Royal Mail’s dividend yield is 13% but I still wouldn’t invest

A reader asked me to review Royal Mail as a dividend investment, based partly on the company’s 13% dividend yield and the fact that he couldn’t believe how low the share price was given the volume of letters and parcels passing through his mail centre.

I’m an obliging sort of chap and so, as requested, here is that review.

Here’s a summary of what I found:

• The market for addressed letters is declining while the market for parcels is growing.
• Royal Mail isn’t growing and profitability is below average.
• Unions have a lot of say in worker pay, hours and conditions.
• The CEO and Chairman have recently changed. Shortly afterwards the company announced a major turnaround plan.
• The dividend will be cut in 2020 from 25p to 15p, but with a share price of 200p that still leaves a forward yield of 7.7%.
• The company’s future is expected to be driven by its international parcels business.

Okay, let’s dig into some details, starting with the numbers.

Royal Mail is a low growth business

Given the significant decline in the company’s share price from 450p at its 2013 IPO to 200p today, I wasn’t surprised to find that Royal Mail has a very weak growth record:

As the chart shows, the company’s key fundamentals of revenues (money coming into the company from customers), capital employed (money put into the company by shareholders and debt holders) and dividends (money paid out directly to shareholders) have barely gone up over the last ten years:

• Revenues went up at an annualised rate of 1.7% per year
• Capital employed went up at an annualised rate of 3.2% per year (after stripping out the effects of the company’s pension scheme)
• Dividends went up by an average of 1.9% per year (although this is a slight fudge as the previously state-owned company didn’t pay dividends before its 2013 IPO)

Taking the average of those three gives Royal Mail an overall growth rate of 2.3%, which is not exactly earth shattering, although it does just about beat my growth rate rule of thumb:

Weak profitability should be expected, but not this weak

Delivering letters and parcels is an inherently low margin business. However, I would still expect a reasonably competitive company to be able to deliver net profit margins (post-tax profits as a percentage of revenues) of more than 5%.

With ten-year average net margins of 1.9% Royal Mail is nowhere near that mark, and that’s true even if you ignore the negative earnings at the beginning of the decade.

This is a problem because extremely thin profit margins can cause profits to be highly volatile. Or as the company’s chairman put it in the 2011 annual report, “Tiny changes in revenue have a major impact on profitability.”

Another sign of weakness is meagre returns on shareholder and debt holder capital, otherwise known as return on capital employed (ROCE).

The average net (i.e. post-tax) return on capital from consistent UK dividend-paying companies is about 10%, and companies generating returns below that level probably have little or no competitive advantages.

Royal Mail’s ROCE performance is mixed.

Note: First you have to strip out the effects of the company’s large pension surplus. It creates a multi-billion pound asset on the balance sheet which really shouldn’t be there as far as I’m concerned (I think virtually all pensions should be managed by life insurers or other financial services companies, rather than companies who do totally unrelated activities such as delivering letters).

Anyway, having stripped out the unproductive pension surplus, Royal Mail has median net returns on capital over the last decade of 11%, with ROCE being above 10% in five of those ten years.

This isn’t a completely terrible result, but combined with the sub-2% net profit margins it does give the impression that Royal Mail has no serious competitive strengths, or at least none which aren’t negated by competitive weaknesses.

The Royal Mail Pension is vast (and that’s after a government pension bailout in 2012)

When the government was considering offloading Royal Mail onto the stock market, there was a problem. The company was making a loss and its balance sheet was insolvent (i.e. its liabilities exceeded its assets), so no sane investor would touch it with a barge pole.

The primary cause of these unsavoury facts was the company’s main pension scheme, which had assets of around £28 billion and liabilities of around £37.5 billion.

For a company generating a few hundred million in profit each year at its best, the idea that it could ever repay a £10 billion pension deficit was laughable.

So in 2012 the government stepped in and removed the pension assets and liabilities from Royal Mail’s balance sheet, used the £28 billion of assets to pay down some of the national debt and kept the liabilities as an off-balance sheet debt which now has to be paid by future taxpayers.

Some might say there’s an intergenerational injustice to loading these liabilities onto future taxpayers rather than the retirees themselves.

Either way, after this bailout Royal Mail found itself with a still large but far more manageable £3.4 billion pension fund obligation and a £0.8 billion pension surplus.

