The shares have fallen to around 341p from a pre-profit warning level of 477p but that has not stopped HSBC from downgrading to ‘hold’ from ‘buy’ after what it called a “productivity bombshell” and RBC from moving to ‘underperform’ - or as RBC calls it (because all broker notes must be confusing), “UP” - from ‘sector perform’.
HSBC has chopped its price target to 379p from 552p previously while RBS’s target has moved to 315p from 500p.
It believes the most disturbing aspect of the profit warning was the update on productivity, with virtually no improvement in the first half of the year.
HSBC said the group’s record on improving productivity up until this year had been good and were it not for the productivity issues, it did not think the parcels and letters delivery outfit would have had to issue a profit warning.
“Granted the letter volume decline of 7% this year is a little worse than expected, but management had already cautioned some quarters might see 7% decline and the stronger than expected parcel revenue and volume growth is a mitigating factor. Stronger than expected margin pressure in GLS [General Logistics Systems] is also unhelpful, but not entirely unexpected in our view,” HSBC said.
The bank also points to a discrepancy between the mood on the shop floor “in the wake of a bruising period for industrial relations” and the more positive attitude of union leadership at the time the pay and pension deal was announced.
In the week the staff can finally cash their shares in. How convenient. https://t.co/4AswhqPcIP— Karl (@KJReik) October 3, 2018
“Royal Mail management will now have to re-examine future targets in light of what can be achieved in this context,” HSBC suggested.
In the bank’s view, it is “hard to build a credible investment case for Royal Mail until there is greater certainty about future cost-saving targets and the sustainable level of dividend payments”.
Management has guided to earnings before interest and tax (EBIT) of £500mln to £550mln before factoring in transformation costs (e.g. redundancies); HSBC thinks this is on the optimistic side and has cut its forecast for the current year to £490mln.
RBC, meanwhile, says that despite the dramatic share price collapse, the current valuation does not yet fully reflect “the amplified profit risks from a cost miss”.
Lost productivity momentum this year means Royal Mail will have to work harder to get back to par and said the group’s inability to hit short-term ambitions does not augur well for its ability to make up the shortfall.
The firm has other buttons it can press, such as increasing prices above the inflation rate in the unregulated letter mail market, but RBC said there is a risk attached to this as it could dampen demand. Its projections already forecast “letter yield” rising one or two percentage points more than the consumer prices index (CPI) inflation rate.
On the plus side, the broker’s calculations indicate that the company can continue to grow the dividend by a penny a year but investors who hold shares in delivery companies typically demand a very high dividend yield; RBC thinks a yield of around 9% is about right for Royal Mail.
“On the upside we see a normalized yield leading to 460p (~+34%) but ~68% downside to 110p possible. 460p needs clear ‘proof' of productivity growth and full catch-up. 110p is possible if productivity remains stalled, stamp prices rise at CPI, thus seeing DPS [dividend per share] falling to 10p (at a 90% payout),” RBC concluded.
Shares in Royal Mail were up 3.9p at 342.3p, 12p above the price at which they were floated in October 2013.