Business, Skills and Innovation CommitteeWritten evidence from David Stubbs
1. Introduction
1.1 I am a leading UK and European postal expert and have been the leading media commentator on the sector over the last five years, commenting regularly on national news and in the press. I was a key member of the teams which opened up the UK mail market to competition (at Postcomm) and EU mail markets to competition (at DG Internal Market of the European Commission). More recently, I have advised the NAO on the withdrawal of retail price controls in the energy, postal and telecoms markets, and Consumer Focus and competing postal operators on postal issues. In 2011, I wrote a strategy for consumers in the postal industry for Consumer Focus having chaired stakeholder meetings across the UK with speakers including Ed Davey and Richard Hooper. In my advice to the consumer body I predicted (contrary to the analysis contained in the Hooper report) that Royal Mail could return to profitability without privatization.
1.2 As a Partner at Trova Consulting, I (with a colleague) wrote a valuation report of Royal Mail in 2011 which valued the company (in a base case) at £5.7 billion. Whilst this was heavily publicized in national media, BIS declined to read it or to discuss its contents with us. I write now at the request of Ian Murray MP, having commented on the BBC national news on the low nature of the Royal Mail pricing before and during the float. During the float process I have been advising Investment Bank analysts and fund managers on the postal market and regulatory development.
1.3 I keep my submission brief (I could say a lot more) in accordance with submission requirements but am happy to provide more detailed information to support my analysis if requested.
2. Executive Summary
2.1 In considering the handling of the privatization of Royal Mail and the considerable undervaluation of the business the Select Committee should seek to understand how far the sale served the public interest in a broader context (rather than purely whether BIS followed due process in consulting sufficient investment banks or funds).
2.2 In this broader context it can be argued that the public interest has not always been well served by the process of the privatization of Royal Mail. In particular it has not been served in respect of:
a)
b)
3. Recommendations
3.1 I would not recommend a further sale of the government’s stake in the business until it has moved towards a better understanding of the market and of how to achieve its objectives in the sector which is an essential infrastructure for the new economy. For example, it may regret a full sale of the business which led to excessive returns for private investors (exploiting light touch price regulation or asset sales at the business) or to excessive returns generated by severe cost cutting and headcount reductions. Realistically I understand that such a sale is likely to go ahead and in this case I consider that the government or Ofcom may soon need to review their approach to future postal regulation if postal consumers or customers are to be protected from a powerful private provider of an essential service.
4. Analysis and Factual Information
4.1 I set out below further analysis and factual information:
a)
The public interest in relation to postal services
4.2 The public interest can be best served by ensuring the provision of postal services (including universal postal services) which are reliable, cost efficient and of high quality. Postal services provide a vital delivery infrastructure for the economy in respect of communications and, increasingly, as a means of low cost distribution of e-commerce. Lower costs and greater efficiency in postal services benefit the wider economy, in particular in reducing costs for businesses and stimulating the development of e commerce.
Privatisation and postal services
4.3 Globally, universal postal services are usually provided by national posts in the public sector. In the EU, which has moved most quickly to reform the sector, there has been only a gradual and cautious move to privatize national posts, with successful and efficient national posts operating both within and outside the public sector. It is therefore counter-intuitive to state that privatization is essential to ensure postal services, which implies that postal services may soon fail across most of the world.
National posts and financial performance
4.4 In practice national posts remain in a fairly cossetted or insulated financial situation compared to most businesses, revenues are largely safeguarded going forward (mail volume declines offset by a changing volume composition and by e-commerce traffic growth) and costs are set through wage level choices and also the pace of achievement of efficiency gains. Although most national posts have not pursued profit maximization strategies, (which renders international benchmarking less useful) margins can be significantly increased both through raising prices (where the national post retains market power) and/or becoming more cost efficient by reducing headcount, making costs more flexible or restraining wages. Where national posts have been privatized they have made significant returns in letters products through increased prices and through a process of cost reduction which remains ongoing.
Royal Mail’s position in the UK as the universal service provider
4.5 Royal Mail as the traditional provider of the universal postal service enjoys a legacy of significant market power in the delivery of postal items, particularly in respect of letters and low weight standard parcels. The profitability or otherwise of its universal service provision as a whole is determined by the level of postal volumes, the level of wage costs at Royal Mail, technical efficiency at the business and the level of its prices. Increases for example in wages will apparently increase the “net costs of the universal service”, whereas greater cost efficiency or price rises will reduce it.
