I couldn't resist jumping on the bandwagon of the country's much beloved postage group. Since the company has more to talk about than I would want to discuss in a single post - even more than usual - and with the dynamics of it being an IPO and not actively trading, I'd rather just ask the questions and ruminate on the issues having read their annual report and the surrounding information.
Off the cuff, we can see that Royal Mail hold quite an unusual position. For historical reasons, they're a dominant market provider - and a monopoly holder in one of the essential phases, the final delivery-to-door bit. They hold 99% of the letter market and around 53% of the parcel market by volume. This should suggest a level of pricing power which becomes more evident when the company is free from direct Government control, particularly in the services they provide to other companies (when they deliver parcels/letters which have come through other providers, for instance).
For the same historical reasons, though, the company is - for better or worse - seen by the wider public as something of an institution. Monopoly holders are already subject to a good deal of regulatory scrutiny, and it seems unlikely Royal Mail would really have the capacity to be a price setter in normal monopoly-esque sense of the word. There's no guarantee that future governments will be committed to the same hands-off approach that the Conservatives have championed in something of a pointed sell-off. Interestingly, in one of their RNSs they note that 'Ofcom has stated that such an indicative benchmark EBIT margin range of five to 10 per cent. on the universal postal services activities would be appropriate'. Two obvious questions there; firstly, how do you split up the 'universal postal services activities' from the rest of their activities and, secondly, why EBIT margin? That seems bizarre. Return on capital seems a far more important metric to be addressing for competitive reasons. Still, my gut feeling is that the regulators, at the moment, verge on the side of caution when it comes to interfering with private business operations, even ones that are politically sensitive. I think it'd make sense to do some research on that. What sort of returns do the energy companies earn, for instance? These are probably the best go-to model.
Royal Mail commissioned a PWC report on UK mail volumes which can be found here and makes for interesting reading. About half of Royal Mail's UK operations are in letters, with the other half in parcels. It seems fairly obvious that letters are in steady decline, while parcels are likely in steady ascension - the twin effects of the internet. Given the group's obligation to provide the delivery service around the UK, a decline in overall volumes could be particularly damaging - it's like a manufacturing company being forced to keep all its factories open, with the staff, when they can only operate at 30% capacity.
The segment of Royal Mail probably less well-known to most people reading this is General Logistics Systems - GLS, their European operation. It operates predominantly in Italy, France and Germany and earns ~£1.5bn in revenue, with a significant (~£100m) contribution to group operating profit. It'd be interesting to compare this to other European operators, but since it's a parcel delivery service, it would appear to operate in the growth segment and be free from the link to the less lucrative bit like the UK operations are. At the same time, GLS is one operator in an extremely competitive market. Royal Mail has an enormous amount of brand recognition, public trust and, therefore, economic goodwill.
Last year already saw one significant 'commercialisation' impact - even though the broader market for their UK delivery services fell, revenue was up by about 6%, adjusted for the year being a week longer. Obviously, falling volumes combined with rising revenues must mean price increases, and if you remember back to April 2012, there were rather large complaints about the magnitude of the increase. That seemed to set the stage for the privatisation - the business actually charging a realistic price for its services.
Either way, last year the business earned 'pre-exceptional' operating profit of £635m and a post-exceptional figure of £363m. The difference between those two figures is largely the impact of the restructuring the business is undertaking. I think it's probably naive to take the pre-exceptional figure as a baseline. Restructuring costs in a business this big seem to be neverending, particularly given the market-wide changes their industry is seeing, and even more so because of the fact that the company is now returning to private hands. Widespread change seems likely. Perhaps a figure somewhere in the middle of the two would be realistic, but it's an absolute nightmare trying to find the information I want to find on the IPO prospectus. I'm used to dealing with annual reports, and with them I know where I'm looking!
I'd love to see the history of the group's property/plant/equipment line. I suspect the balance sheet value underestimates the true value of these assets to the business. Really, relating to the PPE and the restructuring costs, I'd like to see a history of capital expenditure the group's engaged in alongside a history of their depreciation charges.
Even at the lower end of the operating profit figure - £363m - the group doesn't look particularly expensive if you work it through. Finance costs last year will come down, as their more expensive loans are repaid and cash resources are used to pay down debt. They'll end up with £600m of debt vs. £973m of (more expensive) debt prior to the IPO.
The real kicker for me, though, is the pension situation. It's a little confusing, but I think I've got my head around it. As I'm currently understanding it, the Government pension 'bail-out' took on the liabilities of all current pensioners and deferred pensions as of April 2012. The obligation to pay those people is now in the hands of the Government. What Royal Mail have kept, though, is the obligation to service the pension plan for all employees who are currently still enrolled in their defined benefit pension scheme. My assumption was that this was relatively small - I was laughably wrong:
RMG’s contributions had been projected to increase from their current level of approximately £400 million a year to approximately £700 million a year
.. and it was when I read that line when I realised it! Pension costs are still enormous. The main thing that the pension reform did was get rid of a bunch of historic liabilities - it left Royal Mail with an equal asset and liability side going forward. A reset, if you will, but not a solution to the problem. This means that the pension scheme is still a hugely material cost and risk to the business going forward. Optimistically, I guess you could think about pension payments like this - ones to existing employees - as just like any other employee cost. They're a bit on top of the basic salary. Pessimistically, they're just an open-ended liability which is notoriously difficult to calculate the value of.
The final liability I should note is the group's operating lease obligations. They don't give the same information you'd get from an annual report, but you can make a reasonable estimate of scale - their 'operating lease commitments', the money they're contractually obliged to pay, is just over £1bn. As I've mentioned before, this is an interesting figure if you're trying to work out risks in relationship to credit risk, but is less relevant when it comes to calculating economic assets utilised. The true level of economic assets utilised by the business in the form of operating leases are likely considerably north of that figure.
I don't really want to conclude, because it's far more complicated than the companies I usually look at for two reasons - firstly because of the level of regulatory/government involvement and secondly because of the format its information comes in. I'm more used to appraising companies that been listed for a long time. I'll only give a gut feeling, and it's nothing more than that; at the lower end of its valuation (£2.6bn) I think it's probably undervalued. I can't eloquently explain the point beside my feeling that assets are undervalued on balance sheet and by the expectation that a company with such a strong competitive position should be able to at least earn its cost of capital. Cost of debt for the company is very low, which is good for equity investors, and there are likely clear operational improvements that'll come about over the next few years.
As ever, do your own research and all that, but it's a timely reminder that I'm better when I stick to my comfort zone - small companies, with less noise and confusion.
Filed Under: Royal Mail,