Interactive Investor

Royal Mail: Prospectus suggests yield of 6%-plus

27th September 2013 15:17

David Prosser from interactive investor

Good timing is important in both politics and business. The publication on Friday 27 September of the prospectus for the privatisation of Royal Mail came just 48 hours before the Conservative Party convened in Manchester for its annual conference.

What better way for ministers to welcome the faithful than with the biggest sell-off of state-owned assets since the days of Margaret Thatcher? Especially as this is a privatisation that will attract the interest of income-seeking investors.

That is not to say the privatisation of Royal Mail will be a 1980s-style opportunity to nab a quick profit by "stagging" the issue. The offer range of 260p to 330p appears more cautious rather than cut-price. 

The prospectus values Royal Mail at between £2.6 billion and £3.3 billion and commits the company to paying a final dividend of £133 million in its current financial year, the equivalent of a full-year distribution worth £200 million. That's a yield of somewhere between 6.1% and 7.7% - a bumper income in the current market environment.

Moreover, while the company is making no promises beyond this year, Royal Mail's enviable cash flow - £334 million for its 2013 financial year - suggests it will be able to go on offering a steady stream of dividends, and most investors in search of yield will likely want to find a home for the stock in their portfolios.

For those more interested in capital gains, however, the attractions of Royal Mail are far more debatable. There's no reason to expect a short-term jump on listing - even at the top end of the offer range, the company won't qualify for FTSE 100 (UKX) membership, so there won't be instant demand from index-trackers.

Royal Mail privatisation timeline

  • Shares expected to be offered at between 260p and 330p
  • Market capitalisation of £2.6 to £3.3 billion
  • Dividend yield range of 6.1%-7.7% in first financial year
  • Between 401 million and 522 million shares to be offered to institutional and retail investors
  • Government to retain between 37.8% and 49.9% of Royal Mail
  • A 10% tranche of shares available for free to 150,000 eligible Royal Mail employees
  • Applications must be received by 8 October 2013
  • Minimum application amount is £750
  • Shares expected to make London Stock Exchange debut on 11 October
  • Full trading of the shares expected to begin 15 October.

In any case, if the offer does prove popular, the government has the option of making further stock available. It is initially selling between 40.1% and 52.2% of the business (plus 10% to staff), but says it will release another 7.8% if demand suffices.

One other factor will act as a short-term brake on Royal Mail's share price. The government has stuck two fingers up at the Communication Workers Union by scheduling the first day of dealings for 15 October - interested investors should note the short application window - the day before the results of its ballot on anti-privatisation strike action is due. But the ongoing threat of such action, plus the legal steps the unions are pursuing, will dog Royal Mail until the dispute is resolved.

As for the longer term, this is a business that faces major challenges. There are reasons to be positive: the transfer of Royal Mail's pension deficit to the government balance sheet paved the way for privatisation; modernisation investments appear to be paying off; and restructuring has restored profitability. But there is plenty of heavy lifting still to do.

Royal Mail's business has two sides. Its UK Parcels, International and Letters (UKPIL) operation collects and delivers mail such as letters and parcels, while its General Logistics Systems (GLS) unit delivers parcels in 22 countries, including the UK.

But while GLS is where all the growth is to be found, thanks to ever-increasing e-commerce in all the markets where Royal Mail operates, it's a small part of the business compared to UKPIL - the two divisions' revenues last year were, respectively, £1.56 billion and £7.65 billion.

What does that means for margins? Overall, for the year ending 31 March, Royal Mail enjoyed a profit margin of 4.4%. But within the headline figure, margins at GLS were 6.7%, compared to only 3.9% at UKPIL.

The balance of the business will change over time, of course. But Royal Mail can't retreat from its low-margin mail business because it must comply with its legal duty to deliver six days a week to the 29 million addresses covered by the Universal Service Obligation (USO), even though letters volumes continue to slump (the prospectus projects further declines of 4% to 6% a year).

Logistics, meanwhile, can continue to grow, but this is a competitive market - smaller domestic competitors such as UK Mail Group and large international rivals such as Deutsche Post will give Royal Mail a run for its money.

In short, for as long as Royal Mail is bound by the USO, its resources will be consumed by its least profitable business. The move to the private sector is unlikely to magically improve those margins - the high fixed cost of its 170,000 strong workforce alone mitigates against that.

Income-seekers are likely to appreciate the regular arrival of dividends in their post boxes - and that will help to underpin Royal Mail's share price. But those who hope investing in this privatisation will mean a special delivery of windfall profits in either the short or longer term may be disappointed.

The offer is only directed to persons within the UK and any application to apply for shares should be made only in the basis of information contained within the Prospectus.

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