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A right royal management challenge

THE PRIVATISATION of Royal Mail in October has been lauded by the coalition government as a great success, though it has come at a price which, in hindsight, seems to have offered a more than generous discount to tempt investors – both retail and private.

The view of the National Audit Office will be interesting. Undoubtedly, Royal Mail underwent significant change in the run-up to privatisation which saw growth in parcels, greater productivity and price increases produce substantially higher profits.

But how sustainable is the improvement, how much further has the turnaround to go, and will profits and cashflows continue to grow sufficiently to maintain an attractive dividend and finance essential investment?

The privatisation of Royal Mail, in contrast to those that preceded it, had a long gestation period. Margaret Thatcher famously rejected any idea that Royal Mail should be sold, saying she didn’t want the Queen’s head privatised – although some of her colleagues were less sentimental. The John Major government had other, more pressing concerns and focused on rail privatisation, while the New Labour Blair and Brown governments, despite some support for privatisation, decided it wasn’t acceptable politically or ideologically.

Even so, successive governments sought to restructure and re-organise Royal Mail, which then included the Post Office, to make it leaner and fitter. These changes started under Allen Leighton and Adam Crozier but stalled after the industry was opened to competition in 2006 before accelerating again under the stewardship of CEO Moya Green and CFO Matthew Lester, both of whom were appointed in 2010 with a view to privatisation.

Many UK privatisations, from BT to British Rail, have been characterised by the need to reverse years of under-investment and reduce high staffing levels. While Royal Mail faces similar challenges, it has already made significant progress as its financial performance shows. These improvements have not been easy to achieve and necessitated protracted and sensitive negotiations with unions, significant investment in new technology and the beginnings of a shift in culture from that of a public sector utility towards that of a private sector company.

While the Postal Services Act 2011 enabled privatisation, the final hurdles were cleared with the separation of the Post Office on 1 April 2012, the transfer to the government of the pre-April 2012 pension fund as well as its deficit and the publication of the 2012-13 financial statements.

Separation gave Royal Mail greater focus and removed the Post Office’s own problems, transfer of the pension fund removed a liability which had been as high as £7.5bn, while an operating profit (excluding transformation costs) of £598m in 2012-13 (£381m in 2011-12) and an operating margin of 6.5% (4.3% in 2011-12) provided strong evidence that the turnaround has produced substantial improvements in performance.

While the turnaround has yielded some success, what are the challenges to be faced in the future?

Pension problems
First, the issue of labour relations remains a thorny one. Despite being given 10% of Royal Mail shares (and many employees bought more), the threat of industrial action hasn’t gone away. While new technology and working practices have been successfully introduced, even greater employee flexibility and further productivity gains are still needed in this labour-intensive business.

However, employees, who rejected an 8.6% pay increase over three years in the summer, are likely to exact a high price in improved pay and assurances on long-term job security and pensions. The union is mindful that employee numbers have fallen by about 50,000 over the last ten years and that the company continues to view the pension scheme, which has essentially remained unchanged, as unsustainable.

The pre-privatisation deficit has been transferred to the government but Royal Mail will be liable for any future deficit which is likely – unless the generous (in comparison with other private sector schemes) scheme is reformed which would mean lower retirement benefits and/or higher contributions, something the employees will resist.

The continued investment in new technology will also require financing and while some funds may come from the sale of surplus land and property, additional borrowing may be required – the availability and cost of which will depend on Royal Mail’s financial performance. To improve profitability, Royal Mail needs to ensure productivity gains exceed the costs which, in the short term, are likely to include pay increases of about 3% per year and high pension contributions.

Universal obligations
Second, a core activity has been and continues to be in decline; letter volumes (including marketing mail) fell 8% in 2012-13, although price hikes meant that revenues increased 3%. Royal Mail forecasts further falls in volume of 4-6% p.a. through to 2016.

The management team recognises this and has developed strategies to ‘manage the decline’ and transform the letters business although this must be done against the backdrop of its Universal Service obligation which could prove restrictive. This obligation requires delivery on six days a week and collection at a uniform and ‘affordable’ cost.

