Royal Mail parcel warning is major concern

Rather predictably, Royal Mail delivered fewer letters during the first quarter, but a drop in parcel revenue amid fierce competition was more of a surprise and it will need a bumper Christmas if it's to hit City forecasts this year.

Chief executive Moya Greene said revenue growth of just 2% for the three months was "in line with our strategy". Letter volumes fell 3% - less than expected - and were easily offset by higher prices and election traffic. In fact, letter revenue actually grew 3% this time. But a poor performance at the parcels operation must be worrying Greene.

UK Parcels revenue actually fell 1% despite a 1% increase in volume, driven largely by increasing competition as rivals fight to fill capacity, and the strong pound. Amazon's decision to ditch free delivery on orders below £10 and introduction of its own delivery network is hurting, too, and a slowdown in the retail sector meant June was weak.

"Given the increasing challenges we are facing in the UK parcels market, our parcels revenue for the year is likely to be lower than we had anticipated," warned Greene. “Our parcels revenue will be dependent on our performance in the second half, which includes the Christmas trading period, and on no further weakening in our addressable UK parcels market."

If last Christmas is anything to go by, Royal Mail should be okay. With increasing numbers of consumers switching to online shopping, the postal service delivered up to 10 million parcels a day in the period, which boosted overall sales in the nine months to 29 December by 2% - an 8% rise in parcel revenues more than offset a 3% decline in letters.

Now it seems the tables have turned, with the slowing rate of declining letter volumes being attributed to strengthening UK economic conditions. In order to turn its parcel performance around, Royal Mail is extending weekend working hours and has introduced new shipping tools for larger online retailers. These benefits are expected to be felt in the second half of the year, in time for Christmas. It is cutting back costs, too, which should at least make sure that full-year profits match current estimates.

After floating at 330p last year, Royal Mail has outperformed the FTSE All Share over 12 months, but has seriously underperformed in recent months. This weakening share price looks set to continue in the near term, says Investec's John Lawson, who keeps his 2015 pre-tax profit guidance at £462 million and earnings per share (EPS) of 34.1p. However, increased competition and high operational gearing is a concern, and explains the broker's decision to cut 2016 profit forecasts by 9% to £526 million and EPS to 39.4p.

That puts Royal Mail shares on over 13 times forward earnings, a deserved discount to European heavyweight peers Austrian Post and Deutsche Post. And while a prospective dividend yield of well over 4% certainly makes the shares attractive for income seekers, this latest update should serve as a warning signs.

While the letters business saved the day this time it's hardly an improving trend, and intense competition in the parcels industry is a major concern. This could spell trouble for Royal Mail unless the trend is reversed.

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