Royal Mail (RMG) was the stock-market story of the year, no doubt. Ordinary investors made out like bandits from the initial public offering (IPO), which makes a nice change, I suppose. But they should be wary – there’s plenty wrong with Royal Mail.
Now, while I have deep reservations about the long-term direction of Royal Mail, I did advise readers to buy RMG shares. If I do say so myself, my advice to not make applications above the £10,000 level and, instead, make multiple applications using all members of the family was almost prophetic.
Royal Mail has got off to a flying start. And this week, it released half-year results – the first set of figures since the float. Many readers will be itching to know how the figures stack up, and what the company is really worth. I’ll give you my opinion today.
But remember, Royal Mail is very much in transition. It’s not just the change from public to private ownership, but also changes to industrial relations and the whole issue of managing a business in terminal decline.
Put it all together, and it makes the thing incredibly hard to value. Indeed, there’s an awful lot of public debate over exactly where the valuation for the flotation came from!
Though it’s going to be tough putting an absolute value on this business, the accounts released this week reveal some startling facts. I think you’re going to be surprised.
Making sense of the figures
At first glance the figures looked great. Profits for the half-year were £1.6bn – a massive figure. The headlines read well and the stock duly shot up.
Yet, if you look closely, much of the growth was down to one-off factors. Not least of which is the ‘odd’ £1.35bn in profit that resulted from tinkering with the pension account. We’ll ignore this book entry, thank you very much – it’s got nothing to do with actual ‘cash’ profit. Moving on…
There was also the absurdity of a £35m VAT repayment. I say absurd, because, the figure resulted from the fact that Royal Mail will now be liable to pay VAT on more of its services. Anyway, it’s a one-off and won’t be repeated. We’ll ignore it.
But perhaps the most important oddity in these accounts is the figure Royal Mail reported under the heading “transformation costs”. These costs relate to Royal Mail’s modernisation plans. You see, in order to streamline the business, they have to spend money before they can save it. New equipment and redundancies are the main ‘investments’.
But in order to grease the wheels of industrial relations, it seems Royal Mail has put on hold some key modernisation plans. I guess the priority was to get the flotation away without too much fuss.
Last year, Royal Mail reported £120m in transformation costs. Yet this year that number was down to a surprisingly low £70m. But here’s the thing – over the coming year, Royal Mail expects to re-double its efforts in modernising. They’re going to make up for lost time. They expect to spend a cool £160m, and that cost will come straight off the bottom line.
Of course, transformation can’t all be bad news. There’s no doubt that Royal Mail needs to make drastic changes. And as it ‘transforms’, not only does the business cut costs, it also tends to release assets – especially land that can sold for redevelopment.
Of course, this will only generate a series of one-off profits. But it’s profit nonetheless. We’ll wait with bated breath, but for the moment, let’s take a look at the underlying, ongoing business.
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Let’s not forget, that overall, Royal Mail is a business in decline (despite what they may say!). Volume in the all-important letters business was down 4%. Not only are fewer letters posted each year, but competitors are increasingly cherry-picking the high-margin contracts in dense urban areas like London and Manchester. Yet, somehow Royal Mail reported increasing earnings.
And that was all down to the parcels business, where revenues were up an impressive 9%. That’s despite the fact that the number of parcels actually delivered was flat.
Over the period, Royal Mail introduced a new parcels pricing formula, whereby the rates are set not only by weight, but by size too. All that really happened is that Royal Mail hiked prices by some 9%.
But it was all at the expense of losing market share. You see, according to CAP Gemini, e-retail sales were up some 16% during the period. Yet, the amount of parcels Royal Mail delivered was flat. And that’s pathetic.
In response to this awful result, Royal Mail says that it expects parcel deliveries to grow by around 5% in the coming year. Hmm, we’ll see about that. I wouldn’t bank on it. After all, it can take quite a while for all these new online businesses to move away from Royal Mail’s traditional service – but in the wake of 9% price hikes, why on earth wouldn’t they?
And anyway, in a market growing at 16%, 5% growth is hardly setting the bar very high! Letters in terminal decline and losing market share in parcels. Not great, is it?
Now let’s delve a bit deeper into the accounts, for some rather startling discoveries about Royal Mail’s new buddies in the City.
The most rapacious bank in Britain
In the run-up to the float, the government was forced to distance itself from Royal Mail. As part of the plan, Royal Mail had to swap its loans to the government with loans sourced on a commercial basis.
As it happens, now is a good time to be seeking a commercial loan – at least, if you’re a big institution like Royal Mail, it is.
Given the low interest rate environment, Royal Mail says it’s found new loans with interest rates of about 1% above Libor. This means Royal Mail is paying about 1.4%.
But because Libor could rise over the three to five-year term of the loans, Royal Mail is pencilling in an interest rate of about 2.6%.
Now, how do you take an interest rate of 2.6% and hike it to 3.5%, the number Royal Mail will actually pay? Answer: You ask your new City banker buddy to organise the loan for you. Yes, that’s right, Royal Mail’s newfound chums are charging between £60m and £140m in ‘fees’ for arranging the loan. Fees plus loan equals 3.5%.
On that basis, I hardly think the banks are going to lose any sleep over the fact that business secretary Vince Cable is widely reported to be holding back some £4m in fees due on the Royal Mail float. Vince wants to get to the bottom of why the business was sold so cheaply before he pays the City banks any more cash.
So are the banks taking the mick? I would say so. Why Royal Mail couldn’t have negotiated a better arrangement fee, I don’t know. And as for the farce on the flotation, well that’s already well covered in the press. But none of this is as bonkers as what the previous, most rapacious banker to Royal Mail got away with…
As I said, before going commercial on these loans, Royal Mail borrowed from the government. Bear in mind that even with the bankers’ fees, Royal Mail is now paying 3.5% on its debt. Now, have a guess what the government had previously been charging them…
Wait for it…
That kind of puts into perspective the commercial rate of 3.5%, doesn’t it?
I mean, with a sugar-daddy like that, it’s little wonder the business struggled for years under national ownership!
Some interesting conclusions…
Having read this week’s reported accounts, I have to say, I’m none the wiser as to whether Royal Mail will prove to be a profitable short-term investment. As far as a long-term investment goes, my mind has long-since been made up. It’s a business in terminal decline.
Over the short-run though, Royal Mail’s management seems so old-fashioned that there’s plenty that can be put right. And there are valuable assets that will be sold.
That said, there are an awful lot of transformational costs yet to be accounted for. Not only that, but in terms of industrial relations, there’s bound to be plenty of ructions down the line.
In all, Royal Mail is a gamble. Opportunities – yes – providing the management is able to grasp them. Risks – definitely. In fact, they’re all over the place.
For me, I’m hanging on for the moment. I want to see some efficiency gains and asset sales coming through. If the management can slay the industrial relations dragon, then there’s a good chance of a short-term bounty.
But as for the medium term, I suspect I’ll be bidding farewell to Royal Mail. Let’s wait and see what the management comes up with.