The Motley Fool

Is the Royal Mail share price a falling knife to catch after plummeting 65%?

When investing in stocks, it’s all too easy to fall in love with your favourites. When this happens, we often fail to see risks and weaknesses that should have been obvious.

Royal Mail (LSE: RMG) is a potential example. Shares in the postal group have fallen by about 65% from their 2018 peak.

In my piece last weekend, I explained why I’m cautiously optimistic about the outlook for long-term investors in this business. Although I hinted at some of the risks facing the firm, I focused on the positives.

Here, I’m going to take the other side of the argument and highlight three risks facing investors in this 500 year-old business.

1. Big spender

Royal Mail boss Rico Back plans to spend another £1.8bn to help transform the business into a modern, parcel-focused service.

This new spend comes on top of the £2.1bn that’s already been invested in the business since its flotation in 2013. To put that in context, Royal Mail has only reported £2.4bn of profit over that period.

What these numbers show us is that Royal Mail is a capital-intensive business — it needs to invest a lot of money in its operations in order to be able to function. That’s okay if the business can generate attractive profit margins. Unfortunately, that’s not been true in recent years.

2. Low margins

Royal Mail reported an underlying operating margin of 3.6% last year. This included the ongoing modernisation programme, but excluded some one-off items. The group’s return on capital employed — which compares operating profit to capital invested in the firm’s assets — was just 6.3%.

What this means for shareholders is that much of the cash generated by the business is needed for reinvestment. Generous dividends may not be affordable — indeed the payout will be cut this year.

These figures highlight one of the big challenges for the chief executive. His services are always seen as a cost to customers — a necessary evil. No one wants to pay for postage. We do it because we need to. This means customers are always open to switching to cheaper, rival services.

In my view, Royal Mail’s parcel services — a key driver of growth — will always face intense competition on price. That could be a problem, as I’ll explain.

3. Tough competition

Royal Mail has more than 145,000 employees. According to the firm, they enjoy “the best terms and conditions in the UK delivery industry.” One reason for this is that, unlike some rival couriers, the group’s directly-employed workforce is represented by powerful unions.

Without getting into the politics of the situation, it’s probably fair to say this business is more vulnerable to disruption from industrial action than most other parcel firms.

The reality is that large parcel customers such as Amazon won’t hesitate to take advantage of cheaper rival services. In my view, this means Royal Mail needs to overcome its higher structural costs and find a way to gain an advantage from its unique delivery and collection network.

I believe this is possible. Indeed, on balance, I continue to rate the shares as a long-term buy. But the risks I’ve looked at are real and could make it hard for RMG to maintain attractive levels of shareholder returns.

High-Yield Hidden Star?

Discover the name of a Top Income Share with a juicy current dividend yield of around 6% that has got our Motley Fool UK analyst champing at the bit! Find out why he thinks “the stock’s current weakness may offer us the chance to buy a proven dividend performer at what could be a bargain price”. Click here to claim your copy of this special report now — free of charge!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Amazon. 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.