Is Royal Mail delivering?

I offer an updated view of Royal Mail (RMG) equity after the share price bounces 10% from its recent low. The shares look attractive with an above average dividend yield and a fair valuation of estimated earnings.

I note that the Royal Mail Group (RMG) has rallied ten per cent this month – an occasion then, for beating the bushes! I note that a couple of brokers are reported as having some positive views on the shares so I have gone back to the fundamentals myself, for a good look.

The first thing to observe is that the share price chart indicates that the shares have been trading for some time in a ‘trading range’ of between about 425p and 525p – roughly speaking. The share price last seen was 443p, leaving plenty of headroom within the trading range for an upward movement in the share price, should circumstances dictate. Assuming that the fundamentals seem to support that prospect, then the move to 525p implies a possible 18% capital uplift. Adding the dividend to that makes it look an interesting and attractive proposition.

The share price is now well above it issue price of 330p, although that price was, to judge from the immediate and subsequent significant rise in its value, indicative of a politically embarrassing undervaluation – at least until the share price fell again as analysts got to grips with the reality of its immediate prospects and problems. It became, as a result, a pretty volatile share. However, things appear to be settling down as its track record as a publically quoted company gets established.

The problems are well known: it has a declining letters business as the nation grows less literate and less familiar; letters from maiden aunts in Tunbridge Wells are vanishing under a flood of e-mails from the rest of the world with cookies attached; and Royal Mail has a less dominant position in parcel deliveries in part generated by those pesky and often impertinent e-mails and other electronic, so called, electronic media, which I am far too grown-up to wish to get involved with.

However, even in the fairly short time of Royal Mail’s existence as a public company, the balance of competition in the arduously competitive parcels delivery service has moved in Royal Mail’s advantage as one or two low-margin competitors, have gone down before the grim reaper’s competitive scythe (a rare agricultural metaphor for our technological age) in the parcel delivery industry’s fight for survival. I point out that the Royal Mail’s gross margin of over 40% was whittled down to an operating margin of just over 2% last year. The clear desire of Amazon to vertically integrate itself with the entire Universe (or perhaps the other way round), including its own parcels, has not helped a ‘legacy’ company which, as we have been reminded this week, was started by Henry VIII – who no doubt inspired the tradition of putting heads on stamps.

So would it not seem pertinent to ask what an old intermediary delivery service possesses to fight its corner in a fiercely, destructive, competitive parcels market?

First, it still has the inefficiency of a one-time government owned and unionised near-monopoly. It was part of the logic of privatising this ancient and socially useful British institution, to gouge out those inefficiencies to make it a modern competitive commercial organisation. That goal is now being met and looks as though it will continue to be over coming years. There seems to be expectation of a significant improvement in the operating margin as a result. It has the ‘fat’ from those old economic inefficiencies that is being trimmed and turned into cost reductions, and to some extent cash flow. It is the basis on which the market is able to forecast an improving operating margin.

Second, it has critical mass in the shape of nationwide delivery and collection centres, in the shape of increasingly reformed, more commercially organised and staffed High Street post offices which, together with neighbourhood sorting offices, even Amazon cannot easily replicate.

Third, it also has the great commercial advantage of comparatively low balance sheet gearing at a time when balance sheet analysts’ thoughts are turning to rising interest rates at some time next year. The company has some debt but little compared with most companies, both public and private. Total debt, which stood at over £1.1billion three years ago, was down to £0.58 billion in the last September balance sheet, meaning that Royal Mail’s equity gearing is a remarkably low 15%. If one is looking for a lowly geared, high yielding investment with which to ride the forthcoming rise in the UK interest rate cycle, this could be it.

The company has also been exhibiting improved operating cash flow, to which the depreciation charge makes a stabilising contribution of thirty six per cent. The accounts show that operating cash flow of £763 million last year covered the annual cost of dividends a reassuring 3.7 times.

In terms of other investor attractions, I observe that there is a pretty low ‘price to book’ ratio with balance sheet assets estimated to be worth around 350p of a share price of 443p last seen. Even the net tangible asset support is significantly high.

Finally, the current market capitalisation of Royal Mail equity, at £4.47 billion, commands an enterprise value (i.e. the company’s total assets) of near £7.2 billion.

A glance at the market consensus estimates for Royal Mail tells us that a 20% decline in this year’s profits is already discounted in the share price. Earnings per share estimates of 34p put the shares on a prospective 12.3 times for this year and (with an estimated ten per cent rise in earnings per share next year) earnings of an estimated 22.7p put the shares on a forward price to earnings ratio of 11.5 times for next year. Prospective annual dividend yields are estimated at 4.6% for this year and 4.9% for next year.