As pension fund obligations tend to do, this one has ballooned over the years and today the liability is almost £7 billion. However, the fund’s assets have grown faster than its liabilities and the fund now has a huge near-£4 billion surplus, which is much better than a deficit.

Still, I’m not happy about this £7 billion liability sitting on Royal Mail’s balance sheet. Who knows what might happen to the fund’s liability and asset values in the future?

If the assets perform badly then that surplus could turn into another multi-billion pound deficit, which Royal Mail would have virtually no realistic change of repaying, and the government is unlikely to step in now that Royal Mail is a publicly-listed company.

Personally I would much rather the pension fund was offloaded to a life insurer whose job it is to manage these sorts of liabilities and risks. For now though, this huge pension fund breaks another of my rules of thumb:

In Royal Mail’s case, its pension obligations are more than £7 billion while its ten-year average profits are just £180 million, giving the company a pension to profit ratio of 38, which is simply miles above my preferred limit of ten.

Debts have gone from ridiculous to sublime (or at least reasonable)

A decade ago when Royal Mail was drowning under its pension and other employee-related obligations, the company also had far too much debt. To be precise, it had almost £1.9 billion of debt compared to average net profits over the 2010 to 2019 period of just £180 million.

That’s a debt-to-profit ratio of more than ten, which is completely unsustainable. It also breaks my debt rule of thumb for cyclical sector companies (Royal Mail operates in the cyclical Industrial Transport sector).

But that was all in the past and I’m very pleased to see that Royal Mail’s debts have come down consistently over the last decade. In fact, with debts of around £550 million today, its debt to profit ratio is a much more reasonable 3.1.

Capital intensity is through the roof

One side effect of having weak returns on capital is that capital investment (capital expenses, or capex) tends to be high too.

For example, imagine a company which owns a £100m factory producing profits of £2 million per year. Let’s also assume the company wants to open another identical factory. It’s either going to have to take on a mountain of debt (relative to earnings) to fund this £100m capital expense, or it’s going to have to wait decades while it saves up the cash from its weedy profits.

Royal Mail is in exactly this sort of situation. It has and needs lots of buildings, mail sorting equipment, vehicles and all manner of other expensive capital assets which all require maintenance and improvement.

These capital expenses totalled around £3.8 billion over the last decade, largely because Royal Mail has been going through a long and extensive transformation project to turn it from a typical bloated state monopoly into something capable of competing in a capitalist economy.

During that same period, Royal Mail generated total net profits of around £1.8 billion, so total capital expenses were more than double the company’s total profits.

This isn’t an acute risk like excessive debts, but its high capital intensity (i.e. a high ratio of capex to profits) will make it harder for the company to afford the necessary investment required to drive growth.

Once again, this high capital intensity means that Royal Mail fails one of my investment rules:

It’s not looking good, but…

So far things are not looking good for Royal Mail:

• Its growth rate is barely keeping up with inflation
• Profit margins are wafer thin and returns on capital are average
• The defined benefit pension is huge (but at least it’s in surplus)
• Capital intensity is very high, suggesting growth investment may be hard to fund

On this basis alone I wouldn’t invest in Royal Mail today. I would only invest after seeing a few years of proof that the company can increase productivity and profitability whilst reducing capital intensity.

So let’s take a look at the future to see what management hope to do. Who knows, perhaps with a good plan and a decade of hard work, Royal Mail may end up on my buy list at some point.

The future: An internationally-focused parcels business

Royal Mail’s future plans will make more sense if I outline the company’s structure first. It’s made up of four main businesses:

1) UK Letters:

This is the Universal Postal Service, where Royal Mail is obligated to provide a six-day service with a single UK pricing system, collecting and delivering what is now generally known as snail mail.

It’s not exactly a secret that the addressed letters business is in long-term decline. In fact, I’d be surprised if my nine year-old son ever sends a letter to anybody unless he’s forced to. Because of this, I see little value in the letters business other than as a source of infrastructure, knowledge possibly cash which can be used to benefit the parcels and international side of the business.

2) UK Parcels:

Parcel delivery is a growth market because almost everybody buys almost everything online these days. However, Royal Mail already has a 53% share of the UK parcels market, so rapid growth by taking market share is just not going to happen.

Competition in the UK is also particularly ferocious, so more technology and more efficiency is required just to eke out a reasonable return.

