Stamp of Approval for Royal Mail?

Royal Mail, at 532p following the last annual results to late March 2016 – and after the Ofcom report – looks attractive as a dividend stock, but one which seems a bit ahead of events. They rate, in my view, a ‘hold’ now and a ‘buy’ if they fall back on profit taking or ex div considerations, to 500p or below.

With last year’s results out of the way, we may now review Royal Mail’s (LON:RMG) progress, not only in light of those results, but also in light of last week’s Ofcom report on the company and the traditional mail and parcel delivery industry of which it is a key part, as “ statutory letter deliverer of the last resort.”

The latter refers to it’s perceived strangulating obligation as the nation’s “universal services provider” within a regulated industry, which imposes no such obligation on its market competitors, who duck and dive, like fruit loving swallows, picking off the sweetest cherries of Royal Mail’s least costly, higher margin business; leaving the RMG to pick up the tab for the most costly and lower margin business, and without public subsidy for doing so. Put simply, Royal Mail’s competitors can deliver letters to major city conurbations at an optimum profit, leaving loss making deliveries to your folk in the Western Isles – if you have any – to RMG. To the objective observer, this is a system of competition that most resembles highway robbery.

A little share price history

The share price has performed well both over the year and over the last six months. In the last twelve months the share price has improved 1 per cent at a time when the FTSE 100 fell nearly 11 per cent; over six months, Royal Mail shares have risen nearly 9 per cent while the FTSE 100 declined by 1.6 per cent.

Looking back at my note on this equity in January 2016, I had the following comments:

“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. It estimates earnings per share of 34p, putting 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, putting the shares on a further forward, price to earnings ratio of 11.5 times for next year. Forward annual dividend yields are estimated at 4.6% for this year and 4.9% for next year.”

In fact, during the year to late March 2016, earnings per share rose to 41.3p and the dividend to 21.3p. The share price reflecting that has risen 20 percent from the 443p seen in January to the most recently seen 532p, raising the inevitable question as to whether the share price, having had a good run, is now no longer attractive. In order to do that, it is necessary to unpack the Ofcom report just published.

What Ofcom had to say

The Regulator has determined not to impose any further price controls on Royal Mail: the price cap of 55p per second class stamp remains in place. Moreover, the regulator has said that it will act against some of the manoeuvres of the cherry-picking competition piggy-backing (to mix the metaphor) on Royal Mail’s Universal delivery obligation. It is understood, for example, that some companies are reported to contract to sort bills and bank statements, but then put them in the post for Royal mail to deliver. The Universal delivery obligation is to deliver mail, six days of the week, to every part of the country at a uniform price.

The concern of the regulator had been that Royal Mail had no incentive to improve service and efficiency, because it was the only door-to-door letter delivery service in the UK after the withdrawal of Whistl from the business last year.

The immediate response of the market to this report was positive, with the share price adding a further five per cent rise on the news. Evidently, to quote the report from one quarter of the market, the Ofcom outcome was regarded as benign, although the chief executive of Whistl was reported in the papers as saying that he was disappointed because of the lack of greater price control.

Furthermore, the Ofcom reported is said to conclude that the universal delivery obligation was financially sustainable and generally working well. It also concluded that more savings could be achieved through further efficiencies – which, in the immediate term at least, sounds advantageous to equity holders in Royal Mail. Moreover, it underlined the fact that the company is surveyed to be performing well in terms of customer satisfaction.

An important part of the Royal Mail strategy is to build profitable market share in the parcel delivery segment to offset declines in the letter delivery segment. However, parcel delivery remains highly competitive. It is understood that Ofcom has registered the concern, expressed by other parcel delivery competitors, that Royal Mail could subsidise its parcel delivery offering, by allocating an unfair and invalid portion of its overhead costs from the parcel business to the to the regulated letter delivery business. Ofcom have undertaken to keep an eye on Royal Mail’s cost allocation accounting.

Market consensus expectations

On an assumption of almost static top line sales revenue, the market forecasts seem, fairly reasonably, to see little change in earnings per share this year and next. Basically that includes a 5 per cent drop in earnings per share this year followed by a 3 per cent increase next year; that is to say estimated earnings per share of 39.2p for this year and 40.2p per share for next year which values the shares at 12.6 times and 12.5 times prospectively.

Dividend payments are expected to do better by rising some 8 per cent next year to 23p (1.7 times covered) and an estimated 23.9p the following year (with similar cover). That, at the share price above, gives estimated annual dividend yields of 4.3 per cent for this year and 4.5 per cent for next year.

Although the cash to equity relationship is measured at just under 11 times, the company last year did have more than enough cash to adequately pay its annual dividend. Operating cash fell a little last year, but year-end balance sheet cash, after paying the annual dividend, rose 28 per cent.

There is also strong asset backing and a well below average balance sheet gearing ratio. Total assets are worth an estimated 446p, or 380p on a net tangible asset basis. Equity of £4.4 billion commands total assets of £7.6 billion.

Where next for the share price?

The ‘technical’ position on the share price chart shows a continuing strong upward movement in the share price, rising at what looks to me at somewhere near 45 degrees of elevation. However, it has also reached beyond the upper level of the swing about the central trend, where it should most probably meet resistance for the time being.

In reaching this point, the share price has got into new share price territory and thus broken out on the upside of the previous trading range. My interpretation is that the shares are now a bit overbought and could easily, and reasonably, come back to 500p or so.

The forecast dividend yield looks attractive, but on the basis of market consensus forecasts, the payout is not likely to grow significantly. I judge the shares to be a hold – and a buy at 500p and below.