SEPTEMBER │ 2015
FINANCIAL SUSTAINABILITY OF THE USO
FTI Consulting response to the Fundamental Regulatory Review
Public version
Confidential information which has been redacted from this document is indicated by: []
CRITICAL THINKING AT THE CRITICAL TIMETM September 2015
Table of contents
Glossary
Section
1. Introduction and executive summary 1 2. The scope of business within the financial sustainability assessment 6 3. The appropriate measure of the commercial rate of return for the Reported Business 13 4. The “competitive” level of profitability for the Reported Business 22 5. What metrics can be used to assess financial sustainability 31 6. How financial sustainability could be monitored 45 Appendix 1. Methodology for identifying comparators for Royal Mail 47
Copyright 2014 FTI Consulting LLP. All rights reserved.
FTI Consulting LLP. Registered in England and Wales at 200 Aldersgate, Aldersgate Street, London EC1A 4HD. Registered number OC372614, VAT number GB 815 0575 42. A full list of Members is available for inspection at the registered address. September 2015
Glossary
Term Definition
EBIT Earnings Before Interest and Tax
EBIT margin EBIT/Revenue
FAC Fully Allocated Cost
FTI FTI Consulting LLP
FRR Ofcom’s Fundamental Review of the Regulation of Royal Mail, announced 17 June 015
IPO Initial Public Offering
IRR Internal Rate of Return
March 2012 Statement Ofcom publication: “Securing the Universal Postal Service: Decision on the new regulatory framework”, 27 March 2012
NPV Net Present Value
Ofcom The communications regulator in the UK, responsible for the regulation of the USO under the Postal Services Act 2011
Postal Services Act 2011 UK Act of Parliament that defined the USO and made Ofcom responsible for economic regulation in relation to the USO.
Reported Business The part of the Royal Mail Group that undertakes the activities covered by the USO
ROCE Return on Capital Employed
S&P Standard & Poors, a credit ratings agency
USO Universal Service Obligation: Royal Mail’s obligation to provide certain postal services defined in the Postal Services Act 2011
WACC Weighted Average Cost of Capital
Financial sustainability of the USO | i September 2015
1. Introduction and executive summary
Introduction
1.1 This report has been prepared by FTI Consulting LLP (“FTI Consulting”) for Royal Mail plc (“Royal Mail”) in connection with the Fundamental Review of Regulation (“FRR”). Ofcom wishes to ensure its assessment of the financial sustainability of the universal service obligation (“USO”) remains appropriate. We have been asked to provide advice on how the financial sustainability of the Universal Service Provider (“USP” or “Royal Mail”) should be considered as part of the FRR.
Background
1.2 Under the Postal Services Act 2011, Ofcom has a duty to ensure that the universal postal service is secure.1 As part of its FRR, Ofcom has stated that it is examining how triggers for and precursors to a threat to the financial sustainability to Royal Mail could be identified.2 As we discuss below, we agree with Ofcom that, given the current UK postal market context, it is very important to identify early warning signs of a threat to financial sustainability.
1.3 Royal Mail currently faces a number of risks that make it unique when compared to other regulated businesses. Although some of these risks are faced by other companies, we do not consider that there is another regulated industry that faces the combination of risks set out below. These risks include:3
(1) volume decline coupled with a high fixed cost base leads to increasing unit costs. It is easier to adjust the cost base when volumes are increasing than when volumes are declining. As volumes decline, Royal Mail actively works to remove the surplus capacity from the business, where possible. This may mean, for example, reducing staff hours, the number of staff, and/or redesigning routes. This takes time to implement, especially in a heavily unionised industry such as post. An accelerated volume decline (coupled with lower than expected
1 Ofcom (2011), Postal Services Act - Paragraph 29(1).
2 Ofcom (21 April 2015, 11:53), Email from Kamak Arzhangi at Ofcom to Pamela Allsop at Royal Mail.
3 See FTI Consulting report “Efficiency Metrics for Royal Mail”, Section 3
Financial sustainability of the USO | 1 September 2015
parcel revenue) is a significant risk for future financial sustainability of the USO;
(2) the USO obligation requires Royal Mail to be able to deal with peak volumes and maintain high quality standards. This means that Royal Mail requires the network to meet these peak volumes and quality standards, which implies a high fixed cost base that is more difficult to cut in the face of faster than expected decline. This results in Royal Mail having a high operating leverage, which can materially affect its financial metrics;
(3) increased competition in the parcels market means that Royal Mail may not achieve forecast parcel revenue to mitigate the financial impact of volume decline in the letters market; and
(4) the existence of the union means that industrial action risk is high compared to other sectors. In addition, this creates uncertainty around the pace and ability for Royal Mail to transform its operations. Industrial action would itself have a significant impact on Royal Mail’s financial sustainability.
1.4 Consequently, Royal Mail faces a number of risks, the majority of which are asymmetric. The combination of these risks makes the postal sector unique and the sustainability of the Universal Service particularly vulnerable.
1.5 We understand that Royal Mail has developed a challenging business plan that it considers to offer the best opportunity to drive the growth and efficiency to ensure future financial sustainability for the Universal Service. Royal Mail considers that, to be able to achieve this plan and thereby maintain the financial sustainability of the USO, it must target financial performance (and hence financial metrics) that will allow it to raise finance at reasonable cost.
1.6 This requires it to target financial metrics consistent with investment grade credit rating and financial performance that can deliver adequate returns for shareholders. Without this, Royal Mail could be left in a position where it would become increasingly expensive to raise funds to allow it to make potential necessary investments to transform its business to keep pace with its competitors and peers in the future. The loss of an investment grade rating could ultimately leave Royal Mail in a position where it may be unable to fulfil the USO as it may not be able to raise funds at a reasonable and sustainable rate.
1.7 Furthermore, volume risks and the challenges with removing costs mean that achieving efficiency targets is more challenging than would be the case in other regulated sectors. If ex ante expectations of volume decline or the ability to remove fixed costs are wrong it might be that the plan needs to be changed.
Financial sustainability of the USO | 2 September 2015
1.8 Given the market context and associated risks, Royal Mail’s management considers it important to monitor profit margins, key performance indicators and other metrics considered by credit ratings agencies on a forward-looking basis over the period of its business plan. It is important to understand that even if margins and financial metrics are currently at target levels, the future profile of Royal Mail’s financial performance may be sensitive to assumptions about drivers of business performance and under plausible scenarios could lead to the USO becoming unsustainable. For example:
(1) faster than expected volume declines may lead to lower than expected revenues, which in turn lead to weaker financial performance because the business cannot reduce costs quickly enough to maintain financial performance;
(2) declining profitability and cash flow may restrict Royal Mail’s ability to make the necessary investments to achieve efficiency savings or to expand;
(3) decline in performance may result in the departure of key staff and this may subsequently lead to a failure to deliver efficiency improvements and thereby a failure to reduce costs; and
(4) the impact of strikes can mean the loss of customers with associated declines in volumes and revenues.
1.9 Each of these may in turn lead to lower revenues, higher costs and hence lower profitability. It is therefore important that Royal Mail retains the flexibility to rapidly adapt its plan in response to a realisation of any of these risks to ensure that its business, and hence the Universal Service, remains financially sustainable.
1.10 Ofcom should be careful to ensure that it does not precipitate or exacerbate a rapid deterioration of this type through regulatory intervention that reduces Royal Mail’s ability to respond quickly and effectively to changing market conditions. Ofcom should be mindful of the risk of such an outcome and should therefore use the framework it has established in its March 2012 statement as the foundation for considering Royal Mail’s financial sustainability on a forward looking basis under different scenarios, including plausible downside scenarios. We consider this framework should be refined such that the EBIT4 margin range of 5% to10% determined by Ofcom as appropriate for the Reported Business is complimented by certain other financial metrics.
4 Earnings Before Interest and Tax
Financial sustainability of the USO | 3 September 2015
1.11 In this report we set out how Royal Mail monitors its financial sustainability, as it is now required to do under changes to the UK Corporate Governance Code, including its commercial rate of return i.e. profit margins –and how potential early warning signs of a threat to financial sustainability could be identified. We set out the metrics we consider are relevant for both Royal Mail and Ofcom to assess the financial sustainability of the USO. We also discuss how these metrics could be assessed and which parts of Royal Mail’s business should fall within the scope of the assessment. The metrics we discuss are based on those monitored by credit ratings agencies, regulators, other postal operators and by Royal Mail’s banks through its loan covenants.
1.12 We consider that Royal Mail should periodically provide Ofcom with a summary of the key financial metrics it would use to monitor its financial sustainability under its business plan assumptions and under plausible downside scenarios. This would represent an appropriate tool that Royal Mail and Ofcom could use for discussion purposes regarding the financial sustainability of Royal Mail and the USO. We consider this process would be in a manner consistent with Royal Mail’s new requirement to produce a “viability statement” as part of its statutory financial reporting, the precise contents of which is currently under consideration by Royal Mail.
1.13 The risks faced by Royal Mail mean that the financial sustainability of the universal postal service could be quickly eroded. Given that Ofcom has limited ability to control or mitigate the business risks Royal Mail faces in a quick and timely fashion it is important that Royal Mail’s management is allowed sufficient commercial flexibility to act quickly to ensure that the USO remains financially sustainable. We do not consider that Ofcom should place any restriction on the headroom in Royal Mail’s margins, or other constraints on the management of its business, because this may leave it with insufficient flexibility to achieve a financially sustainable level of EBIT margin.
Restrictions
1.14 This report has been prepared solely for the benefit of Royal Mail plc for use for the purpose described in this introduction. In all other respects, this report is confidential. It should not be used by any other party for any purpose or reproduced or circulated, in whole or in part, by any party without the prior written consent of FTI Consulting.
1.15 FTI Consulting accepts no liability or duty of care to any person other than Royal Mail for the content of the report and disclaims all responsibility for the consequences of any person other than Royal Mail plc acting or refraining to act in reliance on the report or for any decisions made or not made which are based upon the report.
Financial sustainability of the USO | 4 September 2015
Limitations to the scope of our work
1.16 This report contains information obtained or derived from a variety of sources. FTI Consulting has not sought to establish the reliability of those sources or verified the information provided.
1.17 No representation or warranty of any kind (whether express or implied) is given by FTI Consulting to any person (except to Royal Mail under the relevant terms of our engagement) as to the accuracy or completeness of this report.
1.18 This report is based on information available to FTI Consulting at the time of writing of the report and does not take into account any new information which becomes known to us after the date of the report. We accept no responsibility for updating the report or informing any recipient of the report of any such new information.
Structure of this report
1.19 This report is structured as follows:
. in Section 2, we consider the scope of the business which should be included within the financial sustainability assessment;
. in Section 3, we discuss what is the appropriate measure of profitability for the Reported Business;
. in Section 4, we review evidence for the benchmark “competitive” level of profitability;
. in Section 5, we discuss the metrics that can be used to assess financial sustainability; and
. in Section 6, we outline how financial sustainability could be monitored.
