Royal Mail Plc – Heavy Lies the Crown

Royal Mail is among the largest logistics businesses in the UK. For centuries it has been the dominant (currently the only) provider of end-2-end letter mail operations and it has built an extensive distribution system in order to support its business model. It is also a Universal Service Obligation designee. As such, RM is required to offer timely postal services within the UK at a uniform tariff established by Ofcom – the postal regulator, and does not have the ability to set stamp prices.

The Internet has pushed letter mail volume into a decline. As a consequence, RM has focused on leveraging its logistics platform and expanding its UK Parcelforce business in order to tap into the e-commerce driven growth in UK parcels. Unlike in mail, the parcel market is not regulated but its growth profile makes it very competitive.

Having in mind that mail is in a terminal spiral to the bottom, RM has taken active steps to reposition strategically its business to parcel. However, while the intent is in place, the operating reality is much different. RM suffers from several significant operational issues affecting its ability to create value for its shareholders.

“The Amazon drone just dropped this for you” (or RM’s lag in adopting new technologies)

 

 

RM has relied mainly on its mail leadership position to drive parcel volumes. This has resulted in significant underinvestment in technology, labor-intensive sorting processes and excessive redelivery costs.

 

 

 

RM has made a significant push to overcome these deficiencies by investing in process automation. Nevertheless, there is still a long way to go and even as it rolls out its new tracking technology, its competitors have long pushed ahead and stole market share by having a technologically superior product.  They are in position to offer GPS-enabled service that pins down delivery windows within the hour². RM management is confident that eventually the gap will be closed, however, the question remains if RM will be able to recoup the cost of automating its process at all or it will simply avoid losing more market share².

 

Meanwhile, the technology lag has diminished the value proposition for large customers active in the e-commerce space who were otherwise attracted by RM’s quality and reliability reputation. Retailers with brick and mortar presence have began promoting “click and collect” model which has undermined package volumes. Amazon on the other hand has announced plans to start independent delivery service and is also aggressively experimenting with technologically advanced delivery methods. Uber is also rumored as a potential new entrant in the parcel delivery business which further erodes and disrupts the status quo.

 

 

“Location, location, location” (or the high opportunity cost of RM’s real estate)

RM operates out of a portfolio of prime real estate properties which serve as its distribution centers. Real estate monetization has been a crucial upside for the business, however, the lack of automation has prevented RM from consolidating faster some of activities into suburbs. As a result the company implicitly pays the opportunity cost of owning assets which could otherwise bring in disposal proceeds estimated at £500 MM³.

 

“United we stand” (or RM’s inability to meaningfully decrease labor costs)

In the face of aggressive volume declines in its core mail business and the need to automate parcel handling, Royal Mail lacks the crucial ability to downsize its labor force. It cannot fire its employees and needs to rely on natural attrition. Most of RM’s employees are part of the Communication Workers Union (CWU), which prevents it from implementing forced redundancies and remains adamant on issues like workers’ pay. Furthermore, the CWU is opposing RM’s automation spending budget and argues that management should focus on human resources issues instead⁴. The high degree of unionization also exposes the business to frequent disruption. Historically, disputes have resulted in wide scale industrial action interfering with RM’s ordinary course of business (1988, 1996, 2007, 2009) and seriously threatened RM’s IPO in 2013.

Employee costs are the highest among RM’s peer group of European postal companies while revenue per employee is about half of the peer group average⁵. Its operating metrics are not much better either. While a Deutsche Post postal worker serves 244 families on average, a Royal Mail one will deliver to only 191 households. It is estimated that if RM was as efficient as its German counterpart in mail delivery, it could operate with 7% or 10,000 fewer staff, generating savings of £300 MM a year⁶. Meanwhile back at home in the UK the emerging competitors in the parcel business have cheaper and more flexible workforce giving them significant cost advantages.

Will Royal Mail ever “deliver”?

To Royal Mail’s credit, since 2006 it has managed to achieve some automation, reduce mail centers from 69 to 39 and cut labor force by 17% thanks to attrition. However, in the face of mail volume declining faster than expected and tough parcel competitive environment, the question for the company is whether its progress in aligning its operations to its business model is sufficient.

As far as its ability to create shareholder value to date is concerned, it has lost about £1.2 Bn of its market cap⁷ since January 2014.

 

Sources:

1. RBC Equity Research “Royal Mail plc. Costs getting better, staying underperform”, November 26, 2015
2. Plimmer, “Royal Mail needs to deliver on modernisation plans, post haste”, Financial Times, June 18, 2015
3. Evans, “Royal Mail: investors eye £500m property windfall”, The Telegraph, October 1, 2013
4. Schram, “Royal Mail to cut 3000 jobs in light of letters decline causing profit to plummet 30%”, International Business Times, November 19, 2015
5. Credit Suisse Equity Research “Royal Mail. Structural challenges remain”, May 14, 2015
6. Analysis by Sam Bland, Investec
7. Yahoo Finance