The Richard Hooper report made public today concluded that with letter volumes likely to decline between 25% and 40% over the next five years:

"There must be no let-up in the pressure on Royal Mail management, workforce and unions to accelerate the pace of modernisation. The need for Royal Mail to get up to best in class as rapidly as possible remains. This is the key priority, alongside the need to give Royal Mail access to private capital, pension deficit relief and a change of regulator and regulatory framework.

The report also stated that twenty months after the original 2008 report, the universal postal service was still under serious threat and that most of the concerns set out in the original diagnosis had actually worsened in the intervening period, rendering the maintenance of the universal postal service even more precarious than in the 2008 findings. The reasons for the deterioration in the financial health of Royal Mail were as follows:

• the market and Royal Mail’s market share both continue to decline;

• the company has, despite good progress, still not modernised sufficiently;

• the accounting pension deficit has increased from £2.9bn in March 2008 to £8.0bn in March 2010;

• the current regulatory regime is not fit for purpose.

In justifying the need for private sector capital, the report stated that Royal Mail was unlikely to generate sufficient cash to finance the modernisation required. Private sector capital would inject private sector disciplines into the company and reduce the risk of political intervention in commercial decisions, thus accelerating modernisation. In addition, the state of the public finances meant that Royal Mail will find it ever harder to compete for Government capital against other public spending priorities. However, the report warned that the introduction of private sector capital was by itself far from sufficient to secure the future of the universal postal service and that its future depends just as much on resolving the closely connected issues of the pension deficit and the need to transform postal regulation. Significantly Hooper pointed out that private sector capital would not be attracted into Royal Mail without actions on the pension deficit and the regulatory regime and the report therefore recommended that the pension deficit be transferred to the public purse.

In terms of regulation, it was felt that responsibility for the regulation of the postal sector should be transferred to the communications regulator, Ofcom, on a timescale that will not hold up the completion of the new regulatory framework from 2012 and thus delay the much needed regulatory certainty.

During the summer and autumn of 2009, there was significant industrial unrest at local and then national level in Royal Mail. The main reason for this being disagreements about the implementation of agreements on modernisation which had been reached after the national strikes in 2007. Although the short term impact of this action was not as great as the action which took place in 2007 (largely due to customers being better prepared and having contingency plans in place), the longer term impact of industrial action within two years of the previous action has still been serious. Confidence in the reliability of the postal service has been significantly shaken. A new 3-year agreement on modernisation between Royal Mail and the Communication Workers Union (CWU) was reached in March 2010.

The update emphasised that success for Royal Mail and Post Office Limited in the growing “fulfilment” market would help compensate for the losses encountered in the declining letters market, but the fulfilment market was not big enough to make up for all the losses in the letters market.

On positive changes since 2008:

• good progress in modernisation
• better regulatory climate
• better industrial relations

However, four interconnected concerns identified in the 2008 report had grown worse:

• decline in letter volumes
• market share losses
• the increased size of the pension deficit
• the deteriorating financial health of Royal Mail

The accounting pension deficit had also continued to grow, nearly trebling in size over the last two years, hurting Royal Mail financially at all three points: profit and loss, the balance sheet and cash flow. The report conlcluded however that Royal Mail had made important changes to the pension scheme and this had materially reduced annual accrual costs.

The balance sheet of the Royal Mail Group for 2009/10 shows that the accounting pension deficit at £8.0bn exceeds total assets by £2.1bn making the Group balance sheet insolvent. But if the pension deficit is considered as a financial liability i.e. a debt, then the Royal Mail Group’s leverage shows that its net debt is 12.7 times greater than EBITDA (earnings before interest, tax, depreciation and amortisation), far exceeding the leverage amongst its peer group and far exceeding anything that would be remotely attractive to investors.

The ingress of digital communications was also highlighted in the report, pointing out that Royal Mail, like all other traditional “analogue” businesses, should also assume that the pounds in the analogue world often convert to pennies in the digital world. Physical mail competing with “free” digital communications, and for example, letters requiring a 41p First Class stamp or a 32p Second Class stamp now competing with emails that have a marginal cost of zero pence to send.

In terms of progress, the report concluded that management, workforce and unions were still a long way from achieving best in class status alongside Royal Mail’s peer group of postal operators in countries such as the Netherlands, Denmark, Sweden, Belgium, Germany, New Zealand. Whilst Royal Mail management said that the company was about half way there, the report noted that the changes that will have the most significant impact on its efficiency have yet to be made across the country, that these were the more difficult changes to implement and are happening at a time when letter volumes was continuing to fall and revenues decline rapidly.

Critics of Postcomm assert that, historically, the regulator has been too encouraging of competition to the detriment of the universal postal service. The report commented that it could be argued instead that, given Royal Mail’s refusal to, or inability to, modernise historically, competition was needed to force the pace. It is insufficient modernisation not too much competition that really undermines the universal postal service.

Introducing private sector, the report stated, would:

• ensure that cash is readily available when needed to fund the accelerated modernisation programme on a commercial basis that matches, indeed tries to get ahead of, the rapid changes in the market;

• inject private sector disciplines into the business; the Queen’s Speech in May 2010 talked specifically of “private sector capital and disciplines” (emphasis added);

• reduce the risk of political intervention in commercial decisions (called in the original report “the spectre of political intervention”). The mail centre closure programme, for example, is critical to achieving cost reduction targets. However it is vulnerable to political and/or union opposition.

On transferring the pension deficit to government, Hooper said that given the worsening situation, the European Commission may consider such a move under its Restructuring Aid guidelines. As stated in the previous report, the purpose of Restructuring Aid is to restore the long-term commercial viability of a business such that it no longer needs further state support. While the Restructuring Aid route has disadvantages, ultimately, a restructuring of both the pension and the business is what Royal Mail needs, and guidelines are in place at the EU level to manage such situations. Many of the measures that the Commission could ask of Royal Mail as a condition of state aid approval (such as reducing its cost base) are things that must happen and are happening anyway. The onus will be on the Government to demonstrate that its support for the pension (and any other support) does not distort competition. It is, however, important that action is taken now to address the problems to prevent it needing rescue aid in the future.

Regulatory proposals include:

• changes to the system of headroom control to take effect from April 2011;
• removing price controls from all packets and parcel services weighing more than 750g, because evidence suggests that this market is increasingly competitive;
• removing retail price controls on pre-sorted bulk mail, replacing them with new regulatory safeguards on the wholesale prices Royal Mail is allowed to charge operators and other users accessing its network for ‘final mile’ delivery;
• giving Royal Mail greater flexibility in setting its prices for pre-sorted bulk mail and access services. In addition, Postcomm is also consulting on cost transparency and accounting separation.

The report recommends that the task of regulation should be transferred to Ofcom, but without delaying the much needed regulatory reform from 2012.

The report strongly recommended the introduction of private sector capital into Royal Mail and that this could be in the form of a sale to a partner/trade investor or an IPO. pointing out that the state of the public finances meant that Royal Mail would find it ever harder to compete for Government capital against other public spending priorities. Secondly, the Government has made employee ownership a key aspiration alongside the introduction of private capital and this could have the benefit of encouraging greater employee engagement within Royal Mail.

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