Delivering profits: should you buy Royal Mail shares?

The volume of parcels delivered by Royal Mail soared during the pandemic, and so did its profits. But it has been coming under pressure lately. So, asks Rupert Hargreaves, should you buy Royal Mail shares?

The Royal Mail (LSE: RMG) share price was one of the big winners of 2020. With non-essential retailers closed for most of the year, the volume of parcels processed by the group surged, and so did its profits.  

For the financial year to the end of March 2021, net profit jumped by 285% to £620m and the stock followed suit, rising 265% in the same period.  

Royal Mail’s latest figures appear to show that higher parcel volumes are here to stay. Domestic parcel volumes were up 31% for the year to the end of March, compared to the pre-pandemic period in 2019 and 2020, although volumes fell by 7% compared to the peak in 2020-2021.  

As the world reopened, there was bound to be some drop-off in parcel delivery volumes, but the stock’s recent performance suggests the market is far more concerned about other headwinds. Luckily, Royal Mail’s pandemic windfall has enabled the firm to make some much needed improvements to its service.  

Royal Mail has been investing for future growth   

Royal Mail entered the pandemic ill prepared for the surge in demand for its services. For example, at the beginning of 2020 most parcels moving through the network were still being sorted manually. 

After hundreds of millions of pounds of investment, Royal Mail is now in a better position than ever to capitalise on the growing e-commerce market. Two new parcel hubs are on the way and the first is slated to open in June 2022. This facility will have the capacity to sort over 800,000 parcels a day.  

New parcel sorting machines are also being rolled out. Five machines were installed last year and by the end of the 2023-2024 fiscal year, management wants automation in parcel sorting to be at 90% (against 50% in 2021-2022). Other investments in technology and efficiency also helped it achieve £59m of productivity savings last year, although this was far less than the £100m+ initially targeted.  

Moreover, the organisation has used some of its profit windfall to expand its international business, GLS, with the acquisition of Canadian road freight carrier, Rosenau Transport, for £210m. This international arm could be a key growth driver for it in the years ahead. Management is targeting an operating profit of €500m by the end of 2024-2025, which would make it around 40% larger than the domestic operation based on current projections.  

There are plenty of other operational “wins” management can point to as well. Royal Mail has the lowest carbon footprint per delivery of any company in the sector in the UK. It plans to push this lower still over the coming years, and has made significant investments in electric vehicles to that end. Management has also introduced barcoded stamps, parcel post boxes, parcel pickups and a new app to help customers pay for and send packages.  

All of these changes will help position the company for the next five to ten years. 

As challenges mount, the Royal Mail share price is coming under pressure  

While the company is making a great deal of progress in some areas, it’s also facing some huge challenges.  

Chief among them is inflation. Alongside its results for the year to the end of March, Royal Mail warned that it sees “significant headwinds” from rising costs including wages, energy and fuel. To offset these headwinds, management has outlined plans to cut costs by £350m over the current financial year. As many as 700 management job cuts have already been announced, which will reduce costs by an estimated £40m per year.  

Royal Mail’s biggest headache is (and has always been) keeping wage costs under control. It has made a pay offer worth 5.5% to its workers in exchange for changing sick pay, scrapping some allowances and Sunday working. This has been rejected by the Communications Workers Union (CWU) as having too many strings attached.  

The union is seeking a “no strings attached pay rise” for staff. The two sides look set for a standoff, and if no resolution is reached, a strike could be on the cards.  

Considering these challenges, it’s easy to see why the Royal Mail share price has crumbled 43% year-to-date.  

With its large unionised workforce, the group is very exposed to inflationary pressures. And in a highly competitive market, that puts the business at a disadvantage. Most of the firm’s competitors pay by the hour (or by the delivery) and the workers have few, if any, rights. That’s not necessarily a good thing, but it does make it harder for Royal Mail to compete.   

Rising shareholder returns are no comfort to investors  

Royal Mail is facing a highly uncertain outlook, and that’s why I’m covering the company’s figures for the year to the end of March at the end of this article. These numbers are backward looking – they’re not going to tell us anything about the group’s potential over the next 12 to 24 months and beyond.  

For the year, revenue ticked higher by 0.6% and earnings per share declined 0.5% to 61.7p. Off the back of these numbers management has proposed a 13.3p per share final dividend for the year, taking the total payout to 20p. Refinitiv broker estimates suggest the firm will payout 22.6p in 2023, suggesting a forward dividend yield of 6.6%. The City has also pencilled in earnings per share of 52.4p for 2023, giving a forward price-to-earnings (p/e) ratio of 6.5.  

Considering all of the company’s challenges, I would take these numbers with a pinch of salt. However, if the Royal Mail share price keeps falling, at some point it’s going to be good value, especially if it reaches an agreement with the CWU. This could be one to keep an eye on over the next few months.

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