Financial sustainability of the USO | 5 September 2015
2. The scope of business within the financial sustainability assessment
Introduction
2.1 When assessing financial sustainability, it is first necessary to define the entity in respect of which financial sustainability should be assessed. In principle, the financial sustainability of a specific business line or activity, a subsidiary, or the whole group could be assessed. In practice, however, the appropriate approach depends on the nature of the assessment being made and the financial information that is available.
2.2 Ofcom is concerned about the financial sustainability of the USO and therefore one might consider that the Reported Business (the part of Royal Mail Group that undertakes the activities covered by the USO) level is the appropriate entity at which to assess financial sustainability.5 However, as we set out in this section there are theoretical and practical reasons why such an assessment may not be appropriate or possible.
2.3 In this section we discuss at which level of Royal Mail’s business different financial sustainability metrics should be assessed. We:
(1) set out a brief summary of the structure of Royal Mail’s different businesses;
(2) explain at what level the commercial rate of return (referred to in this document as “profitability”) should be assessed; and
(3) explain at what level other financial sustainability metrics involving cash flow and balance sheet figures should be assessed.
Royal Mail’s group structure
2.4 Royal Mail contains a number of different businesses within its group structure. A summary of Royal Mail’s group structure is illustrated in Figure 2-1 below.
5 Note that the Reported Business also undertakes non-USO activities. The Reported Business is part of the UK Parcels, International and Letters (UKPIL) business unit of the Royal Mail Group, excluding Parcel Force and the Royal Mail Property Unit.
Financial sustainability of the USO | 6 September 2015
Figure 2-1: The Reported Business within Royal Mail’s operational structure
Source: Royal Mail Group.
2.5 Financial information is available for each of the different business units. However, the quality of this financial data affects what analysis can be undertaken at each level of Royal Mail’s business and hence this also affects the reliability and robustness of such analysis at each level. Consequently, when performing any analysis of financial sustainability, one has to have regard to the information that is available for each entity within the group. In summary the financial data that is available for each entity is:
(1) for Royal Mail Group (the “Relevant Group” in the diagram above), a consolidated balance sheet, income statement and cash flow statement is available. These publicly available audited financial statements are prepared under international accounting standards. It is at this level that Standard and Poor’s (“S&P”) assess Royal Mail’s credit rating;
(2) UKPIL comprises Royal Mail’s core UK and international parcels and letter delivery businesses under the ‘Royal Mail’ and ‘Parcelforce Worldwide’ brands. It does not include GLS. Royal Mail prepares a full income statement for this entity and a cash flow statement; and
(3) the Reported Business includes Royal Mail’s UK mail delivery operations that contains the core network letters and parcels operations, which Royal Mail uses to deliver the Universal Service. Royal Mail prepares a full income statement for this entity. It also prepares a notional historical balance sheet and cash flow statement for regulatory purposes at this level, based on rules set by Ofcom. This information is provided in the regulatory financial statements.
Financial sustainability of the USO | 7 September 2015
2.6 It is important to note that this financial information is not all equally robust. The following issues, in particular, should be noted:
(1) all Royal Mail’s financial statements are prepared on an accounting basis and not on an economic basis. This is potentially relevant for the assessment of profitability;
(2) Royal Mail does not generate a forecast balance sheet for planning purposes at any level of its business; instead it forecasts debt, cash and working capital, without considering the remainder of the balance sheet items. Consequently full forecast balance sheet information is not available; and
(3) accounts prepared under regulatory accounting rules are limited in scope. For example, debt is not allocated to the Reported Business for regulatory accounting purposes.6 Further, the allocation methodologies used may not reflect economic costs and rely on particular assumptions. Royal Mail’s regulatory financial statements explain that:
“Common operational costs that cannot be directly assigned are allocated to the products equitably using an Activity Based Costing system. Overhead costs are allocated to products using a nested Equi-Proportional Mark Up (EPMU) methodology. In line with activity based costing approaches, estimates are required and have been applied in order to comply with the requirements of the Accounting Conditions”.7
2.7 These issues therefore have implications for the assessment of profitability and the assessment of the appropriate financial sustainability metrics to use. We discuss these implications for each assessment below.
6 Ofcom (27 March 2012), Securing the Universal Postal Service - Decision on the new regulatory framework, Page 183 - Paragraph 11.23. “…the Reported Business is not a legal entity as such and so it does not raise external finance. We therefore proposed to require audited annual regulatory financial statements (and supporting information) to be produced for it on a pre- finance basis.”
7 Royal Mail plc (July 2015), Regulatory Financial Statements 2014-15, Page 22.
Financial sustainability of the USO | 8 September 2015
Profitability
2.8 Ofcom has stated that it is considering the appropriate metric and level at which to assess the commercial rate of return i.e. profitability.8 In this subsection we first consider EBIT margin measures of profitability as an indicator of sustainability before defining what we mean by EBIT margin.
EBIT margin as a measure of profitability
2.9 Profitability is a very important indicator of financial sustainability. In Section 3 below, we explain why we consider that the EBIT margin is the appropriate metric for assessing profitability.
2.10 We consider that when assessing the profitability of Royal Mail’s regulated activities (i.e. the amount of profit that is made and whether this is reasonable); one should consider the EBIT margin at the Reported Business level. If Ofcom assessed Royal Mail’s profitability at the UKPIL or Group level, then Ofcom would be assessing the profitability of a significant amount of activities that do not use the core USO network, which would not be appropriate, or indeed provide an accurate picture of the profitability of the Universal Service.
2.11 Ofcom previously considered in detail at what level Royal Mail should report its margins as part of its 2012 review into the regulation of Royal Mail. It concluded that information should cover: (i) the relevant group (i.e. Royal Mail Group) because it is the entity which raises external finance;9 and (ii) the narrower Reported Business which includes all activities the direct costs of which are included in the methodology which Royal Mail is required to use to generate Fully Allocated Cost (“FAC”) estimates for regulatory financial reporting purposes.10 We consider that the circumstances leading to this decision have not sufficiently changed to warrant a change in the reporting requirements of Royal Mail. Reopening a regulatory decision so soon after its previous determination will lead to increased regulatory uncertainty, making major adjustments now will only add to that uncertainty and increase the risks facing Royal Mail.
8 Ofcom (21 April 2015, 11:53), Email from Kamak Arzhangi at Ofcom to Pamela Allsop at Royal Mail.
9 Ofcom (27 March 2012), Securing the Universal Postal Service - Decision on the new regulatory framework, Page 183 - Paragraph 11.18.
10 Ofcom (27 March 2012), Securing the Universal Postal Service - Decision on the new regulatory framework, Page 183 - Paragraph 11.21-22.
Financial sustainability of the USO | 9 September 2015
2.12 Royal Mail prepares robust income statement information and forecasts that are used by Royal Mail in its internal planning and strategy making at the Group and UKPIL levels. The Reported Business forecasts are derived from UKPIL forecasts based on an agreed set of rules. Therefore, it is possible to calculate an accurate EBIT margin for the Reported Business.
Royal Mail’s definition of EBIT margin
2.13 It is also important to define the term “EBIT margin”, before considering what an appropriate level of EBIT margin is. Royal Mail has recently moved to presenting its profit and loss on an adjusted basis that excludes specific items.11 As of 2014-15, this includes a specific item that adjusts for the difference between the income statement pension charge and the actual cash cost of pensions.
2.14 In 2013, Royal Mail reformed its defined benefit scheme. As part of this reform, an actuarial funding surplus was generated. This has allowed Royal Mail to pay cash contributions at a lower rate than the full cost of future accrual. The cash contribution rate is different to the rate used in the preparation of the income statement as they are calculated using different sets of assumptions. The lower cash contribution rate being paid by Royal Mail due to the funding surplus means that currently the difference between the cash charge and the accounting charge is even more marked. Royal Mail considers that the cash charge is a better reflection of the underlying cost of pensions, rather than the accounting charge, as this is what is actually paid to the fund. The lower cash contribution rate is only expected to continue until 2018, when the funding surplus is expected to have been fully utilised, and after this point higher cash contributions are likely to be required if no other action is taken.
2.15 Royal Mail considers that the EBIT margin for the Reported Business should be calculated based on the definition of adjusted EBIT used in their statutory accounts as this is consistent with how Royal Mail’s profitability is viewed internally and also reported to the market.
2.16 As a consequence of this change, current and forecast future EBIT margins are not comparable to those previously reported and, as a result, “adjusted” EBIT margins may appear higher than the margins reported before adjusting for specific items.
11 Royal Mail plc (29 May 2015), Annual Report and Financial Statements, Page 4.
Financial sustainability of the USO | 10 September 2015
Financial sustainability
2.17 We consider that it would be appropriate for Royal Mail and Ofcom to monitor the EBIT margin at both the Group and Reported Business levels from a financial sustainability perspective. This is because Royal Mail finances its activities at a Group level and as a consequence the financial sustainability of the whole group also needs to be considered.
2.18 In addition to the EBIT margin, there are other indicators of financial sustainability that should be considered, which are generally those used by lenders and credit ratings agencies (see Section 5). Although in principle we consider that it would be appropriate to calculate these other metrics at the Reported Business level there are two reasons why this is not possible:
(1) Royal Mail is funded as a single group entity. Therefore lenders and credit rating agencies are mainly concerned with the creditworthiness of the group entity and therefore calculate these metrics at this level. Consequently, the thresholds considered by these entities are only relevant at a group level, and there is no read across to the Reported Business; and
(2) many of the metrics considered require cash flow and debt information. As discussed in paragraphs 2.4 to 2.7 above, Royal Mail does not have reliable and robust current and forecast balance sheet and cash flow information at this level.
2.19 Therefore, it is not currently possible to calculate many of these financial sustainability metrics for the Reported Business. Additionally, it is not clear to us whether, even if such information were easily compiled, it would be fit for purpose. When assessing financial metrics it is important that the data used is reliable and robust. We consider that there would be many difficulties in preparing the balance sheet and cash flow statement for the Reported Business. Importantly, it is simply not possible to robustly apportion many assets and liabilities such as debt to the Reported Business.
2.20 For example, Royal Mail does not separately raise debt or allocate it to particular parts of its business; instead, it aims to operate an efficient capital structure as a group. Therefore, it would not be possible to calculate a reliable debt figure for the Reported Business.
2.21 Preparing such financial information would be costly and time consuming for Royal Mail and would not provide it with any useful information required in running its business. Therefore, the preparation of this additional information may not be proportionate and in any case would be unlikely to be robust enough to use to calculate meaningful financial metrics.
Financial sustainability of the USO | 11 September 2015
2.22 We consider that the preparation of financial metrics at a group level is likely to be a conservative approach. This is because for metrics calculated at group level, poor performance in the Reported Business could be masked by better performance in other segments. Consequently, one should consider the EBIT margin at a Reported Business level as well as metrics at the group level to ensure a holistic approach.
Conclusion
2.23 In theory, financial sustainability should be assessed for the business being examined i.e. the Reported Business. It is possible to calculate the EBIT margin at both the Reported Business and Group level.
