Privatization – Reviving the Momentum

[TrueBlueTerrier]

The full report available at http://www.adamsmith.org/images/pdf/pri ... mentum.pdf

Extract Regarding Royal Mail

Royal Mail/Post Office

The publicly–owned Royal Mail Group (Royal Mail) operates the mail services and
Post Office network in the UK. Successive governments have avoided, partly for
political reasons, undertaking major structural reform of the key businesses within
Royal Mail. Now that many of the sub–Post Office counter closures have been
implemented, without serious political problems, the time is ripe for re–assessing
the role of Royal Mail and how its performance can be materially improved.
Currently, Royal Mail has four main businesses — the key data, based on 2006/07
figures, is set out below:
Business Staff Revenues


In recent years, there have been some efficiency gains but there are far more to come,
notably with greater use of machinery in sorting offices. Even so, in 2006/07, people
costs amounted to £6,145 million, equivalent to 68.4% of the Group’s overall costs.

To that extent, a rigorous focus on reducing the cost base is a top management
priority. However, as a people–dominated business — especially on the doorstep —
there will be limits to staff reductions, unless customer service levels are
significantly reduced.

Irrespective of the challenges on the operational front, there is no doubt that, like
many state–owned businesses, significant capital expenditure increases will be
required. In 2006/07, the capital expenditure figure was £244 million. Nevertheless,
Royal Mail candidly admits that its rivals are 40% more efficient, a serious failing
that it blames on a lack of modernization and a lack of technology.
Royal Mail’s finances are heavily influenced by regulation, which is implemented by
Postcomm, both in terms of price–setting and with respect to competition.
Recently, Postcomm undertook an interim pricing review, which covers charges
between April 2008 and March 2010. In particular, Postcomm considered the issues
of the ongoing reduction in the UK inland addressed mail market, which Royal Mail
estimated at 2.3% in 2006/07, along with the impact of competition. Royal Mail
argues strongly that the average 13p of revenues that it receives for each unit of
delivered access mail does not cover its costs.


Whilst Postcomm decided not to change the current access margin, it did allow
Royal Mail to raise the price of a second class stamp to 29p by 2010, subject to
inflation — the original price cap was 26p.

Looking forward, there is a need to review the Universal Service Obligation (USO)
to which Postcomm apparently seems wedded. After all, there is no inherent
necessity for identical pricing nationwide, which does not currently apply to other
utility services, including telecoms. In the water sector, for example, South West
Water customers pay an average £483 per year compared with an average £275 for
Thames Water customers.

Indeed, there is a case for a pricing structure which is based on zones. Such a change
would better reflect the costs incurred; this policy is backed by Royal Mail. Current
stamp rates could apply for post being sent to addresses in the same county and
enhanced rates for elsewhere. Alternatively, a postal code methodology could be
devised.

Undoubtedly, the permitted charges for first–class and second–class stamps remain
crucial in determining Royal Mail’s financial returns. In 2006/07, almost 90% of
Royal Mail’s core £6,857 million of revenues was attributable to the provision of
price–controlled services. Arguably, there should be substantial increases in stamp
charges, partly to fund the capital expenditure bill; such rises, however, should be
offset by higher productivity.

Increasing competition in postal services provision is a firm aim of Postcomm. Yet,
Royal Mail is currently delivering 99% — in volume terms — of the addressed
letters market. In time, there will be greater competition, not necessarily from
domestic organisations, such as Business Post, but more from leading overseas post
office businesses, such as Germany’s Deutsche Post and Holland’s TNT — the latter
currently has a market capitalization of c. £7 billion.

Both these latter companies, who have spearheaded postal services privatization in
mainland Europe, are very keen to expand. They are both currently operating in the
UK, at the business end of the market. In time, no doubt, they would be keen to
participate in the entire delivery chain.

Under the EU’s legislation to promote competition in the mail delivery markets, part
of which has been delayed, increased competition seems inevitable. In Germany, the
recent decision to impose a minimum wage has caused real problems for
competitors of Deutsche Post; but it has been a boost for the latter. For Royal Mail
itself, it will face challenges for which it needs to be more prepared, both
operationally and financially.

In addition to addressing the capital expenditure programme and the operating cost
and revenue bases of Royal Mail, there is a more general need for an overhaul of its
finances.

Within this proposed restructuring, the long–standing pension fund deficit issue
needs to be resolved by putting the pension fund on a firmer financial footing. As of
March 2007, the pension fund deficit was just below £5 billion, whilst the employee
contribution rate at 6% — very surprisingly — remained unchanged in 2006/07.
This proposed financial restructuring should enable Royal Mail itself to become
more suitable for a public flotation, which would raise further funds for the business
to expand. Moreover, a pension fund deficit should not be an insuperable barrier to
a public flotation, although action will need to be taken to ensure that the deficit is
much reduced.

In preparing Royal Mail for a public flotation, careful analysis would need to be
undertaken regarding the appropriate debt/equity structure. As of March 2007,
Royal Mail actually reported a net cash balance of £392 million.
Last year, the government agreed a £4 billion refinancing programme for Royal
Mail, of which £1.2 billion is earmarked for an uplift in investment and £1.7 billon
for the modernization — and effective subsidy — of the Post Office network, which
will see c. 2,500 branches being closed. A further £1 billion has been set aside for
pension fund payments.

If the debt component is too low, it will encourage private equity investors to bid for
Royal Mail with the aim of substantially gearing up the company. It would also be
important to ensure that current Royal Mail employees, with a lengthy service
record, become eligible for a substantial proportion of the shares on offer.
A public flotation of Royal Mail would not only allow it to be far better funded than
at present, but it would also enable it to expand. After all, members of its staff have
trusted access to virtually every business and house in the UK, amounting to c. 27
million addresses. With that unique level of customer contact, the potential for
cross–selling is considerable.

At the political level, previous manifesto commitments have been cited as a reason
for ruling out any privatization of Royal Mail. However, such policy commitments
are not sacrosanct. Indeed, it is clear that the government’s recent decision on the
future of the Tote goes against previous manifesto commitments.
Valuation: In placing an Enterprise Value (EV) of just over £4 billion on Royal Mail,
comparisons have been made with other quoted Post Office businesses, notably the
Dutch–based TNT. Inevitably, various assumptions have been made about the
underlying worth of Royal Mail, once the many one–off factors have been stripped
out. However, its value — pre the pension fund deficit — clearly lies well beyond
the c. £2.3 billion Regulatory Asset Value (RAV) that applies to the Royal Mail core
business.

Notice has also been taken of a discussion paper published by the Policy Unit of the
Liberal Democrat Party in January 2006, which placed a value of between £4–5
billion on Royal Mail (assuming that the Post Office network was stripped out).
Presumably, too, the c. £5 billion pension fund deficit has also been discarded.