Royal Mail faces pension showdown

Royal Mail's current pension scheme costs the postal giant about £400 million a year, but the charge to the profit and loss account is over £600 million. That's confusing broker UBS, which believes that in the long-run this situation is "unsustainable".

"We believe the most likely option is closure of the Defined Benefit scheme, which should result in upgrades to earnings (although cashflow will be less affected), "writes analyst Dominic Edridge. "However, the reaction of workers and the union to a closure would need to be watched, with a new labour deal required next year."

Pensions are such a big deal for the valuation of Royal Mail because of the importance of cashflow generation. The gap between pension cash costs and the accounting charge has widened from £72 million last year to an estimated £255 million in 2016. This is because a deal with pension trustees allowed a surplus to be created and the scheme to remain open until March 2018. The P&L cost assumes the scheme remains open and has risen in line with interest rates.

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"The mark-to-market pension cost of c£700m pa would wipe out most of RMG's free cash flow and is unsustainable, in our view," says Edridge. Although the range of outcomes is wide, he's betting on a compromise at around current cash levels.

And Wednesday's announcement from industry regulator Ofcom that is launching a review of the regulation of Royal Mail is significant, too. The news follows the recent withdrawal by Whistl from the "direct delivery" letters market, leaving Royal Mail with no national competition.

"With UKPIL now making 6% cash EBIT margin, the market’s focus may move on from supporting and protecting Royal Mail to ensuring customers are well served and Royal Mail continues to improve productivity and therefore can protect itself going forwards," says Edridge.

The analyst upgrades his price target from 414p to 500p using his new assumption that the current cash pension cost remains into perpetuity. The figure is also based on a 5% GAAP operating profit margin, although each 1% change in margin is worth 60p per share.

Earlier this week, we reported how JP Morgan suggested buying Royal Mail shares with a 605p price target, and that superstar fund manager Neil Woodford had increased his stake by over 2 million shares to 5.2% of the company.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.