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Change is coming for companies with public sector roots

After a damaging few months, listed businesses such as Royal Mail and FirstGroup look vulnerable
March 8, 2023
  • UK courier in battle to survive
  • New incentives for train operators 

Last month, Royal Mail’s management team was hauled in front of a House of Commons select committee to answer questions about the business. It wasn’t a comfortable experience for International Distribution Services (IDS) chief executive Simon Thompson, who fended off allegations that the 500-year-old courier tracked the speed of its posties in order to discipline them, and had suspended legitimate sick pay during strike action. 

One line of questioning stood out, however. During a discussion about Royal Mail’s universal service obligation (USO) – which requires it to deliver letters to all addresses in the UK, six days a week – one committee member said: “You would like to compete in the parcels market – but you have a statutory obligation to deliver six days a week. Is not the evidence before us that you cannot do both? You have to do one or the other.”

Thompson said Royal Mail could manage both but agreed with committee chair Darren Jones that the postal service was not fully sticking to its six-day letter delivery obligation: "Our USO performance has definitely not been good enough," Thompson said. 

Given that the government happily floated Royal Mail in 2013, leaving it to contend with rival couriers in an increasingly competitive market, the committee's gripe doesn't seem entirely fair. However, it underlines a growing problem: listed companies that offer public services – be they national couriers or train operators – cannot please all stakeholders. The question is, will it be workers, customers, shareholders or the government who are ultimately left in the lurch?

 

A royal mess

Royal Mail – which is the UK arm of International Distributions Services as per the October name change – has been at loggerheads with its workers since last summer. This has led to 18 days of strike action so far, and a £200mn financial hit in the nine months to 31 December. The basis of the dispute is simple: management is desperate to cut costs and increase productivity because the letter business is declining, while workers want better pay and dislike the proposed changes to working conditions. Adding to the pressure is communications regulator Ofcom, which has told Royal Mail that it cannot keep using Covid-19 as an excuse for poor delivery performance, and that it must meet its universal service obligation. 

The financial situation is not good. For the six months to 25 September 2022, Royal Mail reported a loss of £219mn, with the problems caused by falling letter and parcel volumes exacerbated by inflation and the group's big fixed cost base. Management expects to report a £400mn loss for the full year, assuming (rather optimistically) that industrial relations improve quickly. 

So what happens next?

“Eventually a deal has to get done,” said Bernstein analyst Alex Irving. “But change needs to happen. It’s a constant need at Royal Mail because letter volumes are declining. It’s no longer an appropriate business mix. Without changes to processes and improvements to productivity it will be hard to make money, to run profitably.”

“No business in a competitive environment has the right to survive, just because,” Liberum analyst Gerald Khoo added. “It doesn’t matter how many hundreds of years of history you have, you can be destroyed in five or 10 years if you don’t adapt.”

One possibility is a group split.

In July, Royal Mail announced it was changing the name of its holding company to International Distributions Services, which placed the famous UK business at arm’s length and emphasised the “increased importance” of European courier GLS. The latter is still highly profitable, and management said it would consider separating the two companies unless “significant operational change” was achieved in the UK.

This makes sense from a shareholder perspective. While management said there would be no further cross subsidy in the group, Royal Mail is effectively eroding the value of GLS. Meanwhile, management doesn’t have a free hand to do what it likes with European operations, because of the shadow of Royal Mail and its unhappy workforce. Paying a dividend from GLS earnings, for example, would likely spark rage among union members. While Irving argued that a 2023 dividend wasn’t impossible, he added that it was an “extremely thorny issue”. 

Spinning off GLS wouldn’t solve the fundamental problem, however. A weakened Royal Mail would keep limping along, haemorrhaging cash in a bid to keep the UK postal service going. 

It is possible that Ofcom will ease the statutory burden on Royal Mail to help improve efficiency. After all, it is not in the government’s interest for the group to become unviable. “At the moment, it doesn’t cost the government a penny to have a universal service and it’s not their problem,” Khoo said. The courier is currently pushing to cut letter deliveries on Saturdays, but has yet to make any headway. 

 

 

Another option, of course, is renationalisation. “Ironically, renationalising it would probably be good for shareholders,” said Khoo. “They wouldn’t have to spend the money to fix [the company] without clarity over whether there will be a positive return on that investment. They wave goodbye to all the liabilities, all of the downside risk. Because to transform Royal Mail, you have to spend – on automation, probably on redundancy costs, and then to deliver productivity savings."

 

Transport switches track

The government will be reluctant to take on more cost and political hassle, however – particularly given the existing situation with train operators. Before Covid-19 struck, UK railways mostly operated under a franchise model, which meant transport companies were exposed to fluctuations in demand and costs. When lockdown was announced, however, the government stumped up the money needed to keep operators in business. 

Emergency Covid measures gave rise to national rail contracts for the likes of FirstGroup (FGP) and Go-Ahead. These contracts transfer revenue and cost risk away from companies and onto the government, with operators receiving a fixed management fee plus a performance bonus if their services come up to scratch.

After months of strike action, however, and commuters abandoning unreliable services, cracks are starting to emerge in the new arrangement. According to reports in the Financial Times, the Department for Transport wants operators to introduce double-digit budget cuts next year to ease pressure on public finances. In response, railway bosses are urging ministers to hand power back to companies themselves and restore commercial incentives.

The government seems receptive to this idea. In a speech last month, transport secretary Mark Harper said incoming rail reforms would “enhance the role of the private sector” and allow train operators to take on more financial risk. “We shouldn’t be afraid to let managing directors of train operating companies actually manage and direct their operations. Which is not what they’re able to do at the moment,” Harper said.

This might set off alarm bells for investors who remember the sector's litany of past failures – including when Go-Ahead was stripped of its Southeastern rail franchise and fined more than £20mn. However, analysts think companies are keenly aware of this. 

“The problem is that risk transfer didn’t work under previous systems because it was not adequately remunerated,” said Khoo. “Basically, train operators were not paid enough to take on the risk they took on.”

Shareholders, therefore, are likely to demand higher margins than companies aimed for – and often missed – under the earlier system. “If FirstGroup were to take on a full cost and revenue risk rail franchise in the UK, it would not be at a 3 per cent margin,” said Khoo. “It would have to be substantially higher for it to be acceptable to its shareholders.” Whether the government could stomach that is another question. 

Ultimately – in spite of changing consumer behaviour – both Royal Mail and FirstGroup offer vital public services, which the government can’t allow to fail completely. Whether that offers any protection for shareholders is far from certain, however. It is worth remembering, though, that both transport groups and logistics companies proved popular takeover targets last year. Go-Ahead was bought out at a 48 per cent premium. 

Thirty years after Margaret Thatcher said she was "not prepared to have the Queen's head privatised”, therefore, international bidders could well start to circle again in the next phase of these companies' long journey.