued downward trend in its letters segment, where revenue declined 5%.
Although the company is implementing what appears to be a sound strategy to avoid £600 million of annualised costs within its UK business by 2017/18, the overall picture is one of decline as posting letters simply becomes less popular. Therefore, further cuts to underlying operating costs in its UK division after three years of reductions is only likely to have a limited impact on overall profitability in the long run.
Still, the company’s disappointment within its letters segment was offset to some degree by a 3% rise in revenue within its UK parcel segment. Investment in new technology was a key reason for this improved top-line figure. With net cash investment of £450 million anticipated in 2017/18, more revenue growth could be ahead for its parcels segment. This may help to limit the overall decline in its UK operations.
A growth opportunity
While 78% of Royal Mail’s business is experiencing a difficult period, the remaining 22% is undergoing rapid growth. Its General Logistics Systems (GLS) business recorded underlying revenue growth of 9% last year and now operates in 42 countries across the globe. It achieved growth in revenue across almost all of its markets, while making acquisitions in the US and Spain.
While 78% of Royal Mail’s business is experiencing a difficult period, the remaining 22% is undergoing rapid growth.
GLS could offer a growth opportunity for Royal Mail. It has the potential to not only offset the challenging outlook for the company’s UK business (in particular its UK letters business), but to gradually become a more dominant part of the business which is able to drive revenue and profit growth in the long run.
Therefore, while the company may be forecast to report flat earnings in 2019 versus the numbers achieved in 2017, in the long run the contribution from GLS may be sufficient to generate company-wide positive revenue and profit growth.
Some investors may see the FTSE 100 as overvalued at the moment. Although it has a dividend yield of 3.8%, which is historically high, investor psychology and a strengthening pound may mean that further growth is somewhat limited.
In contrast, Royal Mail is unlikely to be viewed as anything but ‘cheap’ by almost all investors. The company has a P/E of 9.6 and a dividend yield of 5.4%. This makes it one of the cheapest shares in the FTSE 100, and also puts it in the top decile by dividend yield. Both of these characteristics suggest a higher share price could be warranted over the medium term. That’s particularly due to the growth from GLS and the scope for a positive foreign currency translation if Brexit talks cause the pound to depreciate.
Further, CPI inflation is now at 2.7%. It is forecast to move higher over the course of 2017 and 2018, which could reignite interest in dividend growth among investors. Royal Mail’s dividend cover of 1.9x could allow for above-inflation dividend growth in financial years 2018 and 2019 even if profitability fails to rise. Beyond 2019, the cost avoidances, cost reductions, investment in technology and growth of GLS may be sufficient to generate growing profitability that could merit dividend growth.
As well as the risk of further declines in its UK operations, Royal Mail also faces the risk of strike action. It recently announced a plan to close its defined benefit pension scheme to future accrual in 2018. Although it is in surplus at the moment, the company estimates contributions would need to rise to £1 billion per annum over the medium term. These are deemed unaffordable by Royal Mail.
The promise of renationalisation under a Labour government may be holding the company’s share price back to some extent.
In response, strike action has been threatened by unions. This would not only disrupt the company’s operations, but could also lead to declining investor sentiment. Similarly, the promise of renationalisation under a Labour government may be holding the company’s share price back to some extent. However, given the Conservative Party’s lead in the polls, a renationalisation seems unlikely.
The FTSE 100’s record level of 7,500 points may leave some investors feeling nervous about the index’s future prospects. It could indicate high valuations given the risks faced – particularly political risks in the US and Europe. However, the valuation of Royal Mail seems low in a range of market conditions, given the company’s long-term growth potential and current strategy.
Its cost savings and cost avoidance initiatives in the UK could help offset further revenue declines. Expansion of its GLS segment through acquisition and organic growth could lead to a more compelling growth story for the overall business. This could push the company’s dividend higher, while a modest payout ratio indicates inflation-beating dividend growth could lie ahead.
Although the company faces a risk of strike action, and renationalisation cannot be ruled out completely, it seems to be a sound investment. The FTSE 100 may rise or fall. Royal Mail could be a strong performer in either scenario.