2.24 However, there are two key issues in assessing other metrics at the Reported Business level:
(1) there is no direct read across from the key financial metrics as calculated by credit ratings agencies and banks to the Reported Business; and
(2) the financial information required does not exist and would be disproportionately burdensome to generate and if generated may not be sufficiently robust.
2.25 Therefore, we consider that other financial metrics would need to be assessed at the group level. We consider that this would be a conservative approach because, for metrics calculated at group level, poor performance in the Reported Business could be masked by better performance in other segments.
Financial sustainability of the USO | 12 September 2015
3. The appropriate measure of the commercial rate of return for the Reported Business
Introduction
3.1 Ofcom wishes to consider what commercial rate of return is “likely to be consistent with securing a financially sustainable universal service”.12 Ofcom has indicated that it is considering both EBIT margin and ROCE approaches to assess the commercial rate of return of the USO.13 We understand that Ofcom wishes to consider the advantages and disadvantages of these metrics.
3.2 We consider that Ofcom will want to ensure that the profitability metric used to determine the performance of the business from a financial sustainability standpoint is a robust metric. If an inappropriate metric is used, then profitability may be over or understated. This could then lead to inappropriate regulatory intervention, or lack of intervention.
3.3 In this section, we:
(1) provide a high level view of the theory underpinning profitability analysis and approaches to assessing profitability including EBIT margins and ROCE;
(2) review Royal Mail’s current regulatory framework and other relevant regulatory precedent which use EBIT margins to assess profitability;
(3) discuss the challenges in using ROCE to assess the profitability of asset light industries;
(4) discuss the issues with interpreting the results of ROCE analysis; and
(5) conclude on what is the appropriate measure of profitability for Royal Mail’s Reported Business.
3.4 In summary, we agree with the approach adopted by Ofcom in its March 2012 Statement that an EBIT margin (as defined in paragraphs 2.13 to 2.16) is the appropriate metric on which to assess returns.
12 Ofcom (17 July 2015), Review of the regulation of Royal Mail, Page 12 - Paragraph 4.13.
13 Ofcom (21 April 2015, 11:53), Email from Kamak Arzhangi at Ofcom to Pamela Allsop at Royal Mail.
Financial sustainability of the USO | 13 September 2015
Economic theory of profitability analysis
3.5 In economic theory, prices would be set equal to long-run marginal economic costs in a perfectly competitive market. Economic costs comprise:
(1) efficiently incurred operating costs; and
(2) the required return on the capital to operate the business.
3.6 If prices are set equal to long run marginal economic costs, then the Internal Rate of Return (“IRR”) on an investment would be expected to be equal to the discount rate at which the Net Present Value (“NPV”) of the investment would be zero. In reality it is generally not practical to calculate the IRR achieved by a business over its lifetime because of the long time period of analysis that would be required, data limitations and changes in the market over time. Instead, a proxy to the IRR is often calculated over a truncated period, using Earnings before Interest and Tax (“EBIT”) to approximate the cash flows and an estimate of the economic value of capital employed to approximate the value of the investment. This measure of profitability is called the Return on Capital Employed (“ROCE”).
3.7 It is therefore expected that, in a competitive market, the ROCE should be equal to the Weighted Average Cost of Capital (“WACC”) which represents the required return given the risks faced by the business.
3.8 An attraction of ROCE as a measure of profitability is that it takes account of the capital required to operate a business and therefore it has a connection to the definition of a “reasonable” return in a competitive market, derived from economic theory. The EBIT margin is another measure of profitability that economic regulators often consider appropriate. It is widely understood and UK economic regulators – including Ofcom – have previously used a margin approach to assess profitability and set price controls where there are practical difficulties in the use of ROCE.
3.9 In theory, there should be no difference between an assessment of profitability based on ROCE and one based on margins; the two methods should produce consistent conclusions. This is because, in economic theory, there is a relationship between the EBIT margin and the ROCE. The EBIT margin equals the ROCE multiplied by capital intensity:
퐸퐵퐼푇 퐸퐵퐼푇 퐴푠푠푒푡 푣푎푙푢푒 = × 푅푒푣푒푛푢푒 퐶푎푝푖푡푎푙 푒푚푝푙표푦푒푑 푅푒푣푒푛푢푒
Financial sustainability of the USO | 14 September 2015
3.10 This relationship implies that, as asset intensity decreases, so too does the return required by investors. The logical conclusion of this is that, if a firm has no assets, investors would not require any return.14
3.11 However, empirical analysis shows that, between 2008 and 2012, FTSE 100 companies with no (accounting) assets would have been expected to earn a profit margin of at least 5%.15 Given that Royal Mail does have net assets, this analysis would imply that its margins should be higher than this. Additional analysis we have performed suggests that firms with low (accounting) asset intensity16 in the FTSE 100 earned an average ROCE of 22%,17 which would be substantially in excess of most firms’ WACC.
3.12 This evidence shows that, for firms with low asset intensity, the relationship between margins and ROCE appears to break down and is volatile. This suggests that ROCE is not appropriate for assessing the profitability of an asset light business, such as the Reported Business and therefore that an EBIT margin approach is instead a more appropriate measure of profitability.
Royal Mail’s current regulatory framework and other regulatory precedent
3.13 In its March 2012 Statement which was expected to provide certainty over the regulatory framework for a seven year period, Ofcom adopted EBIT margins to assess profitability. In doing so, it noted that: 18
“Royal Mail’s universal service network is largely based around people, and these operating costs are significantly higher than the value of its tangible assets”.
14 The economic intuition behind this is that, if no investment in assets was required to enter the market, then there would be little or no capital to remunerate and so companies would continue to enter the market until any positive margin between prices and long run marginal costs had been eliminated.
15 Oxera (March 2014), Something for nothing? Returns in low-asset industries.
16 We define such firms to be those with an asset intensity (capital employed divided by revenue) of less than 2, which comprises 37 firms.
17 This analysis is based on data from Bloomberg. We make no adjustments to the companies’ reported EBIT and we calculate capital employed as follows. The sum of: current assets; net property plant and equipment; long term accounts receivable; and intangible assets excluding goodwill; minus the sum of: accounts payable; and other current liabilities.
18 Ofcom (27 March 2012), Securing the Universal Postal Service - Decision on the new regulatory framework, Page 46 - Paragraph 5.25.
Financial sustainability of the USO | 15 September 2015
3.14 We note that Ofcom also said that most respondents to its 2012 review also considered that an EBIT margin approach was most appropriate.19
3.15 Ofcom therefore concluded that:20
“An indicative EBIT margin range of 5% to 10% is appropriate and consistent with the need for Royal Mail to earn a reasonable commercial rate of return commensurate with the level of risk within the business.”
3.16 In its March 2012 Statement, Ofcom also acknowledged that: 21
“it was important for Royal Mail to be given a sufficient period of regulatory certainty so that the management of the company could focus on the operational challenges facing the business in an environment of regulatory stability”.
3.17 It went on to explain that it would: 22
“maintain the ability to intervene and conduct a regulatory review if the monitoring regime identifies fundamental and persistent concerns that undermine our duties in relation to post.”
3.18 In its current discussion paper,23 Ofcom does not identify any changed circumstances or articulate any rationale for why its previous determination in respect of the reasonable commercial rate of return for Royal Mail would no longer be appropriate. If Ofcom were to change its methodology now, then we consider that it would need to explain in detail what “fundamental and persistent” concerns that would “undermine its duties in relation to post” have arisen since its March 2012 statement in relation to the assessment of a reasonable commercial rate of return.
19 Ofcom (27 March 2012), Securing the Universal Postal Service - Decision on the new regulatory framework, Page 47 - Paragraph 5.27.
20 Ofcom (27 March 2012), Securing the Universal Postal Service - Decision on the new regulatory framework, Page 51 - Paragraph 5.47.
21 Ofcom (27 March 2012), Securing the Universal Postal Service - Decision on the new regulatory framework, Page 5 - Paragraph 1.29.
22 Ofcom (27 March 2012), Securing the Universal Postal Service - Decision on the new regulatory framework, Page 97 - Paragraph 7.80.
23 Ofcom (17 July 2015), Review of the regulation of Royal Mail.
Financial sustainability of the USO | 16 September 2015
3.19 We would also note that reopening past decisions less than half way through the regulatory period has generated uncertainty in the postal market. This increased regulatory uncertainty affects investor sentiment and may have knock on effects on Royal Mail’s ability to raise capital in the future. If investors consider that there is persistent risk of regulatory intervention and continued changing of rules within short periods of time, they may require higher returns and this may constrain Royal Mail’s ability to raise additional external funding when required to fund the transformation of the business.
3.20 We understand from Royal Mail management that, under its current business plan, it anticipates that the USO will remain financially sustainable provided it retains the flexibility afforded by this range for the commercial rate of return. Therefore, in the absence of a rationale for revisiting the previous determination, we would consider that the previous basis for its conclusions remains applicable.
3.21 There is also other recent regulatory precedent from both the UK and abroad that supports the use of margins to assess the profitability of asset light businesses.
3.22 First, The Netherlands’ postal regulator assesses PostNL’s profitability using margin analysis.24
3.23 Second, Ofwat used margin analysis to set allowed returns for retail water supply, commenting that:25
“A return on capital approach is less suited to retail activities which are ‘asset light’ and may not fully compensate the retail business for all sources of capital and risks”.
3.24 This regulatory precedent supports our view that EBIT margins are an appropriate measure of profitability for asset light businesses. In the following subsection, we outline additional challenges that would arise in any attempt to use a ROCE approach.
Challenges in using ROCE to assess the profitability of asset light industries
3.25 There are a number of specific challenges when attempting to calculate ROCE for an asset light business. These are:
(1) accounting capital employed is likely to understate its economic value due to the existence of material unrecognised intangible assets and tangible assets not
24 Authority for Consumers and Markets (9 April 2015), Besluit van de Autoriteit Consument en Markt houdende beoordeling van het Toerekeningsysteem Koninklijke PostNL 2014 (Dutch), Page 1.
25 Ofwat (January 2014), Setting price controls for 2015-20 – risk and reward guidance, Page 31.
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being measured at economic cost;
(2) there are risks faced by asset light businesses that are not related to value of assets;
(3) ROCE is inherently volatile for an asset light business; and
(4) there are practical issues which make it difficult to reliably estimate ROCE at the Reported Business level.
3.26 We expand on these issues below.
3.27 Notwithstanding these reasons, if Ofcom were to select ROCE as an appropriate measure of profitability, it is important to note that ROCE analysis requires very careful interpretation. We discuss this further later in this paper.
Economic capital employed includes material unrecognised intangible assets
3.28 One of the key weaknesses of using ROCE for an asset light business is that accounting capital employed is likely to understate economic capital employed. Typically, such businesses have invested material amounts in intangible assets. However, this expenditure often does not meet the strict accounting criteria for recognition on the balance sheet and consequently has zero accounting value. We consider that this is likely to be the case for the Reported Business.
3.29 Intangible assets of this nature may include, staff knowledge gained through training, processes, systems, the firm’s brand and certain types of R&D expenditure. Additionally, the depreciated historical cost of tangible fixed assets is likely to understate their economic value and hence require a revaluation.
