Royal Mail won't deliver

Negotiations in early December averted the Christmas postal strike action, but the accord created by the three-year pay deal agreed at the time has already come under threat from the latest round of job cuts and further tensions look inevitable. Indeed, for Royal Mail to live up to its City billing as a restructuring recovery play, it needs to boost margins through cost-cutting and price rises. Lifting prices has had a negative impact on volumes, which means cutting costs will remain key - initiatives include investment in technology as well as unpopular measures such as depot closures and jobs cuts.

Depot closures can be seen as a casualty of a bigger problem for Royal Mail. While the parcels delivery industry is benefiting from growth caused by increased online shopping, this has been accompanied by growth in competition and the evolution of innovative and popular e-commerce distribution trends such as Click & Collect. Meanwhile, online behemoths including Amazon (US:AMZN) and eBay (US:EBAY) are fast developing their own delivery partnerships and networks to offer a competitive edge to customers. Meanwhile, the letters business is in structural decline due to the rise of email and Royal Mail faces the threat of competitors cherry-picking the country's most high volume delivery areas to set up direct-to-letter-box services.

Royal Mail's Christmas trading figures alluded to these challenges. The parcels business, which accounts for just over half the revenues, delivered like-for-like growth of 8 per cent over the nine months to December, but flat volumes. Letter volumes fell 5 per cent, while volume and revenue dipped 3 per cent. Overall group like-for-like sales only grew by 2 per cent.

Management says the restructuring of its pricing approach - now based on size instead of weight - has helped offset stalling volumes, but brokers expect benefits to peter out from 2015. Rising sub-contractor rates in Germany could add to cost pressures across its European network. Better progress is being made elsewhere on the continent - for example, Italy - but a sub-contracted model leaves the company exposed to external rate inflation and, therefore, rising costs.

Royal Mail's attractions as an income stock look increasingly stretched with this year's expected 2.4 per cent yield well below the 4.2 per cent offered by the FTSE 100 and even 2015's forecast 3.6 per cent not matching up. What's more, the internal issues with unions and external pressures from competitors and market trends, coupled with the sensitivity of profits to small changes in volumes, leaves us feeling nervous about the bullishness of brokers' forecasts. Meanwhile, the need for heavy investment in technology upgrades will eat into the cash flows that support the dividend.