Royal Mail - Factors Affecting Costs, Revenues and Profits

Royal Mail PLC was part-privatised in 2013 and fully-privatised in 2016. It generates just under £10 billion of revenue annually (up 2% year-on-year) and it made an operating profit of £694m (1% higher than a year ago).

41% of their revenues come from a profitable parcels business where they currently have a 53% market share in the UK, but their pricing power is affected by the presence of scaled-competitors such as DPD, Hermes, Yodel and TNT each of which provide competition across the UK. The parcels industry is now highly contestable with click and collect services and the possibility of drone deliveries two potentially significant factors affecting parcel volumes in the future. Royal Mail has around 20% market share of parcels delivered by large corporations, their parcel volumes excluding Amazon grew by 4 percent last year - a driver of increased revenue.

The Royal Mail’s profitability is also challenged by the trend decline in the volume of letters being sent, collected, sorted and delivered. In the UK there is a 4-6% annual decline in addressed letter volumes which given the fixed costs of running a universal delivery service leads to higher average fixed costs and increasing losses. E-substitution is a big threat for the Royal Mail as people increasingly prefer digital communication to sending letters through the post. Linked to this is the fact that the industry regulator Ofcom has set a price cap on Royal Mail’s 2nd class letters and parcels - although Royal Mail is free to set their own prices for first class mail services.

Royal Mail has a near monopoly over final mile letter deliveries in the UK but there is increasingly competition from access operators who collect and sort mail rather than deliver it. Royal Mail is required to deliver this mail as part of their Universal Service Obligation. Access operators pay Royal Mail for this service.

Brexit also provides uncertainty for the Royal Mail. Worries about Brexit have contributed to a decline in direct mail spending by many UK firms - this is a key factor since around 91 per cent of all mail originates from business. Delivery costs in the future might be affected by a decision by the UK to leave the internal EU market in postal services. Demand for parcels for example might be impacted by a no-deal Brexit which then means customs duties (tariffs) applied to exported from the EU to the UK.

Given these challenging revenue conditions, it comes as no surprise that the Royal Mail is under pressure from shareholders to deliver significant operating cost savings - they are mid-way through a five-year plan for doing so. This has involved targeting a 1% annual improvement in labour productivity (to lower unit labour costs), cutting back on marketing spending (a fixed cost) and negotiating new pay-deals with the unions that involve a smaller contribution to the pension fund. Most of the operating costs related to the expense of running the postal network, hence a strategy to cut-back on management and invest in the latest sorting equipment to raise efficiency. Some costs are harder to control, for example, Royal Mail owns over 40,000 vehicles, so the volatile price of fuel can affect their variable costs and have a direct impact on profits in any given year. Last year, Royal Mail spent £147m in fuel.