Royal Mail – rising revenues and improving efficiency

Royal Mail reported a 7.1% year-on-year increase in first half revenues, reaching £6.1bn. That reflects good growth internationally, a modest recovery in UK letters and growth in UK parcel revenues.

Underlying operating profits came in at £404m, up from £37m a year ago, as the group saw the benefits of past restructuring efforts, increased automation and easing COVID restrictions.

The group announced an interim dividend of 6.7p per share. Royal Mail also announced plans to return £400m to shareholders, with a £200m buyback and £200m special dividend.

Royal Mail shares rose 6.1% in early trading.

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Our View

The pace of Royal Mail’s turnaround has hugely impressed us.

It would be easy to put the current windfall down simply to the effect of the pandemic on parcel demand. And that has played a part. Parcel volumes have declined from last year’s highs, but crucially appear to be rebasing at a much higher level than pre-pandemic.

However, the most important progress is not in sales, but in costs and operating efficiency. In the first half at least, Royal Mail has been able to increase volumes without substantially increasing costs – doing wonders for margins and boosting profitability. That’s no accident, reflecting significant restructuring work completed last year as well as increased investment.

Nowhere is that better illustrated than in the progress the group has made on automation. Back in 2018-19 just 12% of parcels were sorted automatically, today that’s more like 50% despite a huge uplift in parcel volumes, and the group has ambitions of hitting 70% in the not too distant future. Automated parcel sorting is more cost effective, but also improves quality and provides the extra flex needed to deal with peaks and troughs in demand.

Recent agreements with unions are paying dividends too. Labour costs are more predictable and the group’s committed to bringing down overall operating expenses outside of wages. The group identified another £190m of potential savings over the half year.

The investment in parcels infrastructure is set to increase capital expenditure, expected to be well over £400m next year in the UK alone. Construction of a new, fully automated parcels hub in the Midlands is underway, capable of sorting over a million parcels a day by 2023.

At the PLC level, Royal Mail also benefits from the strength of its international business GLS. It’s historically the fastest growing part of the business and remained robustly profitable throughout the pandemic. Relatively modest spending requirements going forwards mean it’s a blueprint the group would love to emulate in the UK.

As conditions start to normalise, shareholder returns are rolling again, with a progressive dividend policy going forwards, albeit starting from a lower level than what was paid in 2019. A year of bumper sales, lower dividend payments and reduced capital expenditure means the balance sheet is in remarkably good shape exiting the pandemic. That’s resulted in a one-off £400m windfall for shareholders.

Long term we think shrinking the cost base, investing in technology and adding to international acquisitions are the right answers. However, the second half of the year will be crucial. Year-on-year revenue growth will get more challenging as the group laps Christmas in lockdown, and inflation could also offset planned cost savings. If Royal Mail can weather these headwinds then with a price to-earnings ratio some way below the long run average, and a prospective dividend yield over 5% the group will be looking more attractive than it has for a long time.

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Half Year Results

The Royal Mail operating business, which includes all Royal Mail PLC’s UK operations, reported a 6.4% increase in revenues year-on-year, reaching £4.1bn. That includes a 15.6% increase in letter revenues, with volumes recovering from pandemic lows and prices rising, although overall volumes remain 8.1% below pre-pandemic levels. Parcel revenues rose 0.3% year-on-year to £2.3bn, although still represents a substantial uplift on pre-pandemic levels.

Underlying operating profits in the division came in at £235m, versus a £129m loss this time last year. That reflects a 3% fall in operating costs versus the same period last year – benefitting from cost saving actions taken last year and reduction in COVID related costs.

International business GLS reported revenues of £2bn, up 7.5%, driven by rising parcel volumes. That reflects growth in business-to-business parcels, as the end of lockdown restrictions in some markets resulted in a fall in consumer parcels. France and the US were particularly strong performers in the period. Underlying operating profits came in at £169, up 1.8% year-on-year as investment increased.

The group reported free cash flow of £254m in the half, up from £188m a year ago despite an increase in capital expenditure. Net debt nearly halved compared to the same period last year, and now sits at £540m.

The group expects revenue growth to slow over the remainder of the year, as the group laps very strong results last year. Management have also flagged rising inflationary pressure as a medium-term risk. Despite that, the group expects Royal Mail to deliver £500m of underlying operating profit for the year as a whole, while GLS guidance remains unchanged.

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