I like buying cheap shares. But when the price is really low, I’ve learned it’s important to check what you’re getting for your money. For example, I think the Royal Mail (LSE: RMG) share price could be worth buying after falling 50% in one year. But this business has some limitations.
What’s wrong with Royal Mail?
Royal Mail shares fell by nearly 20% in one day last October, after boss Rico Back issued a profit warning. The main reason for this warning was that planned productivity improvements had not materialised.
Back had planned for a 2-3% improvement in productivity for the year to 31 March. In the end, he managed to lift productivity by 0.9% during the year. As a result, cost savings for the year totalled £107m, well below the group’s original target of £230m.
These productivity and cost-saving targets are linked to a 2018 pay deal. This included an agreement to cut weekly working hours from 39 to 35 by 2022, without a pay cut. Uncertainty about the continued delivery of last year’s pay deal has led to a planned strike ballot for 100,000 postal workers on 8 October.
If a strike goes ahead, the resulting disruption could see the group lose valuable parcel business to more reliable rivals during the key Christmas season. It’s not an ideal situation.
There’s another problem
Even in the best of worlds, Royal Mail is a capital-intensive business that requires high levels of investment in equipment, vehicles and staff. At the same time, it operates in a very competitive marketplace.
Profit margins are low and I fear plans to spend £1.8bn on modernisation by 2024 could limit dividend payments. We’ve already seen the payout cut once. At current levels, City forecasts put RMG shares on 9 times forecast earnings, with a 7.9% dividend yield.
This could be good value, but I fear progress will be slow.
A cash machine?
My screening rules have identified another stock that’s unloved by investors and is struggling to deliver meaningful growth. Online gambling group 888 Holdings (LSE: 888) said today group revenue rose 2% to $277m during the first half of the year, but revealed its adjusted pre-tax profit fell by 36% to $27.1m.
At first glance, this seems like bad news. Why would you invest in a business where profits are collapsing? However, I think the news isn’t as bad as it seems.
One reason for the decline in profits was a $7m increase in gaming duties, mostly in the UK. This isn’t ideal, but it’s the same for all operators in this sector and isn’t a reflection of poor operating performance. Non-cash costs relating to acquisitions also depressed the group’s profits.
Historically, this has been a highly profitable business, with strong cash generation. Today’s results show a net cash balance of $111m and no debt, highlighting the group’s financial strength.
Return to growth?
Revenue growth was weak during the half year, but the company is working to expand by launching in several new markets. It’s also boosting customer recruitment, which rose by 20%.
888 is going through a period of investment and consolidation. But management has left full-year guidance unchanged and analysts expect profits to return to rise by 11% in 2020. With the shares trading on 14 times forecast earnings, with a 5.7% yield, I believe this could be a good time to buy.