3.30 A ROCE calculated using only accounting values of capital employed will therefore lack economic meaning for such businesses because the ROCE will be materially overstated, unless all intangible (and tangible) assets are appropriately included in capital employed at their economic value. As these intangible assets are not valued for accounting purposes, it would usually be a substantial exercise to value assets of this nature and the valuation is often subjective and uncertain.
There are risks faced by asset light businesses that are not related to a return on assets
3.31 Asset light businesses, even if they have little or zero assets, still face risk. Simply because the value of that risk is not reflected in the value of an asset (tangible or intangible) on a balance sheet, does not mean that a business should not be able to generate a return commensurate with that risk.
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3.32 For example, if a firm undertakes to provide a service to a customer and takes on a contract to provide that service, then there is a potential downside risk that revenues will be insufficient to cover costs. The USO represents a commitment of this type.
ROCE is inherently volatile for an asset light business
3.33 If all tangible and intangible assets are not appropriately valued, then the low value of capital employed will mean that relatively small variations in profit may result in relatively large movements in ROCE. This means that ROCE is likely to be inherently more volatile for an asset light business compared to a firm with higher asset intensity.
3.34 Further, as described in paragraphs 3.28 to 3.30 above, the adjustments required to estimate the economic value of the capital employed in the Reported Business would be very sensitive to the assumptions used and hence these adjustments would introduce a source of significant volatility in the value of capital employed in each year, leading to unstable and unreliable results.
It may be difficult to reliably estimate ROCE at the Reported Business level
3.35 Assessing the financial sustainability of the Reported Business using ROCE would require an accurate estimate of the economic value of capital employed that it would require on a standalone basis. As we describe in Section 2, Royal Mail does not routinely prepare a full balance sheet for its Reported Business and a significant proportion of these assets are shared by the different businesses and Royal Mail Group as a whole.
3.36 It would be challenging and disproportionately burdensome to develop a robust methodology for constructing a balance sheet for the Reported Business. For instance, for shared assets, there may be no economically meaningful basis for apportioning their value between the Reported Business and its other activities (i.e. GLS, the Property Business and Parcelforce). Royal Mail also manages its working capital collectively at the UKPIL level, rather than managing it separately for the Reported Business.
3.37 Therefore, the estimated ROCE would be sensitive to the choice of methodology and may not be reliable.
ROCE analysis requires careful interpretation
3.38 Although it is theoretically attractive to compare profitability to a benchmark derived from economic theory (i.e. the WACC), it is important to note that a finding of a ROCE above the WACC does not necessarily mean that prices have exceeded competitive levels.
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3.39 First, as we have described above, there is inherent uncertainty in the valuation of the capital employed for an asset light business because the valuation of intangible assets can be very sensitive to the assumptions used. There is therefore a risk of overstating ROCE from failing to identify or understating the value of material intangible assets.
3.40 Second, ROCE is likely to fluctuate over time. This fluctuation is likely to be significant for: (i) an asset light firm as we describe above; and (ii) a firm which has high operational gearing, such as Royal Mail, because EBIT will be particularly sensitive to shocks to revenue, given the high proportion of fixed costs. At the time of its IPO, Royal Mail undertook sensitivity analysis which showed that a uniform decrease in the volume of letters and parcels of one per cent would reduce revenue by approximately £75 million, but costs would only fall by between £5 million and £9 million in the intermediate term.26
3.41 Hence, estimating ROCE over a truncated period may not yield robust results if the average over that period is distorted by years of particularly high (or low) profitability. As we explain below, there are good reasons why high profitability (i.e. profits in excess of the WACC) may be expected to arise at some points in time in competitive markets.
3.42 Third, a finding of a ROCE in excess of the WACC does not necessarily indicate a competitive concern because this may arise from competitive advantages that a firm has invested to achieve rather than, for example, the exercise of market power. We note that even ex ante price regulation frameworks allow firms the scope to earn ROCE in excess of the WACC. For example, in its price determination for the period 2015 to 2020, Ofwat explained that:27
“We consider that good management teams should not be rewarded solely on the basis of allowed WACC and retail margins, but should also have the opportunity to earn additional rewards by being more efficient or by delivering higher levels of performance where this is valued by consumers.”
3.43 The UK Competition and Markets Authority also explicitly acknowledges both the natural fluctuation in ROCE that will arise over time and that returns in excess of the WACC do not necessarily indicate a competitive concern in its official guidance:28
“At particular points in time the profitability of some firms may exceed what might be termed the ‘normal’ level. There could be several reasons, including cyclical factors, transitory price or other marketing initiatives, and some firms
26 Royal Mail plc (27 September 2013), Prospectus, Part VII; Operating and Financial Review - Section 5.7: sensitivities.
27 Ofwat (January 2014), Setting price controls for 2015-20 – risk and reward guidance, Page 37 - Paragraph A4.1.
28 CMA (April 2013), Guidelines for market investigations, Page 28 - Paragraph 117.
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earning higher profits as a result of past innovation, or superior efficiency.”
3.44 Fourth, there are significant uncertainties in the calculation of the WACC benchmark, because it is again reliant on a number of assumptions and estimates.
3.45 Taken together, the factors discussed above create a risk that an ex post ROCE assessment of Royal Mail’s Reported Business could find that profitability had been in excess of a competitive level when, in fact, this may reflect only inherent fluctuation in ROCE, uncertainties in its calculation and misinterpretation of the comparison with WACC.
3.46 The WACC reflects the average return that investors require over the long term. Therefore, the factors we identify above which cause variation in ROCE year-on-year also mean that it would be inappropriate to constrain the Reported Business on an ex ante basis to earn a ROCE in each year that is no more than its WACC. To do so would result in the Reported Business earning a return below the WACC in the long run that could threaten the financial sustainability of the Universal Service.
3.47 This is because outturn cash flows do not reflect the level of specific risk to those cash flows that exists ex ante. Therefore, comparison of an ex ante WACC to ex post returns in any industry may not be reliable or informative because a realisation of a return in excess of the WACC does not necessarily imply that ex ante expected returns were also in excess of the WACC; it may instead simply reflect a realisation of upside risk. Therefore, any ex post assessment of a business’s ROCE to an ex ante WACC must include an allowance for specific risk.
Conclusions
3.48 We consider than EBIT margin approach adopted by Ofcom in its March 2012 Statement continues to represent the most appropriate measure of the reasonable commercial rate of return for the asset light Reported Business.
3.49 We consider that there are limitations in the reliability of ROCE as a measure of the profitability of the Reported Business and as a measure of its financial sustainability. We also consider that considerable care must be taken in interpreting the results of any ROCE analysis.
3.50 We consider that EBIT margins are likely to represent a more robust and reliable measure of the reasonable commercial rate of return.
3.51 Notwithstanding that Ofcom has already made an evidence-based determination of the reasonable commercial rate of return for the Reported Business, we review evidence for the “competitive” level of EBIT margin for the Reported Business in Section 4 below.
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4. The “competitive” level of profitability for the Reported Business
4.1 A “competitive” EBIT margin level is typically determined by benchmarking peer companies in comparative industries. We consider that the most appropriate measure of an appropriate benchmark for the Reported Business is the mail business of other large postal operators in developed countries that have significant privately owned stakes and universal service obligations.29
4.2 In this section, we first explain how the EBIT margin for the Reported Business should be calculated. We then summarise the margins achieved in comparable businesses, which we consider provides an appropriate benchmark for a competitive commercial return. As a cross-check to this, we have also considered other possible benchmarks for the competitive margin.
4.3 We have considered the following possible benchmarks:
(1) the benchmarks used by CEPA in its 2011 analysis, which Ofcom used to support its decision that a 5% to 10% EBIT margin would be appropriate;
(2) margins earned by the end-to-end mail activities of other national postal operators;
(3) margins earned by businesses of a similar scale across a broad range of other competitive sectors that comprise the FTSE 100 and 250, to provide a high level view of what appropriate margins might be for peers of Royal Mail;
(4) the margins credit ratings agencies consider appropriate for postal operators to maintain their investment grade credit rating; and
(5) the margins made in other regulated sectors.
4.4 We discuss the margins implied by each of these benchmarks and their relevance to the assessment of a competitive benchmark for the Reported Business.
29 We note that, under Directive 97/67/EC, each European Union member state is required to provide a universal postal service with certain minimum characteristics. Our comparators are the companies which deliver these services in their respective countries. (European Union (15 December 1997), Directive 97/67/EC Of The European Parliament And Of The Council.).
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Updating CEPA’s 2011 analysis
4.5 In 2011 Ofcom relied upon a benchmarking analysis performed by CEPA (an economic consultancy) to set an appropriate EBIT margin benchmark of 5% to 10% in its 2012 review of the postal market. In this analysis, CEPA looked at the EBIT margins of a number of companies across several different sectors that they considered to be comparable to the postal sector. These sectors included mail delivery, logistics, freight forwarding, network services, companies facing structural change and sectors with a highly unionised workforce over the period FY 2007 to FY 2011.30
4.6 We do not consider that all of the sectors used by CEPA are comparable to Royal Mail and set out our own benchmarking analysis using national mail delivery companies in the subsection below. However, as Ofcom has previously put weight on this analysis, we have attempted to recreate and extend this analysis to the present day. Since 2011, we do not consider that there has been any structural reason as to why this analysis, previously relied upon by Ofcom, would show that the margin for these comparator companies for Royal Mail would have changed materially.
4.7 In its previous analysis, CEPA used a mixture of historical and consensus forecast data from Bloomberg. CEPA did not set out explicitly how it performed its calculations and any adjustments to data that it used. Consequently we have not been able to recreate their analysis exactly. However, to show that there is no material difference between the EBIT margins over the 2007 to 2011 period considered by CEPA and a longer period to 2014, we have calculated EBIT margins for the comparators used by CEPA, first over the period 2007 to 2011 and also the period 2007 to 2014. The results of this analysis are shown in the table below.
30 CEPA (October 2011), Financeability of the universal service, Page 9 onwards.
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Table 4-1: Extension of CEPA’s 2011 benchmarking analysis to 2011
FY07-11 FY07-14 Mail Delivery 11.7% 11.0% Logistics 5.9% 5.4% Freight Forwarding 5.0% 5.0% Transport groups 6.4% 6.3% Directories 35.0% 32.4% Travel Groups -0.3% 0.4% Legacy Telecoms 20.5% 18.5% Airlines 1.7% 2.2% Outsourcing 5.3% 2.4% Notes: Comparator companies are sourced from Table 2.1 of CEPA, October 2011, Financeability of the universal service. Seat Pagine is excluded as the extracted data from Capital IQ appears to be erroneous. Average EBIT margins are unweighted. Source: Capital IQ.
4.8 This analysis indicates that in most sectors, there has been no material decline in the EBIT margins over a longer time period. Where there has been a decline in the average EBIT margin, this appears to be in the directories, telecoms and outsourcing sectors, which are less relevant to the UK postal sector. There has been only a small decline in margins in mail delivery. Therefore, from looking at these companies there is no evidence to support a lowering of the 5% to 10% range, previously considered by CEPA and relied upon by Ofcom.
