Royal Mail: Priced to go for income-seekers

[TrueBlueTerrier]

http://www.iii.co.uk/articles/118289/ro ... me-seekers" onclick="window.open(this.href);return false;

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

What better way for ministers to welcome the faithful than with the biggest sell-off since the days of Margaret Thatcher? Especially as this is a deal that has been "priced to go".

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 is cautious rather than cut-price. What is certain, however, is that Royal Mail shares are likely to be highly attractive to income-seekers.

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 by anyone's standards 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 - should enable it to go on offering a steady stream of dividends, and most investors in search of yield will 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.

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.

Here's the problem. 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.

Just look at what 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 (UKM) 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. And don't expect the move to the private sector to magically improve those margins - the high fixed cost of its 170,000 strong workforce alone mitigates against that.

Don't be too gloomy. Income-seekers will certainly appreciate the regular arrival of those generous dividends in their post boxes - and that will 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 are likely to 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.