Future demand for postal delivery
4.6 Usage of the postal delivery network has changed over time with traditional communications products declining but being replaced by advertising (direct) mail and now by e commerce traffic. Whilst postal providers such as Royal Mail have found it difficult to innovate and have regularly predicted the imminent end of their business, dynamism in the wider economy has continued to find an outlet in the universal postal delivery network, which retains economies of scope and scale which offset its relative technical and cost inefficiency. Royal Mail enjoys around 40% of the e commerce delivery market, with many other companies also delivering to the door every week. First mover advantage in this market represents a significant commercial opportunity going forward.
The level of postal volumes and its financial effects
4.7 It appears that (adjusting for the effects of the cycle and price rises) it would be cautious to assume that there is an underlying predictable annual decline across mature postal markets of mail volumes of around three or four percent.
For Royal Mail the effects of this decline can be offset by:
The changing revenue mix can be benign with volume increases in heavier more pricier items offsetting declines in cheaper items;
price rises can be imposed on traditional letters products where customers have little choice but to use the service;
avoided costs- less items to handle should mean lower costs;
gaining greater market share in e-commerce delivery markets;
greater cost efficiency through better use of automation and a lower wage bill.
Price rises versus efficiency gains as a mechanism for increased margins
4.8 Financial modelling suggests that price rises are a less successful means of raising margins than increased cost efficiency. This is due to loss in volumes from price rises. Fostering greater cost efficiency with relatively small year on year cost saving can significantly increase margins over time. Further benefits of lower postal prices are passed on throughout the economy increasing competitiveness and employment.
Hooper Recommendations
4.9 At the start of the sale process, Royal Mail continued to be in a fairly cossetted commercial situation compared to most businesses but was making low returns due to the effects of the downturn, a bloated cost base, its pension fund deficit and a fussy price control process. Hooper was right to recommend removing the pension deficit, which provided it with a significant commercial cushion and to query the complexity and acrimony which had arisen over price control regulation.
4.10 However, the market analysis used to justify privatization overstated risks to the business. Royal Mail could raise margins further under state ownership through price rises or cost efficiency measures as had happened in other EU Member States and privatization itself was not necessary to save the business. Arguments for additional capital expenditure (beyond that already funded during the process of the sale) were vague and it was unclear why this could not be funded under state control given that such expenditures have been financed in this way across the EU.
Conclusions
4.11 It is unfortunate that the privatization process had led to significant price rises at Royal Mail. As suggested earlier the public interest is best served by cost efficient and high quality postal services. According to ONS figures if postal prices go up then the wider effects on the economy are a net reduction in employment.1 Based on a price rise of 20% at price elasticity of -0.3 we could expect a net employment impact of around 10.000 jobs over time. Increased postal prices lower postal volumes and reduced growth in the e-commerce market, which may damage national competitiveness.
b)
Royal Mail’s financial performance and the privatization process
4.12 In the context of the privatization of Royal Mail, it can be argued that the public interest is best served by ensuring that the sale is achieved at the correct company valuation and that the company has then strong incentives to be cost efficient and innovative.
4.13 In practice the company has been sold at just over half its value and the lack of regulatory oversight of the company provides it with clear incentives to increase margins through a further round of price rises which will damage the postal market and reduce national competitiveness.
The Value of Royal Mail
4.14 As stated earlier, Royal Mail remains in an unusual commercial position. It has a largely predictable recurring base revenue line (a situation most businesses would die for) and can set most of its own costs (labour costs equal around 55% of revenues) through its wage levels.
4.15 Given this it is unsurprising that it has been able to raise margins over the last few years through price rises, (and removal of the pensions’ deficit), though it has shared the proceeds of the rise with its staff through the pay settlement, limiting the actual effect on margins.
Prospects for raising margins further
4.16 The business has significant scope to cut its costs further if it so chooses following the capital expenditures recently made. Further, it can again raise revenues through price rises. Ofcom has indicated already that it expects Royal Mail to raise margins.
Risks to the business
4.17 Given this Royal Mail could be considered to have a ‘licence to print money’ as it were subject to two constraints:
Self-inflicted risks of industrial action. The company has a legacy of industrial disputes.
Risks of a greater level of mail volumes decline due to electronic substitution or greater delivery competition.
4.18 Clearly risks of industrial action have weighed heavily during the process of the sale and are quoted both in the prospectus of Royal Mail and in the Secretary of State’s letter. However, it is debatable whether such threats represent a real danger to the business. Industrial action over recent years has been disruptive rather than significant. Further as postal delivery has become more about distribution than communication, and as alternatives to postal services have emerged, the nuisance of a protracted industrial dispute has abated limiting the power of the threat.