Margins earned by the end-to-end mail activities of other national postal operators
4.9 The Reported Business’s activities comprise principally end-to-end mail delivery of letters and small parcels. We therefore consider that its closest comparators are the end-to-end mail businesses of other large postal operators in developed countries that have significant privately owned stakes and universal service obligations. Using this methodology, that is set out in greater detail in Appendix 1. From these we further considered those operators that provide segmental reports setting out the performance of their mail and parcels businesses and identified the following as comparators: Deutsche Post, Post NL, Österreichische Post, Singapore Post, Bpost and Malta Post.
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4.10 We do not consider that it is appropriate to use publicly-owned postal companies as comparators, because these companies do not face the same requirement to achieve standalone financial sustainability. For example, a number of European postal operators receive subsidies from their respective governments and there may be cross subsidies between products. These subsidies may not be possible to identify from publicly available financial data.31
4.11 We obtained revenue and EBIT financial data for the relevant operations from each comparator from their annual financial statements. These financial statements provide information on segmental performance for the mail delivery operations of each company. In Table 4-1 below, we set out the calculated EBIT margins earned by these firms over the period 2010 to 2014 as well as the unweighted and weighted averages for each year and the whole period.
Table 4-2: EBIT margins earned by mail delivery operations of comparable firms to Royal Mail, FY10 to FY14
Items FY10 FY11 FY12 FY13 FY14 Average Singapore Post 36% 37% 35% 32% 29% 33% PostNL 8% 10% 6% 7% 15% 9% Österreichische Post 12% 18% 17% 18% 17% 16% Deutsche Post 8% 8% 8% 8% 8% 8% Bpost 20% 22% 24% 24% 26% 23% MaltaPost 14% 14% 9% 8% 10% 11% Unweighted average 17% 18% 16% 16% 18% 17% Weighted average 10% 11% 10% 11% 11% 11% Source: Segmental reporting in postal operators published financial statements. Note: The weighted average in each year is calculated as the sum of all firms’ EBIT, divided by the sum of all firms’ revenues. We also note that, in earlier years prior to FY10, levels of profitability were similar.
4.12 The table above shows that average EBIT margins earned by firms with activities similar to the Reported Business are 11% on a weighted basis and 17% on an unweighted basis. The lowest observed margin is 6% and the highest 37%. This suggests that on average of the range of margins previously proposed by Ofcom of 5% to 10% appears to be low.
31 See for example PostNL’s overview of the European postal markets for 2015: PostNL (2015), European postal markets 2015 - an overview.
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Margins earned by businesses of similar scale in other sectors
4.13 Margins achieved by companies in the FTSE 100 and 250 can also provide a useful benchmark of the profitability of companies, which although not directly comparable to Royal Mail, are of similar scale to Royal Mail and are operating in competitive industries, or otherwise are subject to regulation. They are also the direct peers against which investors will benchmark Royal Mail’s returns.
4.14 We find that the weighted average EBIT margin earned by FTSE 100 and 250 companies from 2007 to 2014 ranges between approximately 10% and 12%.32
4.15 We note that, within the average for the FTSE 100 index as a whole, there is variation in the average EBIT margins earned by different sectors, however no sector earned an average margin of less than 8% between 2007 and 2014 and the lowest margin recorded in a sector in a single year was 5%. This is set out in Table 4-2 below.
Table 4-3: Average EBIT margins earned in FTSE 100 across different sectors, 2009 to 2013
Sector FY09 FY10 FY11 FY12 FY13 FY14 Average Materials 24% 33% 19% 13% 11% 11% 19% Consumer Staples 13% 13% 13% 14% 13% 12% 13% Energy 7% 8% 10% 8% 5% 6% 8% Industrials 5% 7% 9% 8% 9% 9% 8% Consumer Discretionary 9% 10% 12% 11% 11% 10% 11% Utilities 11% 13% 12% 12% 12% 5% 11% Other 23% 22% 23% 26% 23% 18% 23% Weighted average 11% 13% 13% 11% 9% 8% 12% Source: FTI analysis of data available on Bloomberg. Note: Average is for the years 2007 to 2014.
4.16 From this analysis, it is clear that companies of a similar scale to Royal Mail appear to typically earn EBIT margins that are higher than the range of margins previously proposed by Ofcom of 5% to 10%. Further evidence that this range is conservative is provided by empirical analysis which shows that, between 2008 and 2012, even FTSE 100 companies with no (accounting) assets would have been expected to earn a profit margin of at least 5%.33 This should therefore represent an absolute minimum level of reasonable return.
32 This is the range between the weighted average EBIT margins earned by companies in the FTSE 250 of approximately 10% and the weighted average EBIT margins earned by companies in the FTSE 100 of approximately 12%.
33 Oxera (March 2014), Something for nothing? Returns in low-asset industries.
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The margins targeted by credit ratings agencies
4.17 As we explain in Section 5 below, it is important to the financial sustainability of the Reported Business and therefore the USO that Royal Mail maintains an investment grade credit rating. Therefore the views of the credit ratings agencies can provide a useful cross check as to what an appropriate level of EBIT margin for a postal operator should be.
4.18 On S&P’s and Fitch’s scale, the lowest investment grade credit rating is “BBB-”; for Moody’s the equivalent grade is “Baa3”. Currently Royal Mail is rated only by S&P and S&P confirmed Royal Mail’s rating at BBB on 20 July 2015, with a “stable” outlook.34 A rating of BBB is one “notch” or level higher than BBB- and therefore sits just within investment grade territory.
4.19 Some ratings agencies publish some general and industry-specific ratings methodologies, including their view on the appropriate level of EBIT margin for postal operators.35 Moody’s, for example, publishes its quantitative methodology for postal operators, setting out inter alia the thresholds it considers important when looking at EBIT margins in the postal sector. (S&P does not publicly provide a specific target margin or set of thresholds for postal operators.)
Table 4-4: Summary of Moody’s threshold values for EBIT margins for postal operators
Rating Aaa Aa A Baa Ba B Caa EBIT margin ≥20% 16-20% 12-16% 8-12% 4-8% 0-4% Negative threshold Source: Moody’s, Global Postal and Express Delivery Methodology, Exhibit 6.
4.20 The table shows that the range to maintain a Baa rating under Moody’s methodology (that is an investment grade rating equivalent to a BBB rating under S&P’s scale) is between 8% and 12%. This therefore provides an indication of the margins that an investment grade postal company is expected to achieve in competitive markets and hence is an appropriate margin for Royal Mail.
34 S&P (July 2015), U.K.-Based Postal Operator Royal Mail 'BBB' Rating Affirmed Following Significant Debt Reduction; Outlook Stable.
35 See, for example, Moody's (December 2011), Global Postal and Express Delivery Methodology.
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Margins earned by other regulated businesses
4.21 Other regulated industries are likely to be less risky and should not be considered by Ofcom as comparators. We consider that there a number of differences between the Reported Business and other regulated businesses. These differences limit the relevance of regulated firms as a benchmark.
4.22 First, the majority of regulated businesses are subject to different regulatory regimes to Royal Mail, because they are subject to ex ante price regulation. Typically, these businesses are providing goods and services that are highly price-inelastic and without readily available substitutes. Therefore, these firms can achieve the price rises permitted within their regulatory determination and are effectively provided with a guaranteed return, subject to achieving the cost performance assumed in the regulatory determination. They therefore face lower risk to their profitability than Royal Mail and require a correspondingly lower return.
4.23 Second, most regulated businesses have different risk profiles arising from the volatility and uncertainty around future volumes. Most other regulated sectors are stable or growing, whereas the postal market faces a number of risks, the majority of which are asymmetric (i.e. significant downside risks and minimal upside risks) and this coupled with a high fixed cost base makes cost savings difficult. For example in water, energy transmission and distribution, access telecoms, and rail, there is limited competition and demand is relatively stable or growing. This is shown in the table below.
Table 4-5: Summary of demand in different UK regulated industries
Industry Demand Forecast Source Water Stable Independent forecasts for PR14 price review - Jacobs on behalf of Ofwat Electricity Broadly stable Electricity Ten Year Statement - National Grid
Gas Stable/slight decline Gas Ten Year Statement – National Grid
Rail Increasing Strategic Business Plan – Network Rail
Telecoms Increasing or declining, Business Connectivity Market Review – depending on segment Ofcom Note: “Telecoms” refers to wholesale access markets and not downstream retail markets. Sources: as indicated.
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4.24 Third, different regulated businesses have different service obligations which means that these businesses are not comparable.36
4.25 Fourth, most other regulated businesses do not have the same proportion of labour costs as Royal Mail does, which further constrains its flexibility to manage its cost base.
4.26 Fifth, Royal Mail faces asymmetric risks to its profitability which other sectors do not. In particular, Royal Mail faces systematically declining mail volumes due to trends such as e-substitution. Therefore, although there may be periodic upswings in volumes for seasonal or other reasons, these impacts are always transient, whereas declines in volume are permanent and will never be recovered. Royal Mail also faces an asymmetry in its ability to manage costs which also arises from the structure of its cost base. Royal Mail can relatively easily increase its capacity in response to an increase or peak in demand (i.e. volume) because it can hire more staff; however reducing staff costs in response to a fall in volume is much more difficult because it requires Royal Mail to achieve headcount reductions requiring in many cases voluntary redundancy. This uncertainty may therefore warrant a higher return.
4.27 We consider that adjusting for all the greater risks faced by Royal Mail compared to other regulated industries would be likely to be subjective and therefore would not represent a robust or reliable benchmark for the competitive EBIT margin.
Conclusion
4.28 Based on our analysis, we observe a reasonable range for the competitive EBIT margins lies between 5% and 17%. The range included in Ofcom’s March 2012 Statement (5% to 10%) falls within the lower end of this range. Our analysis is based on the following benchmarks:
(1) we consider that the most appropriate benchmarks to the Reported Business are the margins made by other businesses with the most similar activities. This peer group therefore comprises the mail delivery operations of other large national postal operators’ that provide a universal service and have significant privately owned stakes. Average EBIT margins for these comparators are 11% on a weighted basis and 17% on an unweighted basis. This is above Ofcom’s range of 5% to 10% and significantly in excess of Royal Mail’s margins in the past;
36 For example, although gas distribution network operators have a duty to connect vulnerable customers to the gas network, they are compensated for doing so by an increase in their revenue allowance, and the cost is recouped from customers by increasing the transportation charge. This is governed by Ofgem’s fuel poor network extension scheme. Ofgem (undated), FAQ on fuel poor network extensions for our website. Available at: https://www.ofgem.gov.uk/sites/default/files/docs/2013/02/guidance-on-how-to-apply-for-a- fuel-poor-discount.pdf
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(2) average margins of FTSE 100 companies lie in the range of 8% to 23%. At the lower end, this supports the margin range previously established by Ofcom of 5% to 10% and at the higher end exceeds it. In additional, Royal Mail has many unique features (such as the USO, asymmetric risk, labour issues, and the issues with its pension plan) that make a direct comparison difficult and may mean a higher margin is appropriate;
(3) credit ratings agencies’ views of target margins are also a relevant benchmark as it is important to the financial sustainability of the Reported Business that Royal Mail is able to maintain its investment grade rating to maintain full access to the capital markets. Moody’s indicates that an EBIT margin of between 8% and 12% would be consistent with an investment grade rating; and
(4) other more stable regulated industries are likely to be less risky and should not be considered by Ofcom as comparators. They face lower risk to their profitability than Royal Mail and require a correspondingly lower return; consequently Royal Mail’s margins should be set above those of other regulated industries.
