People who bought shares in the recent royal mail floatation may be divided neatly enough into two camps – those who hoped to make a quick turn on their money by selling their stake immediately and those who had a somewhat longer investment timeframe in mind. With this latter group, the prospect of an attractive-looking 6% dividend yield may well have played some part in their thinking.
Some investors, aware of how pension scheme liabilities have affected the performance of other privatised businesses – BT and BA being classic examples – might even have trawled through the IPO prospectus’s 500-plus pensions-related references to see what the state of play was. And, having done so, they may well have felt suitably reassured.
On the face of it, the prospectus has the royal mail pension showing a reasonable surplus. For the reasons outlined in articles such as Fear of the new, the value perspective has tended to argue IPOs should be approached with considerable caution but at least here one risk appeared to have been taken off the table, right?
Not exactly. Every three years, pension trustees use guidance from actuaries to set how much cash a company must pay into its scheme each year – and, deep within the prospectus, you would have found that, under the most recent ‘triennial valuation’ in march 2012, contributions of some £700m a year were initially decided upon. Unfortunately, according to the prospectus, paying this much cash into its pension each year “would have put considerable strain on the Royal Mail and would have been a significant risk to the viability of RMG [Royal Mail Group]”.
Payments at the £700m level would have left royal mail generating very little, if any, free cashflow and put it in no position to pay a dividend – which would obviously had a big impact on how attractive it was to potential investors. However the government has been able to ‘finesse’ matters so that, for the next few years, the company has to pay not £700m but £400m a year into its pension fund. As a result Royal Mail is today able to generate around £300m of free cash flow a year, which is sufficient to ensure its forecast annual dividend payment of around £200m is covered.
Royal Mail’s free cash generation going forward will be affected by numerous factors – not least the evolution of the letter and parcel markets. However, if the company’s free cashflow shrinks so does the scope it has to pay its dividend, which makes future triennial valuations rather important. The government’s action to reduce the royal mail’s pension payments is a temporary measure and if when it expires the pension trustees still think £700m a year of cash needs to go into the scheme, then life gets a bit awkward for royal mail – and its investors.
If the step-up in pension payments were to happen today, then the company’s free cashflow would return to being negligible and the dividend payment to being unsustainable. Royal Mail would have to choose between cutting its payout to shareholders and cutting its employees’ pension benefits which, with a workforce that is 85% unionised – and already pretty unhappy – would be easier said than done.
A more upbeat scenario – in effect the ‘get out of jail free’ card for royal mail – is that interest rates, as discussed in articles such as Works both ways, return to historically more normal levels, allowing trustees to reach a lower triennial valuation. Strong operational performance that boosted cashflow would also sort the problem out. However, having such a high percentage of a business’s free cashflow dependant on rising bond yields is not a position with which we would feel comfortable as investors.
Investors looking to generate an income from royal mail are largely, we suspect, unaware of the bet on higher rates they are effectively making. In Power politics, we saw how high levels of corporate debt can threaten dividend income stability and, as can be seen here, so can pension liabilities. An artificially attractive yield brought about by a temporary reprieve on pension contributions is not the level of stability or growth we look for in our income investments here on The Value Perspective.