Is a Royal Mail renaissance too good to be true?

Just over a year ago, both analysts and investors had been getting increasingly pessimistic about Royal Mail (RMG)’s outlook. Here was a business that was tied down by a structurally declining letters market and its ‘universal service obligation’ (USO), and had also been slow to adapt to the rise of online shopping and parcel delivery.

But the shares have staged an extraordinary recovery over the past 12 months as the group has benefitted from surging parcel demand during the pandemic. Having reached a record low of 120p at the trough of the ‘Corona crunch’, they have vaulted to 531p now, and Royal Mail could rejoin the FTSE 100 during next month’s reshuffle after exiting the index at the end of 2018.

But look beyond the exceptionally favourable conditions of the pandemic, and you will find that many of Royal Mail’s fundamental problems remain, including a lack of automation and rising competition. Given that turnarounds have been promised before and failed to arrive, it begs the question: are we finally on the cusp of a Royal Mail renaissance or is it too good to be true?

A pandemic parcel boom

As the pandemic drove consumers to do their shopping online, Royal Mail derived the majority of its revenue from parcels rather than letters in the year to 31 March – the first time this has occurred in its five-century history. Parcels now account for 72 per cent of the group’s total revenue.

In its UK business, parcel revenue jumped by close to two-fifths to £5.1bn, offsetting a 13 per cent decline in letter revenue. This saw the segment’s adjusted operating profit rocket from £117m to £344m.

Meanwhile, the international GLS parcels business increased its revenue by 28 per cent to £4bn, benefitting from higher business-to-consumer (B2C) volumes. Adjusted operating profit jumped by 72 per cent to £358m, with operating leverage and pricing initiatives pushing the margin up 2.3 percentage points to 8.9 per cent – that’s more than double the margin of the UK business.

Overall, the group generated an adjusted operating profit of £702m, well ahead of the £325m seen a year earlier. This came despite a 14 per cent increase in operating costs as it adapted to deal with the pandemic and had to sort more parcels.

Will the momentum continue?

Royal Mail has refrained from providing earnings guidance for this year, citing uncertainty over consumers’ future behaviour. The online shopping frenzy will likely moderate as life returns to some semblance of normality, and analysts are currently forecasting that adjusted operating profit will drop to £676m this year.

Over at GLS, the group believes that around 60 per cent of volume and revenue growth can be sustained post-pandemic and around half of its adjusted operating profit growth.  

In the UK, there is already some evidence that momentum is slowing – while parcel revenue grew by a fifth in April, volumes dropped by 2 per cent.

Still, amid the structural shift to e-commerce, Royal Mail is confident that a “significant proportion” of the parcel growth experienced over the past year will persist.

Some investors are bullish on the group’s long-term prospects. Royal Mail is the top holding of the Temple Bar Investment Trust (GB0008825324), and co-manager Ian Lance is drawn to the group’s “strong revenue growth as a result of their dominant position in parcels delivery both in the UK and in Europe”. He also points to a “very strong balance sheet”.

Indeed, after repaying a £700m loan and boosting free cash flow by more than a fifth to £800m, Royal Mail swung from £46m of net debt (excluding lease liabilities) to £622m of net cash. It has declared a one-off final dividend of 10p per share and is planning a 20p per share dividend for the new financial year.

Royal Mail used to be one of London’s most shorted stocks, but as confidence returns, short interest in the company has declined from almost a tenth of the issued share capital in August to zero now. An investment vehicle that is majority-owned by billionaire Daniel Křetínský has become Royal Mail’s largest shareholder with a 16 per cent stake. Known for his contrarian investments, this has caused speculation that the ‘Czech Sphinx’ may push for the business to be broken up.

As part of the wider Royal Mail group, GLS is potentially undervalued and could conceivably be hived off, either through a sale or flotation. Buyers would likely line up for the faster-growing and more profitable international operations, where Royal Mail is aiming to increase revenue by a compound annual growth rate of 12 per cent between 2020 and 2025.

The fate of the leftover UK business would be unclear. GLS’ profits and cash flow have subsidised the attempted domestic turnaround, although the group now says that its UK business is generating sufficient cash to invest in organic growth, meaning there is “[no] need for any cross subsidy.” Still, it is a less attractive proposition, with the adjusted operating profit margin only expected to reach 5 per cent some time before 2024.

Long-term problems still need addressing

Royal Mail enjoys an effective monopoly in the UK letters market, and with its postmen and women able to reach practically every house every day, you would think this setup would lend itself to a similar level of dominance in parcel delivery.

But the group’s delayed reaction to the rise of e-commerce has allowed a multitude of rivals to enter the market, including the likes of Hermes and Deutsche Post’s (DE:DPW) DHL. As well as lower prices, they have raced ahead with Sunday and same-day delivery.

Amazon’s (US:AMZN) logistics business is perhaps the most significant threat, however. Having only launched in 2012, it has ascended to become the number two player in the UK parcel delivery market with a 15 per cent market share, compared to 35 per cent for Royal Mail. According to logistics provider Pitney Bowes, Amazon Logistics’ parcel volumes grew by a compound annual growth rate of 72 per cent between 2013 and 2019. The momentum is likely to continue as Amazon Logistics now offers seven day and next day delivery for businesses outside of its own e-commerce platform.

Royal Mail is therefore playing catch-up even as it currently remains the UK’s leading parcel courier. It launched a doorstep parcel collection service in October – which it dubbed “one of the biggest shake-ups to the daily delivery since the launch of the postbox in 1852” – and has also now commenced Sunday parcel deliveries.

Part of the reason why Royal Mail has been slow to change is its tenuous industrial relations, although there has been some progress on this front. The group reached an agreement with the Communication Workers Union (CWU) in December, bringing a bitter two-year dispute over job security, pay and hours to an end.

But a pay increase will add a net £130m in labour costs this year. More than half of the group’s £6.1bn of operating expenses are already people costs – with the vast majority of the latter coming from the UK business – and this burden will not be easy to address. While increased use of technology can cut costs, boost processing capacity and improve margins, the substitution of human labour will continue to be a flashpoint with the union.

At present, only a third of Royal Mail’s UK parcels are currently sorted by machine, compared to an industry benchmark of 90 per cent, and it is aiming to hit 50 per cent this year. As it invests in automation and building two new parcel hubs, the group is stepping up its UK capital expenditure from £210m to over £400m this year. A fully automated parcel hub being built in the Midlands will be able to sort over 1m items when fully operational in 2023.

So, will Royal Mail ultimately deliver for investors?

Chairman Keith Williams is cognisant that a transformation is long overdue. "Commercially we must adapt more quickly to the needs of customers and consumers, and finally deliver the long-promised changes on operational and cost transformation,” he says. “Without these changes, we cannot be competitive into the future."

But such promises have been made, delayed and broken before, so we remain cautious about hopping aboard the Royal Mail bandwagon. It is tempting, with the shares trading at just 10 times consensus 2022 earnings, but a successful pandemic shouldn’t mask the fact that the group still faces an uphill struggle. Hold.

Last IC View: Hold, 336p, 23 Dec 2020