4.29 Due to the many features that make the UK postal market unique, we do not consider that margins earned in other regulated sectors would provide a reasonable benchmark for assessing the competitive level of margins for the Reported Business.
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5. What metrics can be used to assess financial sustainability
Introduction
5.1 Under the Postal Services Act 2011, Ofcom has a duty to ensure that the universal postal service is secure.37 As part of this duty, Ofcom has stated that it welcomes suggestions on how triggers and early warning signs of a threat to the financial sustainability of the USO could be identified. We understand from Royal Mail management that it uses a number of forward-looking metrics internally to assess the future financial sustainability of both Royal Mail Group and the Reported Business. Further, under the changes to UK Corporate Governance Code introduced in September 2014,38 Royal Mail will in future be required to explain in its Annual Report how it will be able to continue in operation and meet its liabilities taking account of its current position and principal risks over a planning horizon of longer than twelve months. This is referred to as a “viability statement”.
5.2 As we explain in section 3, the commercial rate of return achieved (i.e. EBIT margins) provides one important measure of financial performance and therefore financial sustainability. However, the financial sustainability of the USO depends in particular on Royal Mail’s ability to finance the investments required to undertake its planned and future transformation programmes at reasonable cost on the capital markets. This is often referred to as “financeability”. A report by the Joint Regulators’ Group defines financeability as:39
“the ability of efficient companies to secure financing in a timely way and at a reasonable cost in order to facilitate the delivery of their regulatory obligations.”
5.3 A firm’s ability to raise finance at reasonable cost is principally determined by:
(1) its access to debt markets and other sources of credit at reasonable cost; and
(2) its perceived risk and hence its ability to meet investor expectations to raise
37 Ofcom (2011), Postal Services Act - Paragraph 29(1).
38 Financial Reporting Council (17 September 2014), FRC updates UK Corporate Governance Code. Available at: https://www.frc.org.uk/News-and-Events/FRC-Press/Press/2014/September/FRC- updates-UK-Corporate-Governance-Code.aspx
39 Joint Regulators Group (March 2013), Cost of Capital and Financeability, Page 10 - Paragraph 3.16.
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equity finance.
5.4 A key determinant of a firm’s ability to access to debt capital markets is its credit rating, as determined by the credit ratings agencies. Additionally, a firm’s ability to maintain and secure additional debt financing depends upon any covenants which exist in relation to any bilateral (i.e. bank) financing it holds.
5.5 In this section, we first explain why maintaining an investment grade credit rating and meeting equity investor expectations is important to the financial sustainability of the USO. We then discuss the publicly available financeability metrics used by credit ratings agencies, Royal Mail and others. In particular, we consider:
(1) the metrics used by Standard and Poor’s (“S&P”), who assess Royal Mail’s credit rating as BBB (Royal Mail is not currently rated by any other agency);
(2) metrics considered by Royal Mail in the running of its business and the loan covenants it is subject to;
(3) Moody’s publicly available quantitative metrics for assessing a postal operator’s credit rating;
(4) metrics that other postal operators have stated as being relevant; and
(5) financial sustainability metrics used by other regulators and any relevant differences between these industries that should be noted.
Why an investment grade credit rating is important to Royal Mail
5.6 Credit ratings are typically applied to the group entity and its guaranteed senior debt rather than to internally reported segments of the group. For the reasons discussed in Section 2, we do not consider that it would be possible to apply credit-rating criteria to just the Reported Business.
5.7 S&P is currently the only credit rating agency that provides a credit rating for Royal Mail. In S&P’s July 2015 research update, it confirmed Royal Mail’s rating as BBB, with a stable outlook.40 S&P’s ratings range from AAA, which is the highest rating available to D, where the obligator has defaulted on their debt and that S&P considers will default on most or all of their debt.
40 S&P (July 2015), U.K.-Based Postal Operator Royal Mail 'BBB' Rating Affirmed Following Significant Debt Reduction; Outlook Stable. This was achieved due to a large debt reduction predominately financed by the sale of the Paddington Mail Centre.
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5.8 A rating of “BBB-” or above is considered “investment grade”, i.e. there is typically a minimal risk of default. Below this level, the firm is considered to be non-investment grade (sometimes also referred to “speculative grade”, or “junk”).41 Non-investment grade firms typically have greater difficulty in raising funds on the capital markets and will have to pay higher rates of interest to reflect the higher risk of default. Many of Royal Mail’s peers also have investment grade ratings. For example, Deutsche Post has a BBB+ rating from Fitch and an A3 rating from Moody’s,42 and PostNL has a BBB- rating from S&P and a Baa3 rating from Moody’s.43 Therefore, investors would expect a postal services business of Royal Mail’s scale to be investment grade.
5.9 As a consequence, Royal Mail considers that it is important to the financial sustainability of its business that it maintains metrics consistent with its investment grade credit rating. Failure to do so might make it more difficult for Royal Mail to raise funds at reasonable cost from the capital markets. This could leave Royal Mail in a position whereby it is unable to make necessary investments to transform its business to keep pace with its competitors and peers and could ultimately be left in a position where it is unable to fulfil the USO.
5.10 As a result of this, the metrics that are used by credit ratings agencies are important tools that can be used to assess the financeability of Royal Mail and hence the USO. Fully replicating the process used to determine a credit rating is not possible, because the process includes qualitative assessments and proprietary adjustments to financial data. However, both S&P and Moody’s provide some guidance as to the measures of margins that they consider to be important and relevant. As we discuss further in this section, similar metrics are commonly used by other credit ratings agencies, businesses and economic regulators.
41 Each grade also has sub grades of “+” and “-“. A BBB grade is one notch above BBB- and two notches above the non-investment grade BB+. Hence Royal Mail’s credit rating has a small amount of leeway from non-investment grade.
42 Deutsche Post DHL Group (undated), Credit Rating. Available at: http://www.dpdhl.com/en/investors/creditor_relations/credit_rating.html
43 PostNL (undated), Financial framework. Available at: http://www.postnl.nl/en/about- postnl/investors/financial-framework/ Note that Moody’s ratings scale is different to S&P’s. A Baa3 rating is equivalent to BBB- and a Ba rating equivalent to BB under S&P’s methodology.
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S&P’s methodology for rating Royal Mail
5.11 S&P provides some limited publicly available guidance on its ratings criteria and uses a single quantitative methodology for both ‘freight railroad’ and ‘package express’ industries.44 However, the industries are adjusted for qualitatively. Royal Mail has provided us with further information on the approach taken by S&P to assess its credit rating.
5.12 S&P explains that its Corporate Criteria Framework combines its assessment of a business’s “Business Risk Profile” and “Financial Risk Profile” to give an overall “anchor” credit rating, to which it then applies “modifiers” for various factors to determine the final credit rating.
5.13 Table 5-1 below summarises how S&P combines its assessment of the Business Risk Profile and Financial Risk Profile to derive its anchor credit rating.
Table 5-1: Combining the Business and Financial Risk Profiles to determine the anchor
Financial Risk Profile Business 1 2 3 4 5 6 (highly Risk Profile (minimal) (modest) (intermediate) (significant) (aggressive) leveraged) 1 (excellent) aaa/aa+ aa a+/a a- bbb bbb-/bb+ 2 (strong) aa/aa- a+/a a-/bbb+ bbb bb+ bb 3 (satisfactory) a/a- bbb+ bbb/bbb- bbb-/bb+ bb b+ 4 (fair) bbb/bbb- bbb- bb+ bb bb- b 5 (weak) bb+ bb+ bb bb- b+ b/b- 6 (vulnerable) bb- bb- bb-/b+ b+ b b- Note: for anchor ratings, S&P uses lower case letters to distinguish these from the actual credit rating. Additional criteria are used to determine ratings below b-. Source: S&P, Corporate Ratings Methodology.
5.14 Financial risk can be assessed on a quantitative basis; however the assessment of business risk is more qualitative. We note that, in deriving its overall BBB rating for Royal Mail, S&P applies a modifier to reduce Royal Mail’s rating due to the degree of business risk it faces:45
“A one-notch downward adjustment [is made] to the anchor for our comparable rating analysis because we consider Royal Mail's business risk profile to be at
44 S&P (August 2014), Industrials: Key Credit Factors For The Railroad And Package Express Industry.
45 S&P (July 2015), U.K.-Based Postal Operator Royal Mail 'BBB' Rating Affirmed Following Significant Debt Reduction; Outlook Stable.
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the weak end of the range. Royal Mail faces strong competitive pressures in a difficult and declining operating environment, especially the U.K. parcels market. Ofcom's fundamental review of the regulation of Royal Mail adds further uncertainty.”
5.15 The remainder of this section focusses on S&P’s approach to assessing financial risk. S&P specifically mentions two metrics as being important:46
(1) funds from operations (“FFO”) to debt;47 and
(2) debt to EBITDA.
5.16 S&P also considers other supplemental ratios, comprising:
(1) one payback ratio: the free operating cash flow to debt ratio;48 and
(2) two interest cover ratios: FFO + interest to cash interest; and EBITDA to interest.
5.17 In general, the threshold values required for an investment grade credit rating are dependent on S&P’s assessment of the associated business risk and financial risk of the business. S&P has not disclosed the threshold values for most of these metrics. However, S&P has stated that, for Royal Mail to maintain its current credit rating of BBB, it must maintain its FFO to debt ratio above 45%.49 We understand that this figure may be specific to Royal Mail based on its particular business risk profile and hence may not be appropriate to use for other companies on a comparable basis.
46 S&P (August 2014), Industrials: Key Credit Factors For The Railroad And Package Express Industry. See also, S&P (July 2015), U.K.-Based Postal Operator Royal Mail 'BBB' Rating Affirmed Following Significant Debt Reduction; Outlook Stable.
47 FFO is defined by S&P as EBITDA minus net interest expense minus current tax expense. S&P also have specific adjustments that are required to be made to net debt. See S&P (19 November 2013), Corporate Methodology: ratios and adjustments - Paragraph 82.
48 Generally defined as FFO after capital expenditure.
49 S&P (July 2015), U.K.-Based Postal Operator Royal Mail 'BBB' Rating Affirmed Following Significant Debt Reduction; Outlook Stable.
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5.18 Based on this, we consider that this is one of the most important metrics for Royal Mail to assess. We understand that S&P currently considers that Royal Mail should be able to continue to meet this 45% requirement under the current margins being earned by Royal Mail Group.50 However, if this ratio were to drop below 45%, then this could lead to S&P reconsidering Royal Mail’s credit rating. We consider this to be a plausible scenario given the risks discussed above, in particular given the potential for unexpected further accelerated declines in volume, or industrial action to occur.
