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Rate rise would release Royal Mail from ‘pension jail’
by Gavin Lumsden on Oct 25, 2013 at 14:18
The UK’s accelerating economic growth is good news for most of us but for Royal Mail’s new shareholders it could be a double blessing.
The third quarter economic growth of 0.8% announced today has revived speculation of whether the Bank of England will raise interest rates before 2016. This is the current date pencilled in under governor Mark Carney’s new policy of ‘forward guidance’.
However, an earlier rise in interest rates would dig Royal Mail out of a hole and avoid a near doubling in the amount it pays into its pension scheme, says Andrew Lyddon of investment group Schroders.
In a note today Lyddon, a member of Schroders’ ‘deep value’ investing team, described rising interest rates as the ‘get out of jail free card’ for Royal Mail which could enable it to maintain the high dividend that drew in so many investors to the flotation this month.
Although the government paved the way for the Royal Mail IPO in 2010 by absorbing an estimated £38 billion in pension liabilities, these related to its final salary scheme only. The company is still on the hook for the money purchase (or defined contribution) pension scheme, which it is why it is locked in dispute with trade unions over proposals to cut the bill.
Under the terms of the last triennial review by trustees in 2012, Royal Mail was meant to pay £700 million a year into the pension scheme. However, Lyddon says the government was able to ‘finesse’ matters so that the bill fell to £400 million. The next review is in March 2015 and, he says, unless there is a rise in interest rates by then it is likely that trustees will demand £700 million.
According to the prospectus issued before its share listing, this ‘would have put considerable strain on the Royal Mail and would have been a significant risk to the viability of RMG’. It would have wiped out the cashflow supporting Royal Mail’s dividend which provided a 6% yield at flotation (now fallen to 4.5% after the rise in the share price).
‘Investors looking to generate an income from Royal Mail are largely, we suspect, unaware of the bet on higher rates they are effectively making,’ Lyddon concludes.
So far this is not disturbing shareholders. Royal Mail (RMG.L) shares today gained over 5p or 1% to 534.5p – more than £2 per share up on their flotation price two weeks ago – as stock broker Panmure Gordon reiterated its ‘buy’ rating with a 570p 12-month price target.
The rapid gain in Royal Mail shares has enraged critics who have accused the government of selling a state asset too cheaply. This week it emerged that bankers at JP Morgan put a £10 billion valuation on Royal Mail as they pitched unsuccessfully for the job of advising on the IPO. The government subsequently decided to float Royal Mail at £3 billion. The Children’s Investment Fund, a hedge fund, has also snapped up a 5% stake in the group.
Meanwhile the FTSE 100 drifted three points higher at 6,716, just below the 13-year peak it reached in May.
G4S (GFS.L) gained 2.7% to 260p after analysts at HSBC responded to takeover speculation by upgrading the stock to ‘neutral’ from ‘underweight’ on the basis of its breakup value.
BSkyB (BSY.L) was the biggest faller on the FTSE 100, down 2.4% to 927p after Macquaire, the Australian investment bank, cut the satellite broadcaster to ‘neutral’ from ‘outpeform’. It cited the risk of overpaying for rights to show Champions League football.
In Europe, the FTSEurofirst 300 index was flat at 1,285 as investors took profits from recent gains as big companies complained of the effect of the strong euro. French insurer AXA and car maker Renault reported lower sales stemming from the rise in the single currency while Schneider Electric lowered its full-year forecasts on the euro factor.
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