3) UK International:

This part of the business is focused on international mail to and from the UK. It’s another e-commerce-driven growth market.

4) GLS:

For me this is far and away the most interesting part of Royal Mail. It was originally called German Parcel and was Germany’s third largest parcel delivery business. Royal Mail acquired it and renamed it General Logistics Systems (GLS) in 1999. This is the truly international arm of Royal Mail with no direct business in the UK. GLS operates in 42 countries, primarily in Europe but with a growing presence in North America.

Okay, so that’s the overall structure of Royal Mail. Let’s take a closer look at its plans for the future.

The future part 1: Automation

For the last ten years, Royal Mail’s UK businesses have been working through an extensive modernisation program. The idea was to transform them into something which could hold its own against aggressive, super-efficient competitors that were not saddled with decades of state ownership.

The company has come a long way and has introduced significant amounts of automation and technology. That, plus the long-term decline of letters, means the company has been able to reduce its work force by tens of thousands, which should improve efficiency, profitability and operational flexibility.

But it hasn’t been enough. The company’s lack of growth and weak profitability are proof of that, and so a new group CEO (previously CEO of GLS) has arrived with a new and even more aggressive plan to improve productivity, profitability and (hopefully) long-term growth.

The technology here is actually quite interesting, so I’m going to dig into it briefly. If you’re not interested then just skip down to the next section in the knowledge that more automation just means more (super efficient) machines and fewer (less efficient) humans.

The company’s Heathrow Worldwide Distribution Centre (HWDC) is a good example of what high automation looks like. It’s the size of six football pitches and processes tens of thousands of letters and parcels per hour in a largely human-free environment:

“HWDC also boasts a fully-integrated distribution process. Parcels and letters whizz around on seven miles of giant conveyors before being loaded into containers by giant yellow robots. It looks a bit like a scene from Blade Runner, and it’s mighty impressive.”

Computing.co.uk

More automation within the next decade is likely to come from autonomous vehicles which are driven by a constantly learning collective of AI neural networks. These will replace human drivers on depot-to-depot routes first because they’ll be cheaper, safer and don’t need to stop to eat, sleep or go to the loo (here’s a DHL whitepaper (PDF) on this).

Also, the maintenance of those autonomous vehicles will become far more efficient because they’ll be electric vehicles, and electric vehicles have far fewer moving parts than petrol or diesel vehicles. More interestingly, maintenance will also be more efficient because of the Internet of Things (IoT).

This basically means that vehicles will be (and sometimes already are) covered in sensors, informing a central AI system of their performance. The AI system can see what happened in the run up to a part failing on hundreds or thousands of vehicles and then use predictive maintenance (PDF) to call other vehicles in for a service if their parts have similar temperature/vibration/etc. characteristics. This means vehicles only get serviced when they need it, rather than on a pre-set schedule.

And then of course we have AI-driven real-time route optimisation, so that all those autonomous electric vehicles can navigate their way from one automated sorting hub to another, without any humans having to waste time learning all the routes.

The trickiest bit to automate is collecting and delivering parcels from and to locations that can’t easily deal with driverless delivery vehicles, e.g. small business and households. So far Royal Mail has started to add its humans (otherwise known as employees) to the IoT network by making them carry GPS devices. This allows their movements to be monitored and optimised.

But robots are always going to be cheaper than humans (eventually), so parcel delivery robots already operate in the real world and the idea of an autonomous vehicle carrying a human-like robot that can knock on your door to deliver a parcel (or leave it on the doorstep as many delivery drivers so) is closer than you might think…

Okay, so the robot in that video is fake and looks a bit rubbish. Here’s something real which with some minor tweaks and cost reductions would be very useful to military logistics organisations:

Anyway, that’s a brief overview of the AI-driven future of parcel and letter logistics. Here’s a logistics AI white paper (PDF) from DHL which goes into a lot more detail if you want it.

One final point on automation:

It’s all very interesting and it sounds like some sort of utopian/dystopian machine-centric future, which it is. But from a capitalistic point of view, these improvements in automation are necessary, but they won’t make Royal Mail a great company.

All they’ll do is allow Royal Mail to potentially earn industry standard profit margins of around 5%, rather than its current sub-par margins. That’s because everyone else will be implementing these improvements at the same time, and their collective improvements will largely cancel each other out.