5.19 S&P also notes that its current BBB “stable” outlook is based on a forecast adjusted debt to EBITDA ratio of between 1.5x and 2.0x, however, this metric appears to be less important in S&P’s discussion of Royal Mail’s business.
Metrics included in Royal Mail’s debt covenants or monitored by Royal Mail
5.20 Other relevant metrics include those that are monitored by Royal Mail’s banks and those that Royal Mail uses internally to monitor its business. It is important that Royal Mail is able to stay within the limits set out by its banks as failure to do this could lead to Royal Mail having its loans called in at short notice. It is also important that Royal Mail is able to meet investor expectations to maintain continued access to equity finance.
5.21 We understand from Royal Mail that the key metrics and thresholds defined in its bank covenants are:51
(1) adjusted net debt/ EBITDA after transformation costs with a threshold of 3.0:1; and
(2) EBITDA/ interest, with a maximum ratio of 3.5:1.
5.22 We understand that additional metrics which Royal Mail monitors include:
(1) liquidity headroom (this is the amount of total available liquidity available to Royal Mail, if it were to access all of its cash and credit facilities). Royal Mail monitors its headroom position to ensure that it remains positive throughout the plan period; and
(2) dividend cover (defined as in-year trading cash inflow divided by the cash dividend paid). Royal Mail considers that its ability to maintain a progressive
50 S&P (July 2015), U.K.-Based Postal Operator Royal Mail 'BBB' Rating Affirmed Following Significant Debt Reduction; Outlook Stable.
51 Adjustments are made to financial data for the purpose of these covenant calculations. These adjustments are as defined by Royal Mail’s lenders under its facility agreements and disclosed in its Annual Report and Accounts. See Royal Mail plc (29 May 2015), Annual Report and Financial Statements, Page 89 (note 5).
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dividend policy is a key signal to equity markets that it represents a sound investment. If Royal Mail’s financial performance were to decline such that it had to cut or not pay a dividend, this could limit Royal Mail’s ability to raise equity in the future, which may affect its ability to equity fund investments in the future.
5.23 These metrics show the ability of Royal Mail to finance its current activities and forecast levels of debt. A deterioration in these metrics could be concerning, because this would indicate either that debt was increasing or that cash available to pay down current levels of debt and maintain its dividend was declining. Consequently, Royal Mail considers these metrics as part of its assessment of its financeability.
Moody’s methodology for rating postal operators
5.24 Although it does not currently issue a credit rating for Royal Mail, Moody’s publishes detailed guidance on the metrics it uses to assess its credit ratings for postal operators. Given that Moody’s is a major credit ratings agency, we consider that its criteria provide additional support to the financial sustainability metrics that one should consider.
5.25 Moody’s assess postal and similar operators52 across four factors at the group level:53
(1) scale and business diversification (a 28% weighting of the overall credit rating is derived from this factor);
(2) efficiency and profitability (14% weighting);
(3) financial policy (20% weighting); and
(4) financial metrics (38% weighting).
5.26 In total, approximately 64% of the factors used in Moody’s postal credit rating methodology (scale, efficiency and profitability, and financial metrics) can be quantitatively assessed, with the remaining 36% being qualitatively assessed. We note that Moody’s may also make adjustments to financial data, so although one can attempt to replicate the calculations that Moody’s would perform if assessing Royal Mail, one may not be able to replicate these precisely.
5.27 We discuss each of these metrics below and how they are assessed by Moody’s.
52 It also applied the same methodology for express delivery providers: Moody's (December 2011), Global Postal and Express Delivery Methodology, Page 2.
53 Moody's (December 2011), Global Postal and Express Delivery Methodology, Page 8.
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Scale and business diversification
5.28 Scale is assessed by total revenues in USD and has a 12% overall weighting towards the credit rating. Business and geographic diversification (16% weighting) are qualitative measures for which it is not possible to replicate Moody’s assessment. The table below sets out the revenue thresholds used by Moody’s.54
Table 5-2: Summary of Moody’s threshold values for financeability metrics for postal operators - revenue
Metric Aaa Aa A Baa Ba B Caa Revenues USDbn >40 40-30 30-15 15-5 5-3 3-0.5 <0.5 Source: Moody’s, Global Postal and Express Delivery Methodology, Exhibit 5.
5.29 We note that Royal Mail’s current and forecast revenues are broadly equivalent to a Baa or BBB rating. These are not forecast to change materially such that there would be change in threshold and hence this metric may not be particularly useful from a monitoring perspective.
Efficiency and profitability
5.30 Moody’s assesses efficiency and profitability using the EBIT margin and the Return on Assets (calculated as EBITA/average assets) metrics. Moody’s states that:
“The profitability of a company’s core business provides a measure of its capability to execute its business strategy…” and “[h]ealthy operating margins will help a company absorb potential shocks in the market.”55
5.31 The stability of the EBIT margin is also considered qualitatively, as this indicates how successfully the company has weathered shocks in the past.
5.32 Moody’s also state that Return on Assets provides a measure of the company’s ability to continue investing efficiently in its core business. We consider that this metric may be less relevant for Royal Mail, as S&P have not stated that it is a metric considered in the calculation of their actual credit rating. This coupled with the fact that such a metric could be affected by the particular accounting policies the firm uses to record its asset values, which may make such a metric less relevant for the purposes of monitoring Royal Mail’s financial sustainability. Both the EBIT margin and Return on Assets metrics are weighted 7% each (14% total) by Moody’s.
54 Moody's (December 2011), Global Postal and Express Delivery Methodology, Page 9-10.
55 Moody's (December 2011), Global Postal and Express Delivery Methodology, Page 11.
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Table 5-3: Summary of Moody’s threshold values for financeability metrics for postal operators – EBIT margin and Return on Assets
Metric Aaa Aa A Baa Ba B Caa EBIT Margins >20% 16-20% 12-16% 8-12% 4-8% 0-4% Negative Return on Assets >16% 13-16% 10-13% 6-10% 3-6% 1-3% <1% Source: Moody’s, Global Postal and Express Delivery Methodology, Exhibit 6.
Financial policy
5.33 Financial policy is principally a qualitative assessment by Moody’s and therefore cannot be replicated. This factor is designed to capture a firm’s willingness to assume financial risks while maintaining an adequate capital structure. As part of this assessment, Moody’s also looks at the debt to market capitalisation ratio which it considers provides an indication of the company’s flexibility to adapt to changing market conditions or the affordability of large investment requirements. The table below sets out the thresholds for this metric used by Moody’s.
Table 5-4: Summary of Moody’s threshold values for financeability metrics for postal operators – debt to market capitalisation ratio
Metric Aaa Aa A Baa Ba B Caa Debt to market <20% 20-40% 40-60% 60-70% 70-85% 85-95% ≥95% capitalisation Source: Moody’s, Global Postal and Express Delivery Methodology, Exhibit 7.
5.34 As we note in Table 5-6 below, regulators are also often interested in debt to equity/ gearing ratios. Therefore this is supportive of a gearing ratio being considered as part of Royal Mail’s financial sustainability monitoring.56
Financial metrics
5.35 In addition to metrics discussed above, Moody’s consider four key financial metrics. These have different weightings in the overall credit score:
(1) Debt/EBITDA (10%). Moody’s considers this an important indicator, reflecting the magnitude of financial risk in the company’s balance sheet, due to the capital-intensive and cyclical nature of the postal and express delivery activities (at the group level). We note that this is supportive of the debt/ EBITDA ratio considered by S&P;
56 It is not clear precisely what adjustments Moody’s might make to debt figures and consequently their gearing ratio thresholds may not be appropriate. Therefore it is the directionality of such a metric that should be monitored.
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(2) Retained Cash Flow (“RCF”)/Debt (10%).57 Moody’s views this as important because it argues the greater the amount of funds, relative to debt, that is being retained by the enterprise and reinvested, the greater is the entity’s ability to withstand operational and financial stress and therefore to avoid default. We note that this metric will be similar to the FFO/Debt ratio considered by S&P;
(3) Free Cash Flow (“FCF”)/Net Debt (8%).58 Moody’s considers this ratio for the same reasons it examines the RCF/Debt ratio; and
(4) Funds From Operations (“FFO”) plus Interest/Interest Expense (10%).59 Moody’s notes that this ratio is used to assess a company’s ability to pay interest and other fixed charges and therefore provides an indication of its financial strength.
5.36 The threshold values typically required for its quantitative measures to receive different credit ratings are summarised in Table 5-5 below.
Table 5-5: Summary of Moody’s threshold values for financeability metrics for postal operators
Metric Aaa Aa A Baa Ba B Caa Debt/EBITDA <0.5x 0.5-1.5X 1.5-2.5x 2.5-3.5x 3.5-5x 5-7x >7x RCF/Debt >60% 45-60% 30-45% 20-30% 10-20% 5-10% <5% FCF/Net Debt >25% 15-25% 10-15% 5-10% 3-5% 0-3% <0% (FFO+Interest)/ >12x 8-12x 6-8x 4-6x 2.5-4x 1-2.5x <1x Interest Expense Source: Moody’s, Global Postal and Express Delivery Methodology, Exhibit 8.
5.37 Therefore, again, the metrics considered by Moody’s appear to be consistent with those considered by S&P. Although the precise calculation of some of these metrics varies (e.g. RCF/ debt and FCF/ net debt are not the same as FFO/ net debt and (FFO+Interest)/ Interest is not the same as EBITDA/ interest), similar ratios (e.g. a measure of cash flow to debt and a measure of interest cover) are considered by different ratings agencies. Consequently, the metrics considered by S&P and Royal Mail appear appropriate for the monitoring of the financial sustainability of Royal Mail.
57 RCF defined as cash flow from operations before working capital less dividends
58 FCF defined as cash flow from operations after working capital, dividends and capital expenditure
59 FFO defined as cash flow from operations before working capital and interest expenses
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Financial sustainability metrics used by other postal operators
5.38 We have reviewed the financial sustainability metrics monitored and/or targeted by other national postal operators. Relatively few disclose specific ratios or thresholds, however we note that:
(1) La Poste (the French national postal operator) highlights its gearing and cash flow from operations to net debt in a presentation on debt issuance;60
(2) PostNL states that it targets "[a]n efficient and strong capital structure, with a long-term investment grade credit rating of BBB+ / Baa1”61 and manages its financial risk profile base on (i) its cash flow to debt ratio; and (ii) its debt to EBITDA ratio; and
(3) Deutsche Post state the goal of their finance strategy is “to maintain [the Group’s] financial flexibility and low cost of capital by ensuring a high degree of continuity and predictability for investors.” “A key component of this strategy is a target rating of “BBB+”, which is managed via a dynamic performance metric known as funds from operations to debt (FFO to debt).”62
5.39 The approaches used by other national postal operators are therefore consistent with those typically targeted by credit ratings agencies and lenders.
Financial sustainability metrics used by other economic regulators
5.40 We have also had regard for the types of metrics used in other regulated sectors. It is important to note that metrics that are relevant for one sector or company many not be relevant for other sectors or companies. Therefore, we consider that the types of metrics used provide useful benchmarks but it is likely that the thresholds will not be appropriate to the postal sector.
