Dying business, striking staff – should you really buy Royal Mail?

Privatisation is back in fashion.

The government will want to sell its stake in Lloyds Bank before too long. But before then, we have a Royal Mail share sale that is almost ready to go.

Many private investors made good money from the last big privatisation boom in the 80s. So does it make sense to play the same game almost 30 years later?

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In particular, should you buy shares in Royal Mail?

The reasons to avoid Royal Mail

The biggest minus point and it is a very big one is that Royal Mail's traditional business is in massive decline. The number of letters delivered by Royal Mail has slumped by 30% since 2006, with an 8% decline over the last year alone.

Granted, that decline is at least partially offset by Royal Mail's fast-growing parcels business. But there's plenty of competition in that market, and not all the players involved are prospering. For example, Rentokil Initial sold its courier business, City Link, earlier this year for just £1.

What's more, Royal Mail will continue to be constrained by the Universal Service Obligation (USO). In other words, it must carry on charging the same price for each letter, even if it is sent from Cornwall to an address in the Scottish Highlands.

Strike action in protest against the privatisation also looks likely. And that will only help Royal Mail's rivals in the parcels sector pick up new customers from the incumbent, just as it needs all the business it can get.

So we've got a company whose main business is in decline, whose workers are fomenting rebellion, which is handicapped by social obligations, and where the best hope of growth is in an already cut-throat sector of the market.

Doesn't sound too promising, does it?

Yet, in spite of these problems, I still reckon that Royal Mail will prove to be an attractive investment.

Why Royal Mail is worth a punt

And with an election looming, there's one thing the government wants more than anything out of the Royal Mail sell-off: to promote the feel-good factor' by helping the small investor make a quick buck from this new-wave privatisation.

So that means Royal Mail is likely to go at a reasonable price. We don't yet know what that will be, but City analysts reckon on an initial valuation somewhere between £2.5bn and £3bn.

Given that Royal Mail's pre-tax profits rose 60% to £324m last year, that kind of valuation doesn't look unreasonable.

It also looks like the company will pay a decent dividend. New shareholders will receive a total dividend of £133m next summer. That would be equivalent to £200m if the company had been listed on the stock market for a full year. Even at a £3bn valuation, the upper end of estimates, that's a 6.6% dividend yield.

It's reasonably well covered too. Royal Mail generated free cash of £334m last year, so it shouldn't have any problems paying out, as long as the parcels business can continue to grow and offset declining letter volumes.

And despite the strong competition in the sector, I think Royal Mail's parcels division can do just that. Parcels now account for more than half of the company's sales, and this is growing at 13% a year. There's also plenty of scope for further efficiency gains once extra investment in new machinery and the like is made.

That takes us back to one of the main points of privatising the service: enabling that extra investment. Just now, Royal Mail pays 8.6% interest on its debt to the government. That cost of capital should fall sharply once the company is in the private sector.

What's more, the management team seems capable, having already delivered an impressive turnaround. That free cash flow figure of £334m last year that I cited earlier is up from a £390m free cash outflow in 2009 (effectively a loss, in other words).

And there's no need to worry about looming pension deficits, as all those pension responsibilities have been transferred over to the government. That might bother you as a taxpayer, but as a potential Royal Mail shareholder, it's good news.

It's also worth remembering just how well some private investors did from privatisations back in the 80s. If you'd bought and held £1,350 worth of British Gas shares at privatisation, you'd now have shares worth £16,534 in all the successor companies, according to Hargreaves Lansdown. And that's excluding dividends!

If you're tempted to invest, we'll have more details on the technicalities in the next few days. But we do know that the government plans to sell shares within weeks' and that it will sell at least 41% of the company.

It should also be pretty easy to participate. If you already have a stockbroker, you'll probably be able to buy without paying a dealing charge. The government will also be selling shares directly via post or the web.

We'll be covering the story in next week's issue of MoneyWeek magazine if you're not already a subscriber, you can subscribe to MoneyWeek magazine.

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