4.19 Other analysts have commented on how such strikes may actually increase the value of the business in demonstrating management determination to reduce costs.
4.20 Mail volumes decline due to electronic substitution have been discussed earlier. In relation to end-to- end delivery competition it is noticeable that Ofcom has proposed to intervene if competition for traditional letters delivery becomes more significant. In any case Royal Mail already competes in a wider postal market which incorporates e-commerce delivery and can gain as well as lose market share. It is moving to a more normal commercial situation than before.
Our Analysis
4.21 The analysis undertaken at Trova came to the following assessment of potential margins across three scenarios- one our base case which was largely as is now and assumes increases in margins following some future efficiency gains/price rises, one a scenario of protracted industrial action and failed efficiency drive and one of industrial action combined with rapid volumes decline. This suggested the following future margins at the company.
FUTURE MARGINS FOR ROYAL MAIL UNDER THREE SCENARIOS
Trova Consulting 2011.
4.22 These margins suggested a base case valuation of £5.7bn (after debt).
4.23 In light of current valuations, clearly the market has taken the view that although there are risks, they are offset by the commercial opportunities available to the company both to increase margins in its traditional letters delivery and to grow revenues in e commerce delivery. For example were mail volumes to decline more rapidly, then the business could increase the pace of its efficiency improvements or raise prices more steeply.
4.24 Further, our analysis did not take account of the effects of such steep price rises at Royal Mail as have occurred over the last couple of years, though we did assume that the business would at least get a return on the capital investment made.
Why was the company so undervalued?
4.25 In light of the above how then can the undervaluation of the business be explained, even considering that the government would have wished to attract investors?
The argumentation for the sale
4.26 In part the origins of the undervaluation lie in the Hooper Report which presented an over-gloomy view of postal market development, focusing on negative market trends (electronic substitution of letters exacerbated by economic downturn) and financial problems at Royal Mail rather than looking at the market as a whole. The results of this led to a strange argumentation for the sale which ran along the lines of “this business is falling apart and soon to die…please buy it.”
4.27 Whilst this may have been seen as politically necessary it was a very weak starting point for a negotiations with city investors and, it can be argued that this by itself may have been a cause of undervaluation.
Regulatory capture
4.28 The undervaluation also reflects weaknesses in the manner that BIS has handled its stewardship of the postal industry. This has included a tendency to become captured by Royal Mail’s view of the postal business and to place too high a priority on short term political risks for Ministers (in relation to concerns over postal strikes or service failures).
4.29 During the process of the sale Postcomm and Consumer Focus, which represented customer and consumer interests and provided an independent perspective were both scrapped and a more light touch regulatory regime put in place.
4.30 Faced with this legacy of unbalanced argumentation about the potential for rapid decline of the business and with a departmental advice which reflected a very cautious view of the prospects for the business, it was difficult for Ministers to take a more objective view of its potential for commercial success.
Lack of alternative voices in the process of the sale
4.31 Ministers went down a conventional route in seeking advice on the valuation asking Investment banks who knew little about the postal sector and about Royal Mail in particular. This was reflected in the wide valuations. Faced with suggestions that Royal Mail may be worth much more money, advisors and Ministers, unsurprisingly viewed any dissenting valuation (compared to over-negative ones) with skepticism. In practice an objective view was only likely to come from outside BIS and from the enthusiasm of buyers during the process of the float. However, even when faced with clear evidence of over subscription of the sale, Ministers could not believe that previous advice was incorrect and seeing the political risks of a failed sale continued to undervalue the business.
Gaming strategies during the process of the sale
4.32 It is also likely that the government’s attempt to tilt the ownership of the business towards long term and passive investor led it towards undervaluation.
Recommendations
4.33 In light of the above analysis, I would not recommend a further sale of the government’s stake in the business until it has moved towards a better understanding of the market and of how to achieve its objectives in the sector which is an essential infrastructure for the new economy. For example it may regret a full sale of the business which led to excessive returns for private investors (exploiting light touch price regulation or asset sales at the business) or to excessive returns generated by severe cost cutting and headcount reductions. Realistically I understand that such a sale is likely to go ahead and in this case I consider that the government or Ofcom may soon need to review their approach to future postal regulation if postal consumers or customers are to be protected from a powerful private provider of an essential service.
3 November 2013
1 Europe Economics: “The Benefits of Competition in the UK mail market”. 2008