Royal Mail (LSE: RMG) shares, at the current price, look like a bargain at first glance. The price-to-earnings (P/E) is under six and the yield is hovering around 10%, one of the highest yields I can see anywhere on the market. Usually, I like a combination of a low P/E, and a high dividend and accept the risk that it may be a sign of trouble ahead, but in the case of Royal Mail, the risk looks too great to me as the P/E and yield are just too extreme.
What’s worse though, is that in the UK, the business doesn’t seem to be going anywhere as year-on-year letter volumes are falling and GDPR has reduced even more the potential for Royal Mail to benefit from distributing junk mail. The business is pinning its hopes on parcel delivery, a potential growth area given the popularity of online shopping.
However, the delivery company faces a few challenges in this area. As it is a growth market, there is plenty of competition and margins are wafer thin as a result. Added to this, Royal Mail has its own issues with productivity and efficiency, which were to blame for a profit warning back in October.
From where I am sitting, what is worrying for investors is the level of debt with net debt of around £470m and rising. Adding to the woes is the challenge the postal delivery company faces in the form of a unionised workforce, a hangover from its nationalised days, which also adds to costs and reduces management’s ability to launch productivity and efficiency drives, something it needs to do to reward shareholders.
A better bet
BAE Systems (LSE: BA), the weapons manufacturer, has far greater potential to make investors money, I think. The company offers an attractive dividend yield of 4.7% and the P/E ratio is under 11, representing good value for the shares.
The most recent results for BAE showed a company in good shape, despite the low P/E and relatively generous dividend yield. Its full-year operating profit rose 14.3% to £1.6bn, despite falling revenue. But the order intake hit a record £28.3bn, a 39.4% increase, which bodes well for investors going forward.
Defence spending is unlikely to let up any time soon meaning BAE Systems should continue to keep picking up work both in the UK and abroad. Contract wins show that it has markets all over the world, including controversially in Saudi Arabia. The country is a major market for BAE Systems, which introduces a risk for investors to watch as countries like Germany have banned arms exports to the state recently. But these are thought likely to be lifted soon, so should not affect the investment case for BAE.
To me, BAE Systems looks like a much better investment proposition. As a weapons producer, it won’t be everyone’s cup of tea, but from a purely financial perspective, it looks like it is in a much stronger position to deliver value for shareholders than embattled Royal Mail.
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Andy Ross has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.