Royal Mail: return to sender

The ‘UK parcels, international and letters’ (UKPIL) division provides its core domestic delivery service through the ‘Royal Mail’ and ‘Parcelforce’ brands. As the ‘universal service provider’ it acts as a ‘one-price-goes-anywhere’ courier across the country, six days a week. UKPIL has found itself overtaken by the times – over reliant on a shrinking letters market amid the rise of electronic alternatives and underinvested in parcel delivery. Royal Mail was slow to capitalise on the rise of online shopping and parcel delivery is now a crowded space, with competition including UPS (US:UPS), Hermes and Deutsche Post’s (DE:DPW) DHL. More than just pricing pressure, Royal Mail has been unable to follow rivals into services such as Sunday and same-day delivery.

UKPIL made an adjusted operating profit of £117m in the year to the end of March – versus £234m a year earlier – on the back of £7.7bn of revenue. It was weighed down by higher distribution, conveyance and people costs and was loss-making on a statutory basis, largely because of a £91m impairment on Parcelforce. UKPIL says it will be “materially” loss-making this year, with a potential £600m hit to revenue and £155m of additional costs blamed on Covid-19.

Meanwhile, the ‘general logistics systems’ (GLS) segment delivers parcels across Europe and North America. Acquired in 1999, GLS has emerged as the engine room of profits, generating £208m of adjusted operating profit last year. Its 6.6 per cent profit margin compares with just 1.5 per cent for UKPIL, yet this has been deteriorating since 2017. Further erosion could come as weak demand hits volumes in its higher-margin ‘business-to-business’ (B2B) operation while ‘business-to-consumer’ (B2C) deliveries has higher unit costs. 

Royal Mail has been desperately trying to transform itself. Through its ‘Journey 2024’ plan unveiled last May, it aims to become a parcels-led business, reducing costs by investing in automated sorting. Already behind schedule by November, Covid-19 has provided a further setback. The sticking point is opposition from its unionised workforce. Staff costs account for almost 60 per cent of Royal Mail's £10.6bn costs, and efforts to become more productive have encountered resistance. There were six national industrial action ballots in its 2020 financial year and Royal Mail needed a High Court injunction to prevent a Christmas strike. The Communications Workers Union voted to walkout in March and, while a strike has been delayed, it is a problem Royal Mail has yet to solve. That said, chief executive Rico Back’s departure in May could allow union relations to be reset.

Royal Mail’s saving grace is its balance sheet. Excluding lease liabilities, net debt improved from £300m to £46m in 2019-20, equivalent to just 0.2 times adjusted cash profits (Ebitda). It generated £653m of free cash flow and is sitting on £1.9bn of total liquidity. Still, there was no final dividend last year and management does not intend to restore the payout until 2021-22. In light of the pandemic, management will cut capital spending by £250m across the next two years and look to trim 2,000 management-level jobs to boost operating profit by £330m in 2022.

There is a possible near-term share price catalyst. Vesa Equity Investment – owned by Czech billionaire Daniel Křetínský – has been building its stake in the aftermath of the ‘Corona-crunch’ and now holds 12.1 per cent of the shares. As Royal Mail’s second-largest shareholder, there is speculation Mr Křetínský could launch a takeover bid or renew pressure to spin off the GLS business. That potential hasn’t been enough to deter Royal Mail’s sceptics. Short-selling interest has risen over the past year to 9.5 per cent of the issued share capital, making Royal Mail London's second most shorted stock.