Royal Mail Group (RMG LN) – Delivering returns

Trading at just 7x earnings, offering a 5% dividend yield, occupying a strong market position, possessing a highly trusted brand, and with a very strong balance sheet, Royal Mail Group (RMG)’s qualities are evident. 

The Group has two businesses. The first is Royal Mail, the UK’s designated Universal Service Provider, which delivers parcels and letters to 31m UK addresses 6 days a week, while Royal Mail’s Parcelforce unit offers express parcel delivery. Royal Mail has 137,300 employees (85,000 of whom are post men and women), 50,800 vehicles, 37 mail centres and an 11,100 strong local collection network.

RMG’s other brand is GLS, which collects, sorts and delivers parcels across 40 countries. It employs 21,300 people. 

Why is RMG so cheap? Cost headwinds (wage inflation, oil prices) can’t be helping sentiment. Competition from the likes of Amazon can’t be helping sentiment either. Presumably there’s also a view out there that with COVID (hopefully) moving into the rear view mirror, that there will be a mass return to the office that will curtail demand for parcels. I think these views are misplaced – the need for cost recovery is hardly something that is ‘new’ for RMG’s management team; it has a very advanced self-help programme in automation; and e-commerce is here to stay.

“We are transforming from a UK-focused letters business that delivers parcels, to a parcels-led, international business, delivering letters in the UK” says the Royal Mail Group (RMG) website. This is a logical pivot, given the prognosis for letters and parcels. 

RMG goes on to add that “Transforming our network to handle more parcels is a key part of our plan. It was important before, but the growth in parcels we have seen during the pandemic makes it even more so. We are making good progress on the construction of our first two parcel hubs. The new fully-automated parcel sorting system in the Midlands hub will have the capacity to sort over one million parcels a day when it is fully operational in 2023. Of equal importance, we are continuing to increase the number of parcels that are sorted through automation across our operation. The number of parcels successfully sorted at least once grew significantly from 356m in 2019-20 to 652m in 2020-21 – an 83% increase. However, our percentage of parcels sorted by machine was unchanged year on year by 33%. The industry benchmark is 90%“. That last sentence is a clear hint at management’s ambition in this area. 

RMG provides a good overview of its new parcel hubs here. These will be opening in early 2022 (North West) and 2023 (Midlands). 

In the analyst call following the release of its H1 results in November, management said that RMG had improved its parcels automation from 12% in FY 2019 to c. 40%. By the end of next year I expect that this will be significantly higher, which should have a clear cost benefit for the Group. 

Staying with distribution, RMG has around 3,000 electric vehicles in its fleet (so, about 6%) and this figure is only going to grow from here. RMG notes that the “delivering on foot” facilitated by its post men and women means that it has the lowest carbon emissions per package of any UK delivery company, which could become a useful competitive advantage given the rising awareness of and demand for ESG gains. 
In 2016 the Group detailed progress that it had made in boosting the efficiency of its fleet, including: (i) centralised network route planning to reduce mileage; (ii) optimising the road, rail and air network to reduce routes; and (iii) matching vehicle type to need. While fuel is a near-term headwind for the Group, I suspect that the work it has put into the distribution side of the business gives it an advantage over peers. 

RMG is also experimenting with drone deliveries to remote and island communities, which has clear cost and environmental benefits. 

Let’s turn to recent developments at RMG. 

In December the Group announced that it had exchanged contracts for the sale of a 3 acre plot in London’s Nine Elms for £111m. Of these proceeds, £35m will be reinvested in its distribution network. 

In October RMG’s GLS business acquired a Canadian peer for £211m which gives GLS coast-to-coast coverage in the world’s ninth largest economy. 

Alongside the Group’s Half Year results in November management announced the launch of a £200m share buyback, which seems an excellent use of capital given the current rating. 

A further £200m was distributed to shareholders this month through a special dividend. 

The H1 results themselves showed a strong performance, with revenue of £6.1bn +7% y/y, the operating margin expanded from 70bps a year ago to 6.7%, and a strong cash flow performance pared headline net debt from £1.0bn to £540m. Excluding leases, the Group had net cash of £685m at the end of September, although recent shareholder distributions should be borne in mind here. 

While management noted that “we are seeing upward pressure in costs in all of our markets”, I am guessing that this pressure has intensified in the two months since the results. On this note, apart from the automation and distribution points cited above, I would also mention the progress management has delivered in securing trade union buy-in to restructuring efforts. The CWU’s Terry Pullinger made these comments at the results presentation: “Everyone should be extremely optimistic about the future of this wonderful organisation. We refine in our revision processes, whether they’re, you know, small revisions or whether it’s large scale revisions. We’re learning from this and we’re refining them so that when we go again, you know, people be more up to speed, we will be as well more empathetic of what’s needed, what enables us to move quickly, increase our productivity, but also make sure we keep on top of what is really the jewel in the crown, which is quality of service“. 

The final point I’d make on cost pressures is that these are exogenous to RMG and common to all of its competitors, so it seems reasonable to assume that its rivals will all behave rationally in response to them. 

On distributions, management has clearly articulated its balance sheet policy: “we’re happy with the cash going towards a net zero balance. And clearly, there’ll be some flex around that depending on what acquisition or whatever. But that’s the intention is to keep it around net zero“. That hints at the potential for further special dividends and/or share buybacks, unless accretive acquisitions can be identified, all of which sounds positive for shareholders. 

And now to turn to the valuation. RMG is, on every conceivable metric, cheap. Taking 2023 multiples, it is on 7.2x PE, 3.6x EV/EBITDA and 0.8x P/B. The dividend yield is an attractive 5.1% and clearly well covered by earnings. 

Yes, the cost pressures are a headwind, but even if earnings estimates move down to account for these, the above metrics are still likely to read as “cheap”. And, over time, cost recovery measures will restore profitability metrics. 

For me, as a shareholder in RMG, I see it offering exposure to strong cash flows, underpinned by investments made in enhancing efficiencies and a highly trusted brand in its home market and a scalable international logistics business that will help to augment growth. The strong balance sheet provides optionality for enhanced distributions and/or earnings accretive M&A. I really like this company.

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