Results review: Royal Mail plc delivers progress but value is uncertain

Source: Royal Mail

Roland owns shares of Royal Mail.

FY17 results: 18 May 2017

My review of Royal Mail’s 2016/17 full-year results.

Royal Mail is a holding in another of my portfolios. This has historically focused on income, but I’m now shifting it towards my value strategy.

I’m trialling a new format for this article, based on my personal notes on the stock. My hope is that posting like this will enable me to post more often around other work commitments. But let me know if it’s too hard to follow.

Comments

The narrative seems reasonably positive. Ongoing shift to focus on parcels and manage the decline of the letters business. Growing contribution from international GLS business.

However, it’s also worth remembering that Royal Mail already has a 50% share of the UK parcels market. The group is aiming to keep this share steady, growing in line with the parcel market (about 3% p.a., according to Royal Mail figures). Significant market share growth could be unlikely, as competition from Amazon and other parcel operators appears to be intense.

This is a key risk, in my view — retaining this dominant market share is probably essential to ensure the profitability of Royal Mail’s universal delivery network. Any reduction in market share could be seriously bad news.

Total capex has fallen from £694m in FY16 to £529m in FY17. Guidance for FY18 is c.£450m, with sub-£500m expected for the foreseeable future.

Earnings analysis

Reported eps rose by 14% to 27.3p, so the stock looks fully priced on a P/E of c.15 @ 435p

Adjusted eps is more encouraging at 43.8p, giving a P/E of about 10. Are the adjusting items reasonable (in my opinion)?

Operating adjustments:

• Transformation costs £137m (FY16: £191m) – Good to see this number falling. But I’d still include these costs in my calculation of operating profit, as in my view they’re necessary for both the present operation and the future survival of the business.
• Employee free shares £105m (FY16: £158m) – I’d normally argue these were part of remuneration and should not be adjusted out, but in this case the free shares appear to have been gifted by HM Government into trust for distribution to employees (see 2016 Annual Report Note 15). So for the time being, it seems fair to ignore the income statement cost of these, as the actual cost to RMG appears to be zero.
• The other adjusting items to operating profit are small and perfectly fair, in my view.

My estimate of ‘clean’ FY17 operating profit = £324m (FY16: £296m)

This gives an operating margin of 3.3% (FY16: 3.2%) and an earnings yield (EBIT/EV) of 7.3%. The operating margin is low but the earnings yield is quite attractive. Thus these figures suggest to me that the current valuation of the group is quite attractive, relative to its profitability.

Non-operating adjustments:

• Net pension interest: £120m (FY16: £113m) – Royal Mail’s pension scheme is currently running a surplus, hence this line item. But it’s an accounting item only — it’s non-cash and isn’t a business-related gain. So in my view it should be excluded from earnings per share.

My estimate of ‘clean’ FY17 pre-tax profit = £320m (FY16: £283m)

The average tax rate over the last two years is 17.7%. Using this rate gives:

My estimate of ‘clean’ FY17 after-tax profit = £263.5m (FY16: £232.9m)

My estimate of ‘clean’ FY17 earnings = 26.3p per share (FY16: 23.3p)

This gives a trailing P/E of 16.3, which isn’t obviously cheap for a low-growth business. Does the cash flow situation paint a more favourable picture?

Cash flow analysis

The beauty of the cash flow statement is that you don’t need to worry about non-cash items distorting the results. The only adjustments I might make here are based on my view on whether a cash item is truly exceptional or not.

The figures from last year’s cash flow statement seem to confirm my view on profits. Free cash flow is the metric I’m most interested in here, given that this is a dividend stock with low growth expectations.

I’ve calculated free cash flow to equity on this basis:

Free cash flow to equity = Net cash inflow from operating activities – net cash outflow from investing activities – finance costs paid – payment of obligations under finance lease contracts

My calculations indicate free cash flow to equity = £153m (excluding acquisitions = £275m)

Note re. acquisitions: I usually exclude acquisitions from free cash flow calculations, but in this case I haven’t. Royal Mail has made similar sized (fairly small) acquisitions in each of the last two years as part of its growth plans for GLS. This seems likely to continue, so I want to see if the dividend is affordable alongside these costs.

The cost of the dividend last year was £222m, exceeding my estimate of the free cash flow available for shareholder returns. That’s one possible reason why Royal Mail’s net debt rose from £224m to £338m last year — the group’s cash flow wasn’t enough to support its transformation costs, acquisitions and dividend.

I’m not concerned about Royal Mail’s use of debt or its level of gearing, yet. But it’s something to watch.

Profitability

I’ve done a quick calculation of return on capital employed for Royal Mail. The results are quite interesting:

• FY17 ROCE (including pension surplus): 5.1%
• FY17 ROCE (excluding pension surplus): 13.1%

These figures suggest that Royal Mail’s underlying business does generate a reasonably attractive return on capital employed.

Dividend

A key attraction, the full-year dividend has been increased by 4% to 23p per share, giving a trailing yield of 5.3% at a share price of 430p.

The yield is attractive, but dividend cover is poor based on my eps estimate of 26.3p per share and on the group’s reported eps of 27.3p per share. Dividend growth may be limited over the next few years.

Conclusion

Royal Mail has 50% of the UK parcel business. With such a dominant market position, I don’t think it’s reasonable to expect anything more than low single-digit growth in parcel revenues. The group is hoping that its international GLS business (of which Parcelforce is the UK arm) will provide some growth to offset the decline in the letters business.

If you’re wondering about the discount to book value which shows up on some data services, I’d be aware that that this is only due to the pension surplus, which was listed as a £3.8bn non-current asset for FY17. Even if this persists (we’re told it won’t), I don’t see this as an attraction for equity investors. Stripping out the pension surplus gives a book value of about £1.2bn, putting Royal Mail on a pension-adjusted price/book ratio of about 3.7.

In my view, Royal Mail’s current valuation is probably attractive for income investors. This was the original reason for my purchase of the stock.

I’m moving away from income to focus more heavily on value. And I’m less certain whether Royal Mail is cheap enough to qualify as a value buy. Although the earnings yield and ROCE are fairly attractive, the parcels business is fiercely competitive. I’m not sure how much room the group will have to increase profits or margins, especially as it will have to maintain capacity in its declining letters business.

Overall, I’d rate the stock as a hold. I’m going to mull it over, but may soon sell some or all of my holding.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.