So while consumers will benefit with faster deliveries and lower costs, don’t expect automation alone to turn Royal Mail into a world class business.

The future part 2: UK Parcels

The second major theme of Royal Mail’s transformation is its continued swing away from letters and towards parcels. This is a pretty obvious strategic move because, as I’ve already said, letter volumes are in long-term secular (i.e. not cyclical) decline while parcel volumes are increasing.

The increasing focus on parcels will be driven by investment in three new parcel hubs, a massive increase in the percentage of parcels handled almost solely by automation from 12% to more than 80% and the introduction of around 7,000 parcel-only delivery routes.

This is all good news and by 2024 the company hopes to generate around 70% of its revenues from parcels (up from just over 50% today). However, the net result of declining letter volumes and increasing parcel volumes is that total revenues for the UK business are expected to be more or less flat over the next five years. That would leave them at an estimated £8 billion in 2024 compared to almost £7.7 billion today.

In terms of profit, operating profit margins from the UK business are expected to be around 4% by 2024. That would generate operating profits of £320 million which, unfortunately, isn’t substantially different to the average of the last ten years, although it would at least reverse the decline of the last two or three years.

Overall then, the move toward parcels is similar to the move towards automation. It’s a necessary step to avoid the company shrinking, but don’t expect it to produce meaningful growth anytime soon.

The future part 3) International expansion by acquisition

Where investors can potentially expect some growth is in the company’s international business.

Having been founded in 1999, GLS has spent most of its life growing by acquisition. In the 2000s there were acquisitions in Austria, Denmark, France, Germany, Italy and many other European countries, with most of the acquired companies being either partner in their delivery network or GLS franchisees.

Following the global financial crisis, the scale of acquisitions dried up and this led to stagnation in GLS’s revenues and profits. More recently though, GLS has started to make larger acquisitions again, including Golden State Overnight Delivery (GSO) for $90 million and Dicom Canada for £212 million in 2018.

These post-2016 acquisitions have led to an up-tick in GLS’s revenues and profits, as you can see in the chart below:

Management expect GLS to continue acquiring other businesses, with much of that growth occurring in North America. GLS hopes to grow its revenues to around £4 billion in 2024, at which point it will be generating around 33% of the group’s total expected revenues of £12 billion.

If it can achieve management’s expected 7% operating margin (notably better than that of the UK business) then GLS will be generating operating profits of around £280 million.

If that happens then GLS will be generating almost half of the company’s operating profits in 2024, and at that point GLS will become the real engine of Royal Mail’s future.

With GLS in the driving seat, Royal Mail will truly be an international parcels business which just happens to deliver letters in the UK.

Valuation: Are Royal Mail’s shares worth their current 200p price?

Here’s a very quick summary of what I think are the key points:

• Pros:
  • Royal Mail is the market leading parcel and letter delivery business in the UK with a very strong brand
  • It owns GLS, which has some potential for long-term growth by acquiring and tying together logistics businesses around the world
• Cons:
  • The UK business has weak profitability and needs to invest more than a billion pounds to improve productivity
  • The UK business has a massive defined benefit pension scheme
  • The UK business is the market leader by a wide margin, so market share growth seems unlikely
  • The UK business has no track record of growth
  • The UK letters business is in long-term secular decline
  • The UK business has to negotiate with very powerful unions

Overall, this is not the sort of company I want to invest in, despite the potential for long-term international growth through GLS.

In terms of valuation, the current share price of 200p gives Royal Mail PE10 and PD10 ratios (price to ten-year average earnings and dividends) of eleven and nine respectively. For comparison, the FTSE 100 has PE10 and PD10 ratios of 17 and 34 respectively, so Royal Mail is currently trading on very low valuation multiples.

If you’re interested in investing in turnarounds or ‘deep value’ stocks, where the price is so cheap that even a low quality company seems attractive, then Royal Mail may be for you.

But I don’t like to invest in turnarounds and I gave up deep value investing way back in 2010.

These days my strategy is to try to buy above average companies in the hope that they continue to succeed, rather than below average companies in the hope that they don’t keel over.

So for me Royal Mail isn’t a serious candidate for my personal portfolio or the UK Value Investor portfolio, although perhaps it will be in 2024 if all its plans work out and if GLS becomes the dominant part of the business.