Tuesday 1 October 2013

Initial Public Offerings

And Royal Mail PLC

Son of Man by Magritte, courtesy Wikipedia 
"Investors even remotely tempted to buy new issues must ask themselves how they could possibly fare well when a savvy issuer and greedy underwriter are on the opposite side of every underwriting. Indeed how attractive could any security underwriting be when the issuer and underwriter have superior information as well as control over the timing, pricing and stock or bond allocation?" (Margin of Safety, Seth Klarman, 1991). 
Klarman was writing about Wall Street, but things are no different in the City. The Alternative Investment Market (AIM), where every company has staged an initial public offering (IPO), is a good proxy for the IPO secondary market. Since 2000, AIM (in blue) has lost 60% of its value compared to the FTSE All Share (in green), where most companies have long been listed on the exchange:*

Graph courtesy Yahoo, click to enlarge
*AIM was founded in 1995, but the current index only goes back to 2000.
However, in 2012 the average IPO on the main market gained 10.2% in value in a year when the FTSE All Share gained 12%. Some IPOs saw their share price increase in excess of 50% while others fell sharply.
It pays the investor to take special caution over IPOs and ask the following:
1. Is the risk analysis that accompanies the prospectus consistent with the optimistic outlook propagated by the underwriters?
2. Is the company raising new funds to invest in the business or is it merely a means for existing shareholders to realise their gains? This is particularly pertinent when private equity is behind the IPO; they load up the issue with debt and are experts at getting a full price for their investments.
3.  Is the company coming to market at the peak of its cycle? 
Klarman notes that investment trust IPOs are especially poor value. Some, he claims, are driven solely by "the lust for underwriting fees". Investment trusts must pay several percentage points to get a listing and then they usually fall to a discount on net asset value. The IPO investor is out of pocket on both counts. Also, investment trust IPOs are most frequent at the top of the market and absent at the bottom of the market. Much better to buy in the secondary market.