In addition, Ofcom, the regulator, has stipulated minimum service standards and a cap for second-class stamp prices of 55p in 2012 although that rises in line with the consumer price index. Interestingly, there is no such limit on first-class stamp prices and Ofcom recognises that Royal Mail must be able to earn a reasonable rate of return while meeting the Universal Service obligation, which provides some leeway to raise revenues.

Furthermore, since the industry was opened up to competition in 2006, competitors, which are free of the Universal Service obligation, have entered the letters business and are able to ‘cherry-pick’, offering low-cost delivery within and between large cities. As letter volumes continue to fall and competition intensifies, it will become increasingly difficult, even with further productivity gains, to maintain profits in the delivery of letters.

Against these challenges, the other core activity, parcels, offers great potential. This activity has underpinned the turnaround; it grew 5% (with price increases revenues rose 13%) in 2012-13 and as growth in internet shopping continues strongly, Royal Mail forecasts similar rises in consumer parcels through to 2016, with business-to-business parcels rising slightly above GDP growth.

However, this is the area where Royal Mail faces greatest competition from companies such as Deutsche Post (DHL in the UK), FedEx, TNT, UK Mail and several others. While Royal Mail does have some significant contracts for parcel delivery, Amazon being one of the largest, there’s no guarantee that the contracts will be retained against aggressive competition.

Finally, what about Royal Mail’s continuing independence? Will Royal Mail remain an independent UK-listed company or fall into foreign ownership as have many of the privatised electricity and water companies? Deutsche Post, which was privatised by the German government in 2000 and has made a number of acquisitions, notably DHL in 2002, to become an international force, might be one possible buyer. Royal Mail, with its substantial share of the UK parcels market, could prove a tempting target.

Alternatively, Royal Mail, which already has a limited presence in Europe, could itself, subject to finance availability, seek to replicate Deutsche Post’s acquisitions-led growth strategy.

Much has been achieved at Royal Mail but there remains much more to do if the opportunities offered by the parcels business are to be exploited and the challenges faced by the letters business are to be overcome. If the management team maintains and builds on its recent success, it should enable Royal Mail Group to grow profitably, sustaining its market value and ensuring a future sale of the government’s minority shareholding, maybe in 2014 or 2015, yields substantial revenues.

Dr Paul Simmonds is senior teaching fellow at Warwick Business School

Royal Mail timeline
2001: Post Office Group renamed Consignia in rebranding exercise which reportedly cost £2m
2002: Postal service renamed the Royal Mail Group focusing on its key brands – Post Office, Royal Mail and Parcelforce
2006: After 350 years, Royal Mail loses its monopoly on the postal service when the regulator, PostComm, opens up the market three years ahead of the rest of Europe
2007: Royal Mail announces plans to close 2,500 Post Office branches
2009: Labour business secretary Lord Mandelson launches an attempt to part-privatise the Royal Mail, but the bid fails after opposition from the Communication Workers Union (CWU)
2010: The new Conservative/Liberal Democrat coalition announces its intention to sell off the Royal Mail’s delivery business but retain the Post Office network in public ownership
2012: The government takes on historic assets and liabilities of the Royal Mail pension scheme
2013: Royal Mail privatised

Source: Telegraph

A private practice
Privatisations have had mixed fortunes over the years, with British Gas and British Rail illustrating perfectly the disparate conditions formerly government-owned entities now find themselves in today. In 1986, when British Gas was floated on the stock exchange, shares cost 135p each, or 334p in today’s terms. Since then, British Gas has undergone several organisational changes and the resulting organisation, BG Group, is worth £11.09 a share. A £100 investment in 1986 would have gone up by £821, according to the Guardian.

But for many, the privatisation of British Rail has become the yardstick by which failure is measured. While the transaction itself did not take place until after Thatcher had left office, she was known to be discussing it with the then Department of Transport months before her resignation. Since the privatisation, the size of government subsidies to the rail industry has risen higher than it was in its state-run days. A yearly average of just over £1bn in the late 1980s rose to a high of more than £6bn in 2006/07, according to a public spending report from the House of Commons.

Since privatisation, more than 100,000 jobs have been lost at BT – however, it has managed to maintain a strong position, to the point where it now has the financial muscle to out-bid BSkyB and ITV for Champions League football.

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