Royal Mail Profit Warning: £1bn Wiped Off Market Cap

The 1st October saw some odd goings on. Royal Mail (LON:RMG) made the rather unorthodox decision to put out a trading statement/profit warning less than an hour before the market closed. Usually the markets punish this type of behaviour rather harshly, and so it was: the share price was 491p yesterday afternoon, and in 24 hours, would touch as low as 350p: almost a loss of 30%. Such a price drop wouldn’t be unheard of for a smaller firm, but Royal Mail could not be classed as that. In terms of market capitalisation, this trading statement has cost them over £1bn.

Unlike many other companies here, Royal Mail needs no introduction at all. A history going back some 500 years, it has huge significance in the UK, for most of its time it has been under public ownership, providing an essential service. Since 2013 the company was traded on the stock market and not long after the government washed its hands of its remaining shares.

The nature of post has seen many changes over the years. At one time (prior to the dot-com boom) it was thought that physical letters would become redundant altogether as all documents could be replicated electronically. That hasn’t been the case, and indeed letters and physical cards have remained resilient. The proliferation of mail-order and Ebay/Amazon in particular also provided a resurgence for services. Current issues affecting the business as the new GDPR laws which may affect how firms can communicate with their customers.

Since privatisation Royal Mail has returned most of its profits to shareholders by means of dividend among a series of profitable years. However, the share price is not that far off the 330p that it initially floated at.

The Warning

The RNS came out at 3.27pm amongst their half-year trading update. It read:

·  UK productivity performance significantly below plan at 0.1 per cent in H1 2018-19. Expect the full year performance to be significantly below target (upper end of the two to three per cent range).

·     As a result, 2018-19 cost avoidance target lowered from £230 million to £100 million. Implementing a range of short-term cost actions.

·     Now expect Group adjusted operating profit before transformation costs to be in the range of £500 million to £550 million on a 52 week basis.

It could be noted that the CEO has only been in the job a couple of months. There easily could be an element of the outgoing CEO Moya Greene leaving some bad stuff behind, or a deliberate kitchen sink job, allowing for a lower low (which makes subsequent performance look better).

The Business

By most scales, Royal Mail is a colossal business. Employing over 140,000 people and having 1,350 delivery offices around the country, they enjoy a virtual monopoly position for some items such as letters, and in markets where they do have competition some large cost advantages (existing infrastructure).

Their profitability and cash generation has been impressive, albeit stable: last year, profit before tax came in at £565m. The majority of this figure was generated by the services inside the UK but an increasing portion of profit is now coming from GLS, its logistics services which operates overseas.

We can also see that it whilst the business has an obligation to serve some areas even if they are loss making (some rural areas), the pricing power of the business is good. The cost of a first class stamp is now 65p, which is a rough trebling in the space of two decades. Other items could only dream of such leverage.

The last year saw £515m allocated to pension-related adjustments, which comes as little surprise given the large amount of employees that draw a pension. But the pension fund shows a large accounting surplus of £3.3bn. Royal Mail is also capturing the value in its real estate assets. It holds many large sites in prime locations. Sales of these properties have seen its net cash position improve rapidly. The only debt is a long-term bond worth £500m.

Comment: Is the Royal Mail profit warning an opportunity?

Initial instincts are that this is well oversold. The Royal Mail profit warning restates profit to between flat and a 10% decline, and the market has reacted as if the 10% option is definite. There is certainly a premium attached for filing an RNS late; almost inconceivable that the CEO wouldn’t know that the reaction would be more pronounced.

Some parts in the warning potentially point to other underlying problems in the business. The ‘cost avoidance’ target was up to something like £640m in 3 years in the last annual report. It could well be brought into question as to just how much of these costs can be continued to saved without impacting on quality.

One of the more obvious ways of saving is via the workforce, for example cutting benefits, or reducing pay. But perhaps one of the symptoms of doing so is the lack of productivity. With no disrespect to posties, these jobs are not skilled, and it may be difficult to squeeze out gains here either via the carrot or the stick. On a backdrop of declining share price I’d imagine this would be even harder to establish credibility of management. As a people-based business, they are quite vulnerable to strikes disrupting service.

A third worry is whether Royal Mail might be prepared for change. 10 years ago, it was thought that next day delivery was only possible using Special Delivery, nowadays Amazon Prime routinely delivers that. 5 years ago, waiting for a purchase too big to fit through the letterbox meant an unwelcome trip to the sorting office (which also wasn’t open outside of working hours), nowadays we can simply collect from a variety of locations. The next change is unknown, but seems likely to be driven by Amazon, whose logistical capabilities are only going to get better. Perhaps the legacy of Royal Mail could prove to be its downfall: Amazon could cherry-pick the profitable letters/parcels, leaving Royal Mail with a greater proportion of expensive areas to serve (which they have an obligation to do so).

However, there are some opportunities. The GLS division is growing at a decent rate, and Europe-wide there may be opportunities to acquire other related companies, for which there would be some synergies in the economy of scale. It is perhaps a fact that physical mail is in decline, but there will inevitably always be a need for delivery companies in the short and medium term future.

I see the core business as being slowly in decline, but short of disaster striking in the next couple of years I would expect Royal Mail to be in a good position to adapt itself and be in a position to deliver stability. With a good dividend looking safe I think the price could recover gently. 4/5.

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