Royal Mail warned of earnings risk

Risks are building for Royal Mail this year. Competition is becoming even more intense, the free cash flow story is deteriorating, and political risk is likely to grow in the run up to the general election in May. It's why Credit Suisse has cut its target price and is left bemused as to why after a sharp cut in consensus earnings per share (EPS) estimates the stock has re-rated sharply this year.

Credit Suisse warned in November that 2016 consensus estimates had to "shift down". They have. Since January EPS forecasts have fallen by about 9%. Royal Mail shares, however, have re-rated by about 8% on a price/earnings (P/E) basis. "We think this is unjustified and see further negative earnings momentum to follow," says the broker. "We now sit 24% below 2016E EPS consensus and we see risks building into calendar year 2015."

Whilst - part of Dutch mail giant PostNL, formerly Post UK - looks close to completing its joint venture with Lloyd's Bank's private equity arm LDC, says Credit Suisse, providing funds for a resumption of its UK rollout and serious competition for Royal Mail.

Meanwhile, the free cash flow yield has fallen from a peak of 9.4% in 2014 to an estimated 6.7% in 2016 "representing a fundamentally less attractive offer. Scope for further Transformation (£100 million) and cash pension costs (£50 million) in 2016E would reduce that to 3.2%."

What's more, political risk clearly grows as the election nears, and while property disposals may provide some respite, Credit Suisse thinks incremental cash returns to shareholder are unlikely.

The broker cuts underlying EPS forecasts again, this time by 3% for 2016 and 12% for 2017, driven by currency adjustments for a weaker Euro impacting Royal Mail's European parcel delivery business GLS, the impact of German minimum wage adjustments on margins, price cuts, plus a weaker mail pricing modelled for 2017.

"High operational gearing in UKPIL [UK Parcels, International and Letters] highlights the challenge RMG faces from small changes to its top line," says Credit Suisse. "We cut our target price by c3% to 370p and remain U/P [underperform]."

At 427p, Royal Mail trades on an adjusted 2016 P/E of 17.5 times for 6.7% free cash flow yield and 4.9% dividend yield. That compares with peers at 17.4 times, 5.4% and 4.2%, respectively.

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