Royal Mail should price below middle of IPO range

September 27, 2013

By Robert Cole

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Royal Mail shares should be priced below the middle of their 2.6 to 3.3 billion pound range. The growth story for the UK postal service is uncertain at best, and that means the stock will need strong support from a high dividend yield when the company is privatised.

True, there is some potential. About half of Royal Mail’s business is delivering parcels. British consumers do just under 10 percent of their shopping online at present. That’s already more than in Germany or America, but it is reasonable to assume that online retail will create more business for logistics outfits, Royal Mail included.

There’s some upside in letters too. Volumes are declining at about 5 percent per annum, the Royal Mail concedes, but margins could expand with more aggressive cost cutting. Operating margins, currently 4.5 percent, could plausibly rise to 5 percent this year. Royal Mail might push them to the high single digit figures enjoyed by some European peers.

The snag is that rising demand for parcel logistics is also attracting more competition. And while efficiency gains might soften the blow in letters, Royal Mail’s heavily unionised workforce means it has to be careful about cuts. For every step forward, Royal Mail seems destined to take at least part of a step backwards.

Gains in parcels and letters might enable Royal Mail to lift annual dividend payments from the 200 million pounds already promised in the short term. But the longer-term outlook for a market facing structural change and increased competition is harder to gauge. Dividend income – even at elevated levels – translates into reliable investment only if the payments can be sustained.

Meanwhile, Royal Mail faces competition as an income stock too. UK bank stocks are in recovery mode and some will resume paying proper dividends in the next couple of years. At the top of Royal Mail’s price range, the shares’ dividend yield would be a healthy 6 percent. At 285 pence to 290 pence, just below the middle of the range, the yield would be a more generous 7 percent. That is the minimum investors should accept to compensate for the modest growth story.

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