When investing in stocks, its 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 Im 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, Im 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 thats 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. Thats okay if the business can generate attractive profit margins. Unfortunately, thats 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 groups return on capital employed which compares operating profit to capital invested in the firms 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 Mails parcel services a key driver of growth will always face intense competition on price. That could be a problem, as Ill 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 groups directly-employed workforce is represented by powerful unions.
Without getting into the politics of the situation, its 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 wont 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 Ive looked at are real and could make it hard for RMG to maintain attractive levels of shareholder returns.
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