Goldman Sachs upgrades Royal Mail

It's not been an easy year for Royal Mail, with regulatory uncertainty and a highly competitive parcels market causing share price volatility. But the group has had a firm grip on costs, and fundamental drivers of growth are beginning to turn in the firm's favour. In fact, analysts at Goldman Sachs now reckon Royal Mail shares are worth 610p, up from 585p previously.

With spending falling over the last two years, investors will be looking out for what Goldman has pencilled in for 2016/2017. There's also further potential for Royal Mail to unlock value from disposals of its London real estate assets over the medium term.

Investors will be able to judge the sustainability of Royal Mail's first quarter parcels' recovery when numbers are published on 21 July. Growth turned positive in the fourth quarter, although revenue is expected to be flat in 2015 due to increased capacity from Amazon, DPD and DP DHL. Investors should also keep an eye out to see whether mail volumes continue to sink by around 4% - guidance is set at between 4-6%.

The disposal of its GLS Germany business, which made £96 million of revenue but no earnings last year, will trim revenue by an average of 1% over the next four years. In all, revenue is tipped to decline by 1.5% a year. The lack of election traffic won't have helped. Sales of £9.2 billion are expected in the year to March 2016, generating adjusted cash profit of £907 million and EPS of 27p. Letter sales are expected to have fallen by 2%.

Changes to its pension accounting will drive increases to headline operating profit and EPS, but cash is set to fall. Goldman uses cash profit as the best reflection of Royal Mail's profitability, which contributes to the higher price target.

"We see Royal Mail as offering good value and expect a significant expansion of its EBIT margin, from 6.4% in 2015 (March year-end) to 7.5% in 2018E, driving a 5.5% CAGR [compound annual growth rate] in EBIT and 7.2% in earnings; at the same time, the stock offers a dividend yield of more than 4% and a high-single-digit FCF [free cash flow] yield."

There are still risks investors need to watch out for, particularly a quicker decline in letters or a failure to maintain parcel growth. Changes to regulation could also hit the group's profitability, especially after the Ofcom review prompted by the suspension of Whistl's end-to-end delivery service.

At 507p, the analysts reckon Royal Mail is attractively valued at 11 times forward cash earnings, with a 4.3% dividend yield and 5.6% FCFe yield (pre-disposals).

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.