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Royal Mail's fine by Ofcom for breaching competition law comes as its letter delivery business continues to struggle and as margins come under pressure from higher wages
Ofcom’s £50mln fine on Royal Mail Group PLC (LON:RMG) could have broader implications for the postal operator, according to Liberum.
The regulator accused Royal Mail of breaching competition law by discriminating against its only major competitor delivering letters, Whistl.
Royal Mail raised the prices it charges wholesale customers, such as Whistl, to deliver letters in early 2014. Whistl complained to Ofcom about the changes to its contract, saying it had to suspend plans to expand its business to compete directly with Royal Mail.
Royal Mail denies the claim that it abused its dominant market position and plans to lodge an appeal against Ofcom’s decision.
“Although the fine itself is not material, and the competitor that brought the complaint has long since withdrawn from the market, we see broader potential implications,” Liberum said, maintaining a ‘sell’ rating and target price of 415p on the stock.
“Importantly, we believe this is a reminder that Royal Mail must act with restraint given its dominant market shares in both letters and parcels, and this limits the group’s ability to grow parcels revenue over the long term.”
Letters business struggles, margins squeezed by labour market pressures
The news comes as Royal Mail's letter delivery business continues to struggle with shrinking volumes. In July the company warned that annual address letter volumes could drop more than expected due to the impact of the General Data Protection Regulation (GDPR) and business uncertainty.
The group has been trying to increase parcel volumes enough to mitigate the poor performance in letters. But Royal Mail said its margins could take a hit from ongoing labour market pressures.
It forked out a frontline pay award of £101mln in the first quarter as part of a deal with the Communication Workers Union (CWU) in February to end a long-running dispute over plans to replace the company’s defined benefit pension scheme.
“Letters revenue remains in structural decline (4-6% per annum on management's own long-term assumptions) and we believe Royal Mail will continue to struggle to grow Parcels revenue fast enough to compensate fully,” Liberum said.
“Against a top line that is likely to be flat at best, we see a potential margin squeeze from cost inflation.”
Higher cost inflation to offset productivity improvements
Royal Mail has argued that its agreement with the CWU on pensions, pay and a shorter working week will improve productivity. But Liberum reckons the productivity improvements will be offset by higher cost inflation resulting from an increase in annual pay and reductions in the working week.
“Although only the first one-hour reduction in the working week is a contractual commitment, we believe the failure to implement subsequent reductions would be very badly received by the trade union and staff who agreed to a below-inflation pay rise in exchange for a shorter working week,” Liberum said.
“If industrial action can be avoided, the experience of the past year shows that underlying productivity progress tends to stall when there is disagreement between management and the union.”
Liberum thinks Royal Mail’s current valuation does not “adequately reflect the lack of long-term growth” at the firm, the risks of productivity gains failing to offset cost headwinds or the possibility of letters revenue disappointing on GDPR and general business uncertainty against a backdrop of high operational gearing.