Royal Mail PLC


Royal Mail messenger, courtesy Wikipedia 
Royal Mail has shed its post offices, the 2.7 billion pounds deficit on its defined benefit pension fund and it is reaping the benefits of large price increases forced through in 2012. The spruced up Royal Mail is coming to market. The last day for applying for shares in the IPO is 7 October. 6 days later, the Treasury will decide the share price, which will be between 260p and 330p. On an implied forecast yield of 6.7% and a PE ratio of 11 on its mid-price of 295p, Royal Mail has already received offers from institutional investors in excess of their allotment. 10.2% of the new shares will go to the benefit of Royal Mail's employees, who will not be permitted to sell them before April 2017. 
But has the Treasury merely dressed up a venerable old nag, pumped him up with hormones and offered him to the public for a consideration of 3 billion pounds, take or leave a few hundred million? If this seems a harsh question, consider (data is from Royal Mail's prospectus): 
1. Operating risk.
        I.            The Market
Royal Mail has 99% of the UK letter market, which is in long-term decline. As it provides the universal postal service, Royal Mail is subject to quality and economic controls by Ofcom. The company has 33% of the UK parcels market, which is growing slowly and is highly competitive. It also has a profitable European parcels business.   
      II.            Revenue.
Billion pounds
FY 2013
Letters UK
Parcels UK
Parcels Europe
     Total Revenue
 Revenue has been inching up thanks to price increases: 
Percentage changes
FY2013 on FY 2012
FY2012 on FY 2011
Weighted price change
Weighted volume change
Revenue change
Going forward, PwC forecasts (PwC Strategy & EconomicsThe Outlook for UK Mail Volumes to 2023) that UK letter volumes will decline by 5% p.a. through 2018 and that UK parcel volumes will increase by 3.3% p.a. Given the greater weighting of UK letters compared to UK parcels, Royal Mail's overall UK volumes are likely to decline.  
Royal Mail hopes to grow its European parcels company, GLS. GLS obtains 71% of its revenues from France, Germany and Italy and Royal Mail has targeted Spain and 'emerging Europe' for expansion. This makes sense since GLS's margins are better than the UK business. But volumes there have increased by just 2% p.a. in the past 2 years and this represents just 16% of Royal Mail's revenue. 
    III.            Pricing
1st and 2nd class letter prices have increased by a compound 11% p.a. since 2006. The last increase of 30% for 1st class and 39% for 2nd class letters was effective April 2012. This huge increase, taking effect one fiscal year prior to the IPO, strongly suggests that Royal Mail would not have been saleable without it.
Ofcom has stated that it will allow Royal Mail freedom to increase the 1st class letter rate, but that it will freeze the 2nd class letter rate for a number of years in real terms (i.e. permitting increases in line with the CPI). Royal Mail says that Ofcom will limit its net margins on letters to 5 to 10% of revenue. 
    IV.            Operating costs
Royal Mail's 167,000 employees account for 57% of all costs. Royal Mail has undertaken an efficiency programme called 'transformation' to mechanise parts of the service. Efficiency gains are declining and most of the programme will end in 2014. 
FY 2013
FY 2012
FY 2010
Efficiency gains %
Royal Mail's objective is to make efficiency gains of 2 to 3% going forward, but there is no explanation of how this is to be obtained beyond FY 2014. 79% of all letters sequenced to final delivery points are now sorted mechanically versus only 8% in 2010. There does not seem to be much opportunity for further such efficiencies. 
Another obstacle to cost reduction is the requirements of the universal postal service. While letter volumes are shrinking, the number of delivery points is increasing. This means higher fixed costs for Royal Mail on lower revenues. 
Royal Mail has limited the increase in operating costs to 2% p.a. for the last 2 years. But can it continue to keep cost increases below inflation beyond 2014? 
      V.            Profit 
Pounds millions
FY 2013
FY 2012
FY 2011
Profit /loss after tax*
% of revenue
*Excludes charges/gains from deferred tax 
Royal Mail, until FY 2013, was a loss-making concern. No profit or revenue forecast is included in the prospectus. The first quarter of FY 2014 has begun with a net profit (excluding movement on deferred tax) of 126 million pounds, compared to 55 million pounds for the first quarter of last year. But the rest of the year could be badly affected by industrial action (see below). 
    VI.            Return on Equity
The return on equity of the Royal Mail for the past 3 years has been 20% for FY 2013 and negative for FY 2011 and FY 2010.
2. Risk of Industrial Action 
Royal Mail employees below managerial level are represented by the Communications Workers Union (CWU). The union is balloting its members for strike action between 27 September and 16 October. In the prospectus, Royal Mail makes it clear that it expects industrial action, including a strike. The CWU is opposed to the privatization of Royal Mail and wants, according to its Deputy General Secretary Postal:
·         An increase in pay that betters the increase in the cost of living
·         A better defined contribution pension scheme
·         Strengthening Royal Mail's commitment to the defined benefit pension scheme (see below).
3. Political Risk
The Labour party opposes the privatization of Royal Mail. It has announced that it would, if elected, impose tight conditions on both the pricing and service quality of the company. Since sooner or later Labour will win an election, investors should be prepared for:
·         A possible renationalization on unfavourable terms
·         Price and efficiency controls that could require further financing by Royal Mail's shareholders.
4. Risk that the dividend will be cut.
 In the 3 years included in the prospectus, Royal Mail had an accumulated shortfall of 154 million pounds in free cash flow.*
Pounds millions
FY 2013
FY 2012
FY 2011
Free cash flow*
*Net of capital expenditure including software.
Net debt is a manageable 35% of equity at June 2013. While Royal Mail will almost certainly pay the 13.3p dividend per share, costing 133 million pounds, forecast in the prospectus, future dividends depend on operating performance.  
5. Defined benefit pension scheme (DBPS) risk.
The Treasury has removed the 2.7 billion pound deficit on Royal Mail's balance sheet for the DBPS. From March 2012 onward, Royal Mail is liable for the defined benefit pension of its members. It was only closed to new members in 2008 and  the current membership is 112,000.
In a rambling passage in the 477-page prospectus, Royal Mail avoids any sensitivity analysis on this liability. However:
·         Royal Mail currently pays 400 million pounds a year into the DBPS.
·         It was forecast that Royal Mail would have to pay a further 300 million pounds annually into the DBPS. The company imposed a 'reform' without the agreement of the union. This would reduce this contribution to 50 million pounds annually from 2016 if the Trustees so require.
·         There is also a small deficit on the senior executive pension scheme.
A further 300 million pound a year contribution would most likely wipe out Royal Mail's profits.
With the limited information at hand and the many uncertainties surrounding the business of Royal Mail, it is not possible to run a valuation for the company. IPOs that use the new funds to expand the business of the issuing company are much more desirable than IPOs that solely reward existing shareholders. Royal Mail falls into the latter category.
[Note: I will be returning to the portfolio of AIM shares next week.]

1 comment:

  1. Excellent post, I had the prospectus on my list of things to read but now I don't think I'll bother. You covered pretty much all the concerns I had after a brief glance and I guess the prospectus doesn't address them.