At the beginning of this week, Royal Mail shocked the market by issuing a surprise profit warning.
On Monday morning, the quintessentially British company told investors that thanks to missed productivity targets, core profits would now be 20% lower this year than City expectations.
It is no surprise that after this announcement, shares in the company lost more than a fifth of their value. Over the past few years, even though letter volumes have been falling, Royal Mail’s management has remained optimistic about the group’s prospects as costs savings, rising parcel volumes and its international business have helped offset some of the legacy business declines. However, it is now starting to look as if the companies future is not as bright as management believes. Rising labour and other costs are hitting margins in the UK, meanwhile, the international business, GLS is also suffering from the same factors.
According to the company, adjusted operating profit before transformation costs is now forecast to come in between £500m to £550m in for 2018–19. In comparison, for the year ended March 25, Royal Mail churned out £694m of operating profit before one-off costs.
Good value?
The dilemma investors now face is whether or not the stock presents good value at current levels. After recent declines, shares in Royal Mail are trading at an all-time low of 355p, surpassing the low of around 380p printed this time last year.
Based on current City earnings expectations, the stock is changing hands at approximately 9.7 times forward earnings, which looks to me to be a low multiple for such a well-established business.
At the same time, the group’s dividend yield has surged to just under 7% making it one of the most attractive income stocks in the FTSE 100.
However, the elephant in the room is Royal Mail’s slowing growth. The bulk of the company’s earnings growth over the next few years was expected to come from its cost savings initiatives.
Now the group is expecting to undershoot on these cost-saving targets significantly, earnings per share are expected to remain almost unchanged for the next two years.
And with this being the case, I’m hesitant to recommend this stock. Yes, it looks cheap and has an attractive market-beating dividend yield, but at the same time you are getting what you pay for and that is a low growth business with limited room for dividend growth (the dividend is currently covered 1.5 times by earnings per share not giving much headroom for distribution growth if earnings continue to stagnate).
What’s more, Royal Mail’s international business is showing signs of strain, and to me, this is much more worrying than problems at home.
So overall, I am hesitant to recommend Royal Mail as an investment. The stock might look attractive from a valuation and income perspective, but its mixed growth outlook is concerning. In my view, there are plenty of other companies out there which have more growth potential.
Disclosure: The author owns no share mentioned.