Judging by the mixed reaction to the government's proposed privatisation of the Royal Mail, an impartial observer might conclude that selling off the last great government controlled monopoly will be a non-starter - an exercise in quaint nostalgia by an administration desperate to recapture the 1980s buccaneering spirit, if not its many excesses. However, convincing both investors and postcard senders that the Royal Mail needs access to fresh capital is going to be an uphill challenge. The irony is that few people who wax lyrical about the company's history can remember the last time they posted a letter to a friend, or indeed paid a utility bill with a cheque in the post.
Unsurprisingly, Investors Chronicle is never going to be a hotbed of support for state-run monopolies, but in the context of a rapidly changing postal market, the sale of the Royal Mail represents a genuine opportunity to safeguard a significant part of British life, while ensuring a good return for investors prepared to risk their cash in an initial public offering (IPO), if it goes to plan.
Understanding the business
Royal Mail is often confused with the Post Office, but in fact they are completely separate businesses, with the Royal Mail the delivery and logistics arm of the modern postal service. It currently employs around 150,000 people from sorting office workers to drivers to the neighbourhood postman. Traditionally, it has always been a licence to print money for the government - the size of the daily post bag peaked at 25m items in 2005, with the Treasury taking an estimated £600m annual tribute. Since then, regulatory changes and the advent of new communications technology has left the Royal Mail struggling to adapt. Privatisation is one response to the structural problems that come with running a full-service postal enterprise at a time when smaller companies such as UK Mail and giants such as DHL and UPS have started to compete in the lucrative corporate delivery market.
When competition authorities opened up the market, and letters were squeezed by email - mail volumes have fallen by 25 per cent since 2005 - the Royal Mail found itself overmanned and under-invested when it came to new sorting technology. The result was that annual losses spiralled above £320m in 2004 before a turnaround programme started by current ITV chief executive Adam Crozier brought it back to operational profitability. The turnaround has continued with notable success under current boss Moya Greene, the former chief executive of Canada Post, but the scale of the project is vast. Up to 50,000 jobs have been cut and the company has started to rationalise its vast property estate after the government agreed to underwrite an investment programme in 2010 worth up to £1.8bn to turn the business around. The effect of that extra cash was such that 75 per cent of letters are now automatically sorted, compared with only 8 per cent in 2009. The company has changed so radically that, for the first time in its history, the parcels it delivers will outnumber letters as a proportion of total sales: £4.47bn of parcels compared with £3.66bn of letters in 2013. And it is in parcels where the opportunities are to be found.
The state of the books
That is the background to the proposed sale of the Royal Mail, but in order to decide what the company is worth, we need to take a closer look at its past financial performance and make a clear-sighted evaluation of the state of its accounts.
As the table shows, there has been a considerable amount of progress in getting the business back to health over the past few years, helped by the government taking on the company's historic pension liabilities. The £8bn pension deficit had, by Royal Mail's own admission, made it "balance sheet insolvent" and it was vital if its commercial future was to be assured that this major poison pill for investors was removed.
Royal Mail financial results for the past five years
| Year to 31 Mar | Turnover (£bn) | Operating profit (£m) | Pre-tax profit (£m) | Free cash inflow |
|---|---|---|---|---|
| 2008 | 8.47 | -176 | 32 | -74 |
| 2009 | 8.65 | 75 | -42 | -476 |
| 2010 | 8.51 | -33 | -199 | -355 |
| 2011 | 8.41 | -30 | -118 | -200 |
| 2012 | 9.14 | 95 | 201 | 154 |
| 2013 | 9.27 | 363 | 324 | 334 |
| % change | 1.4 | 382 | 61 | 117 |
The recent preliminary results for 2013 showed an underlying operating performance that looks solid enough, with a combination of efficiency gains and cost savings helping to double free cash-flow generated by the business to £334m (from £154m in 2012.) Excluding £52m of disposals, the cash inflow of £282m allowed net debt to be reduced to £906m from £1.18bn, giving the company a relatively low gearing ratio for the sector of 64 per cent in relation to its total equity, or just double cash profits. Surprisingly for a state-backed entity, the average interest rate on the loans is a relatively high 8 per cent - most of this relates to unsecured lending facilities that attract rates of 12 per cent. In which case, it seems obvious that the Royal Mail will be able to borrow from a wider range of sources, including the retail bond markets, at cheaper rates if it goes private.
Meanwhile, like-for-like sales growth came in at 5 per cent to £9.28bn, after a very strong performance from the parcels business. It is hard to imagine, but the Royal Mail traditionally made a loss on transporting parcels - internet shopping has, however, transformed the economics of the business over the past decade; the sheer volume of merchandise purchased over the internet means that parcels now make up 48 per cent of revenues, compared with around 10 per cent historically, and volumes are growing by 13 per cent a year.
What is Royal Mail worth?
An analysis of Royal Mail's intrinsic worth is slightly complicated by the fact that the government has only outlined the details of privatisation in the broadest possible terms. For example, we don't know any details about the size of the float, or how active an investor the government intends to be if it retains a significant minority stake, or indeed what percentage of the business will be sold in the first tranche. Until we know these key points, all attempts at meaningful valuation are based on guesswork. Fortunately, there are some good international comparisons on which we can base some rough calculations.
