Gifts in the mail

Gifts in the mail

15 Jun 2015

The privatisation of Royal Mail in October 2013 was a lesson in how the City can run rings around politicians who fancy themselves as financial sophisticates. In this case the sap-in-chief was Vince Cable, a man whose CV includes many “economics advisor” titles. Despite this supposed in-house expertise, his department for Business, Innovation & Skills hired a vast syndicate of City banks, perhaps believing in the wisdom of crowds.

It is well known that the shares were priced at 330p, that the institutional offering was oversubscribed by 24x and the retail portion by 7x. Most applicants for shares got none at all but 16 priority investors shared 38% of the entire offer (representing 22% of the company). On the first day of trading the shares closed at 455p. Within a few weeks, seven of the sixteen priority shareholders had cashed out completely. The grounds on which the priority investors had been selected were said to include their willingness to be long-term shareholders.

It is hard to escape the conclusion that the government behaved with a mixture of ignorance and fear. For many years, financial institutions have gorged themselves on the naivety of their customers but, as a citizen, I find it very disappointing that my elected representatives are quite so useless.

The underpricing and mishandling of the IPO was something of a public humiliation that may have contributed to the ejection of Vince Cable in the recent general election. It took only until March 2014 for the National Audit Office to publish a report that criticised the government for being cautious and pointed out in restrained language that “the taxpayer interest was not clearly prioritised within the structure of the independent adviser’s role”. 

Royal Mail was something of a dinosaur company in stock market terms. It was a state-owned business that retained a highly unionised workforce and huge defined benefit pension liabilities. Moreover, it was obliged to maintain a national postal delivery service while the potentially more lucrative parcel delivery service was open to new competitors who could to some extent cherry-pick the services that they fancied. Letter volumes are in clear decline as most of us prefer e-mail while parcel volumes are rising as the online ordering of goods grows.

In view of the above it is perhaps understandable that when the advisors tutted and said that this pig needed some lipstick, the Business Secretary and his minions wobbled. Aside from operational challenges, there was one ticking bomb in the Royal Mail balance sheet – the pension liabilities.   

Consequently the IPO prospectus stated that all pension liabilities up to April 2012 were transferred to the government. With one bound they were free! This seems to me (admittedly no expert on pensions) to be extraordinarily generous.

State-owned businesses that go private are notorious for having challenging pension liabilities. For example, BT has 300,000 pension obligations to manage. Due to the fact that BT was once a state monopolist, its pensioners are protected by a Crown guarantee but this is not the same as the Royal Mail deal at all. The Crown will step in BT fails to meet its obligations but it has not assumed the obligations. BT’s pension liabilities are a constant headache. At the last three year actuarial valuation (in January 2015) its deficit had risen from £3.9bn to £7.0bn.

The government tried to get out of its guarantee for the BT pensioners who joined the firm after privatisation but lost in the High Court in 2010. This action was driven by the Department of Business, the very body that effected the taking over the Royal Mail liabilities.

In 2012 the government took over assets of £26.5 billion from Royal Mail and liabilities of £30.2 billion i.e. it assumed a pension liability that was £3.7 billion in deficit. Whether this was a responsible use of the nation’s money is a good question that I do not propose to address here. It is true to say that Royal Mail would have been unsellable had it not been relieved of its pension baggage. But there’s more.

Royal Mail naturally shoulders the burden of future pensions. But this was sweetened as well. It was decided to leave Royal Mail’s future pension liabilities fully funded on an actuarial basis. Consequently at the time of the IPO it had pension assets of £3.3bn and liabilities of £2.7bn, a surplus of £600 million.

By March 2014 (the end of the 2013/14 financial year) the surplus had grown to £1.7bn. The main driver of this improvement was the performance of government bonds which made up a large part of the assets.

We now have the accounts for the year to March 2015. The surplus has grown to £3.2bn. All the numbers are much bigger. Actuarial estimates of liabilities have grown to £3.4bn, driven by lower interest rates. But the assets have rocketed in value to £6.6bn, again driven by large holdings of gilts.

There is some evidence of embarrassment in the small print in the accounts.

“The Directors do not believe that the current excess of pension scheme assets over the liabilities on an accounting basis will result in an excess of pension assets on a funding basis. However, the Directors are required to account for the pension scheme based on their legal right to benefit from a surplus, using long-term actuarial assumptions current at the reporting date, as required by IFRS.”

Essentially, the accounting rules acknowledge that the pension surplus might accrue to the company but the directors are reluctant to contemplate anything so grabby, particularly in view of the company’s history of troublesome industrial relations.

Last week the government reduced its remaining stake in Royal Mail from 30% to 15%. It is clearly part of the current government’s strategy to flog assets and from the point of view of independent shareholders it is probably preferable that HMG clears out. If delicate decisions, such as whether to hand surplus funds to shareholders rather than pensioners, need to be taken, political influence would play no helpful part.

It should be said that the luck or judgement of the pension fund administrators could run out and the pension surplus might be swallowed or even reversed by the collapse in gilts that many people have been anticipating (for quite a few years). But we can only address the facts as they are.

At 500p a share Royal Mail’s market capitalisation is £5 billion. It has net financial debt of £263 million giving an enterprise value of just under £5.3bn. I always add net pension liabilities into this calculation because they are genuine financial liabilities and I believe that they give a truer reflection of the company’s financial state.

In this case consistency says that I should deduct Royal Mail’s pension surplus from its enterprise value which reduces the latter to just £2.1 billion. Last financial year Royal Mail generated free cash flow (after capex) of £342 million. That gives me a free cash flow yield of 16.3%. On the previous year’s free cash flow of £399 million the yield rises to 19%. If you take this pension surplus at face value these shares are laughably cheap.

Back in January I suggested Royal Mail shares as a way of playing lower fuel prices. The results release in May contained this pleasing paragraph.

“Savings were also achieved on vehicle costs through improved fleet management and on fuel costs. Diesel and jet fuel costs were £186 million in the year, compared with £195 million in the prior year. We buy forward a large part of our fuel requirements, therefore we are not materially exposed to short term fluctuations in oil prices. We expect fuel costs to be around £171 million in 2015-16.”

So due to forward buying, more of the savings will come through in this fiscal (2015/16) year than last. That is another small but helpful factor.

This dividend yield is 4.1%. I’m not finding much not to like here. I see gifts in the post.

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