60 La Poste (November 2012), Le Groupe La Poste Debt Investor Presentation, Page 33.
61 PostNL (undated), Financial framework. Available at: http://www.postnl.nl/en/about- postnl/investors/financial-framework/
62 Deutsche Post DHL Group (2014), 2014 Annual Report, Page 51.
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5.41 Ofwat and Ofgem are the two main UK regulators that regularly assess the financial sustainability of firms in their industries.63 The ratios used by Ofgem and Ofwat are influenced by credit rating agencies. For example, Ofwat states that it focuses on ratios “similar to those used by credit rating agencies”.64
5.42 There are differences between how regulators and credit rating agencies apply ratios. Ofwat and Ofgem principally consider financeability at what they consider to be efficient (as opposed to actual) levels of costs and assume a notional (as opposed to actual) capital structure.
5.43 Table 5-6 below summarises the main ratios that are commonly reviewed by Ofgem and/or Ofwat in assessing financeability.
63 The ORR only assesses gearing for Network Rail, as its debt is guaranteed by the government. Prior to this they assessed similar metrics to Ofwat and Ofgem. Ofcom does not assess BT’s sustainability, as a sufficient proportion of its revenue is unregulated.
64 Ofwat (December 2014), Final price control determination notice: policy chapter A8 – financeability and affordability, Page 13 - Paragraph 8.2.3.1.
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Table 5-6: Summary of financial sustainability metrics used by other regulators
Ratio Description Ofgem Ofwat Gearing Debt/ (debt + equity) Assessed as a Assessed as a A high gearing may lead to percentage of percentage of difficulties servicing debt regulatory asset regulatory capital value value Interest cover Ratio indicates whether Assessed Assessed ratio the business is generating (FFO/ interest) sufficient returns to meet its interest repayments Adjusted Ratio indicates whether Assessed Must be reported Interest Cover the business is generating annually as a KPI Ratio: sufficient returns to meet by water (FFO – capital its interest repayments companies charges) after accounting for / interest required capital expenditure FFO/net debt Ratio indicates the ability Assessed. Assessed of the business to pay RCF/Capex is also down its outstanding debt assessed EBIT Margin Ratio indicates whether Not Assessed Not Assessed the business is generating positive returns EBIT/Net Debt Ratio indicates the ability Not Assessed Not Assessed of the business to pay down its outstanding debt Source: Price control methodology documents issued by Ofwat and Ofgem.
5.44 Again, these metrics show a broad consistency with the ratios considered by S&P and Royal Mail.
Conclusions
5.45 Table 5-7 below summarises which ratios are used to monitor financeability by different institutions. Note that, where institutions are shown as using the same ratio, there may still be differences in the precise definitions of the ratios.
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Table 5-7: Summary of financeability ratios monitored by different institutions
Royal Other postal Other Ratio S&P Mail’s Moody’s operators regulators lenders FFO/Debt - - Debt/EBITDA - Debt/Market cap - - RCF/Debt - - - - FCF/Net Debt - - - (FFO + Interest)/ - - Interest Expense EBITDA/ Interest - - Dividend cover - - - - - Liquidity headroom - - - - - Source: paragraphs 5.11 to 5.44 above.
5.46 Based on this, we consider that financial sustainability should be monitored over the period of Royal Mail’s business plan using EBIT margins at both a Reported Business and Group level (noting the adjustments made by Royal Mail to its accounting data)65 and other financial metrics assessed at Group level. These would be based on the metrics used by S&P, metrics defined in Royal Mail’s loan covenants and other metrics used internally to assess financial sustainability. In the next section we discuss how these metrics should be monitored and reported to Ofcom.
65 See Section 3 for a discussion on the relevant definition of EBIT.
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6. How financial sustainability could be monitored
6.1 We explain in section 5 that the financial sustainability of the USO (and therefore the USO) is dependent upon Royal Mail being able to earn a reasonable commercial rate of return and maintain ready access to capital markets at reasonable cost. This requires Royal Mail to be able to maintain its investment grade rating and to provide a reasonable return to equity investors. Therefore it is important that Royal Mail and Ofcom are able to identify threats to these measures of the financial sustainability of the USO and Royal Mail as a whole.
6.2 Financial sustainability is an inherently forward-looking assessment that is based on current and forecast data. Under Royal Mail’s current business plan it expects to remain financially sustainable. This plan is based on forecasts for and ex ante assumptions about the key drivers of its business performance. However, there is uncertainty and asymmetric risk around some of the drivers of Royal Mail’s business performance which means that, under some scenarios, Royal Mail would need to respond very rapidly to prevent any threat to its financial sustainability. This is why Royal Mail closely monitors its financial sustainability to identify the impact of market and other outcomes early and why it requires the flexibility to quickly make changes to its business strategy.
6.3 We therefore consider that Royal Mail, along with its banks and credit ratings agency, is best placed to assess its financial sustainability, given the risk analysis, forecasting and scenario testing that it already undertakes for its own internal business risk management purposes. Royal Mail is also establishing a framework for externally reporting on its financial sustainability to fulfil the new requirement of the revised UK Corporate Governance Code. Royal Mail refers to this framework as a “viability statement” that will form part of its statutory annual reports.
6.4 Royal Mail does not consider that it requires additional regulation because it considers that market forces, such as e-substitution in letters and direct competition in parcels impose a competitive constraint on it. It also considers that the need to provide a reasonable return to equity investors and its executive remuneration structure create strong incentives to reduce costs and drive up profitability. FTI Consulting discusses the nature and strength of the competitive constraints Royal Mail faces in the separate report titled “Competitive Constraints on Pricing Faced by Royal Mail”.
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6.5 We consider that the most appropriate and proportionate way for Ofcom to monitor the financial sustainability of the USO would be to use the same information and analysis that Royal Mail uses internally to assess financial sustainability. We consider that Royal Mail should engage constructively with Ofcom on a periodic basis sharing what it considers to be the most relevant metrics. We would expect these metrics to represent a combination of the metrics included in the viability statement and any other metrics Royal Mail considers are relevant, relating to Royal Mail’s loan covenants or to Royal Mail’s ability to provide a sufficient return to its shareholders. This would provide the basis for discussion of financeability between Ofcom and Royal Mail regarding the financial sustainability of Royal Mail and the USO, when required.
6.6 Given the unique combination of risks to Royal Mail’s financial performance discussed in Section 1 and the asymmetric nature of some of these risks, we do not consider that it would be appropriate for Ofcom to implement a more prescriptive financial sustainability monitoring regime. Any additional constraint on the financial performance that the business is permitted to achieve would risk limiting Royal Mail’s flexibility to adapt its business strategy in response to the realisation of risks.
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Appendix 1 Methodology for identifying comparators for Royal Mail
A1.1 This appendix explains the methodology used to determine the average EBIT margin achieved by postal operators that could be considered Royal Mail’s peers. It addresses the following points:
(1) how the cohort of comparable companies was selected;
(2) the segment considered comparable to Royal Mail’s Reported Business; and
(3) how weighted and unweighted margins were calculated.
Selecting comparable companies
A1.2 Initially, national postal operators for a sub-set of countries were considered. Countries considered were those with a GDP per capita of over $20’000, or which are members of the European Union.
A1.3 Only companies where a stake is privately held were considered. The ownership status of companies was determined using many sources, including a 2013 report on European postal operators,66 companies’ own websites, and press articles describing them.
A1.4 After applying these filters, the following six companies were considered:
Table A1-1: Postal operators with a stake held privately Country Company Germany Deutsche Post The Netherlands PostNL Belgium Bpost Singapore Singapore Post Austria Österreichische Post Malta MaltaPost Notes: Royal Mail (UK) is excluded from this list
66 WIK-Consult (August 2013), Main Developments in the Postal Sector (2010-2013).
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Identifying the comparable segments
A1.5 An initial benchmarking exercise was undertaken using data from Capital IQ for the entire company, for financial years 2010 to 2014.
A1.6 However, this may include divisions which are not comparable to Royal Mail’s Reported Business. A further benchmarking exercise was performed at the segment level. We specify the relevant segment for each company in the table below.
Table A-2: Identifying relevant segments
Company Segment Segment description Deutsche Post Mail/Post The Post - eCommerce - Parcel division handles both Ecommerce domestic and international mail and is a specialist in Parcel dialogue marketing, nationwide press distribution services and all the electronic services associated with mail delivery. In addition to Germany, it also offers domestic parcel services in other markets. It is divided into two business units: Post, and eCommerce - Parcel.67 PostNL Mail in NL "Our services include mail delivery, data and document management, printing, direct mail and billing solutions.”68 Bpost Mail & Retail The Mail & Retail Solutions business unit (MRS) Solutions offers solutions to big customers, private and public, (MRS) self-employed workers and small and medium businesses on one hand and serves the residential customers as well as all customers using mass market channels such as the post offices, the Post Points or the Bpost’s eShop to purchase their mail products on the other hand. It also sells banking and insurance products under an agency agreement with Bpost bank and AG Insurance and offers to its clients a number of other payment products.69
67 Deutsche Post DHL Group (2014), 2014 Annual Report, Page 157.
68 PostNL (2014), 2014 Annual Report, Page 10.
69 Bpost (2014), 2014 Annual Report, Page 96.
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Singapore Post Mail Mail segment provides comprehensive services for collecting, sorting, transporting and distributing domestic and international mail as well as sale of philatelic products. International mail service covers the handling of incoming international mail and outgoing international mail. Mail division also offers ePost hybrid mail service which integrates electronic data communication with traditional mail.70 Österreichische Mail and "The company’s Mail & Branch Network segment Post Branch engages in the acceptance, sorting, and delivery of Network letters, postcards, addressed and unaddressed direct mail items, newspapers and magazines, and regional media; and provision of address management, data management, mailroom management, document scanning, and response management services, as well as data and output management, document collection, digitalization, and processing services. This segment also sells postal and telecommunications products, and retail and philatelic products; and offers financial services through cooperation with BAWAG P.S.K. bank, as well as online services."71 Note: In FY 2010, Mail and branch network were reported as separate segments; the sum of both is used for this year MaltaPost Entire The Company primarily operates in one segment, company which comprises the provision of postal and related retail services to customers, which activities are substantially subject to the same risks and returns.72
70 Singapore Post (2015), 2014/15 Annual Report, Page 204.
71 Bloomberg (undated), Research on Oesterreichische Post Ag. Available at: http://www.bloomberg.com/research/stocks/snapshot/snapshot_article.asp?ticker=POST:AV
72 Malta Post (2014), 2014 Annual Report, Page 51.
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A1.7 EBIT, or operating profit, was identified for each of the segments. The revenue figure used includes inter-segment revenue (sales to other divisions within the company).
Calculating weighted and unweighted margins
A1.8 The unweighted margin was calculated as the simple average of margins (EBIT/Revenue) for all companies, within the relevant period.
A1.9 The weighted margin was calculated as the sum of EBIT for all companies, divided by the sum of revenue.
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