We can use the shares in issue for Deutsche Post, along with historical examples of previous large-scale UK privatisations, to guess at the likely size of the share float. By comparing the relative size of Royal Mail to Deutsche Post we get a figure for the number of shares in issue at launch of around 2bn, which puts Royal Mail at the lower end of the scale when compared with the 4bn shares issued in the British Gas float and the 3bn for British Telecom. With this in mind, in order to raise the estimated £3bn in the initial sell-off, the pricing for a 2bn share float could be around 150p a share. The government could, of course, price the shares at 1,500p and issue 200m shares, although that might inhibit market liquidity and risk the politically contentious exclusion of small investors.
Whether that pricing level is realistic is the next question investors have to evaluate. According to its latest accounts, Royal Mail's book value is around £1.8bn, or around 90p a share if 2bn shares are issued. What we don't know is whether that represents an efficient valuation of its assets - companies are notoriously bad at valuing the things they own. Let's take the Mount Pleasant sorting office in central London as an example. There have been covetous glances at this piece of real estate, which sits between a regenerated King's Cross and trendy Clerkenwell, for some time, and plans for a sale and redevelopment are now being considered.
The sale of the Rathbone Place office just behind Oxford Street raised £120m in 2011, but the Mount Pleasant scheme is on a different order of magnitude. Such a scheme could see a 12-acre site in the middle of London developed for housing with a potential value of £1bn, which is only half of the total area the Royal Mail owns. Significantly, any sale will happen after the company is fully privatised next year and could round up the possible book value to £2.8bn, bringing Royal Mail much closer to our 150p float price target.
The metrics
The ratios also look interesting if we take 2bn issued shares as a guide. With operating profits of £294m, underlying earnings per share (EPS) comes out at 15p a share, giving a PE ratio of 10, which is at the lower end of the sector. The total enterprise value (EV) of £3.5bn (market capitalisation, plus debt, minus cash) gives the Royal Mail an EV to cash profits ratio of four. Both of those valuations compare well with Deutsche Post's valuation of a PE ratio of 13 and EV/cash profits of 6.2, while the average for the sector is a PE ratio of 19 and EV/Ebitda of 9.3, according to Bloomberg data.
One hint that the government is pricing the IPO to go is that Royal Mail is not as profitable as it should be if it conformed to the norms within the industry. International comparisons are again useful - for example, the recently privatised Belgian Post turns 17 per cent of its sales into profits. This is an extreme example, but Royal Mail ought to aim for matching the industry standard of 8 per cent, double its current effort.
The risks
Our analysis shows that the IPO could be priced attractively, at a potential discount to the sector, reflecting the risks within the business. The problems of switching over to fully-automated parcel sorting have yet to be quantified. Royal Mail has spent more millions modernising its practices, including reducing staff numbers by a third, but the indications are that this process will have to continue, and that it will cost a lot more money. For example, the company still has to reorganise the final third of its sorting office system and install new machines that can cope with parcels to bring it up to maximum efficiency.
The other imponderable is the highly unionised work force - the union has sounded belligerent over the privatisation - although an offer of 10 per cent employee ownership will probably be too good to turn down. Secondly, logistics has relatively low barriers to entry, with many different players, including the likes of listed company UK Mail, offering fierce competition to the established operators. This is reflected in declining margins over the past decade.
Allied to that is the company's statutory duty to deliver a full service to every address in the country, which means its profitable activities have to subsidise rural services. On the other hand, other postal companies manage this successfully and demand for postal services related to online shopping means rural services can never be considered redundant. Still, the Royal Mail will be tied to a set of obligations around which it must build its business model. One way of off-setting this is to expand overseas and take its highly visible brand into new markets. That means matching the likes of UPS, FedEx and DHL in the global logistics market. This will cost money and there are currently no reliable estimates as to how much money the company will need to raise in the long term in order to fulfil such global ambitions.
The gold standard
The gold standard for assessing Royal Mail's IPO, and probably its long-term prospects, is Deutsche Post as it gives investors a good idea of what a mature company can achieve. The German operator came to the market in the autumn of 2000 in the aftermath of the dot-com bust. Priced at €21 (£18.09), or equivalent DM, the shares are now worth €20.5 after a rollercoaster ride including two major stock market slumps in 13 years. That flat share performance has been cited as a reason why Royal Mail's stock market float may not prove to be a long-term success. In fact, what Deutsche Post's experience tells us is that, with the benefit of hindsight, the original IPO was hideously mis-priced on the back of a dot-com bubble-inflated market in 2000.
More telling is what the flotation allowed the company to achieve. Its DHL brand has become one of the biggest and most important logistics companies in the world, with a dividend yield of 4.8 per cent that is double the size of its competitors. It is true that Deutsche Post was able to build up its business at a relatively benign time for competition. It has also suffered from declining margins but has been able to expand sales to compensate. That has come on the back of a lot of investment but, ultimately, if Royal Mail is to succeed as a private company, then it has to follow the example set by Deutsche Post.
