Royal Mail: is it as ludicrously cheap as JPMorgan seems to think?

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Royal Mail Group PLC (LON:RMG) has been out of favour as a stock for ages so JPMorgan’s “just buy it” recommendation this week was an eye-opener.

From the day of its controversial flotation in October 2013, masterminded – if that’s the word – by Vince Cable, Royal Mail has carried a metaphorical “beware of the dog” sticker.

Its well-publicised disputes with its staff, the enduring concerns over its pension plan obligations and the apparently terminal decline of its letters delivery business have all been cited as reasons to leave the stock well alone.

JPMorgan, however, crunched the numbers and evidently found enough there to merit its unequivocal advice to its clients to get on the Royal Mail bandwagon, so it might be worth taking a closer look at those numbers and what they mean, expressed in layman’s terms rather than investment analyst jargon.

I say operating profit, you say EBIT

Royal Mail reported that operating profit in the 52 weeks to the end of March shot up to £611mln from £55mln the year before. That’s the so-called “reported” figure that the company is obliged to publish using standard accounting principles, known as IFRS (international financial reporting standards).

Like a lot of companies, Royal Mail tweaks its figures and presents them as “adjusted” numbers, purportedly to iron out certain anomalies or to give the shareholders an insight into those numbers that management is paying attention to; Royal Mail calls these “alternative performance measures” and because no company announcement is complete without a TLA (three-letter acronym), these are also known by Royal Mail as APMs.

Adjusted operating profit, also known as earnings before interest and tax (EBIT – an FLA, as opposed to a TLA), rose 116% to £702mln from £325mln the year before, with Royal Mail (the UK parcels, international and letters business, also known as UKPIL) and GLS (General Logistics Systems) making a roughly equal contribution to the increase in EBIT.

EBIT is essentially a measurement of how the company is running its core business, without “clouding” the issue with inconvenient things such as interest on debts (or occasionally interest on positive cash balances).

Some fine margins

From the operating profit, it is possible to calculate the operating profit margin by dividing operating profit by sales (and multiplying the result by 100 to turn it into a percentage).

The operating margin measures how much of a company’s sales end up as operating profit. This varies from industry to industry; in the pile ‘em high and sell ‘em cheap world of supermarkets, the margins are razor-thin whereas in, say, a software company, the margins can be enormous.

Royal Mail’s operating margin improved to 5.6% from 3.0% the year before, an improvement of 260 basis points. There are 100 basis points to a full percentage point so 260 basis points could be expressed as 2.6 percentage points and we’d all (well, nearly all) understand what was being measured but every profession needs its jargon to exclude amateurs so “basis points” it is.

The UK parcels, international and letters business (UKPIL) enjoyed a margin of 9.8% in the second half of the year just ended, as, for the first time in the Royal Mail’s five-century history parcels (high margin) provided the majority of its revenues, rather than letters (low margins and a PITA – an acronym I am not going to explain to you, other than to reveal the first letter stands for “pain”).

In JPMorgan’s view, the UK business “doesn’t need to generate a margin of anywhere near 9.8% for Royal Mail to be materially undervalued”.

Undervalued on what basis, though?

There are a gazillion ratios, metrics or multiples that analysts use to evaluate the relative merits of investment securities.

JPMorgan seems to favour one called EV/EBIT, which is the enterprise value divided by EBIT.

Enterprise value is broadly speaking the market capitalisation (number of shares in issue multiplied by current share price) adjusted for the company’s net debt or net cash (and cash equivalents).

You might think of EV/EBIT as an indicator of how many years you would have to own the company (assuming EBIT remains unchanged) before you earnt back all the money you spent to acquire it.

The higher the number, the more expensive the company is. Everything is relative, as Einstein never said, so investment analysts like to compare the EV/EBIT multiple with the average for the sector and determine whether a particular stock is cheap.

JPMorgan thinks the implied EV/EBIT for UKPIL based on its own profit forecast for the current year is around 2 (or “2x” as the investment analysts would have it).

Put like that, the shares do look ludicrously cheap.

Flies in the ointment

Enterprise value does not include pension-plan obligations, however, which in Royal Mail’s case are pretty severe, it being a former nationalised company from the era when the rank and file, rather than just senior management, got a decent pension.

During 2020-21, the group contributed around £405mln in respect of all UK pension schemes and in 2021-22 expects to contribute around £400mln in respect of all UK pension schemes.

The above might explain why the shares are ostensibly undervalued. Then there are the company’s patchy labour relations although funnily enough, these have improved a lot since the company essentially trousered windfall profits during the lockdown thanks to the explosive growth in online shopping.

It’s elements such as these that make investment decisions an art rather than a pure number-crunching science.

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