Time to deliver – privatising the Royal Mail

13 June 2014

Royal Mail Group is one of the most high-profile businesses in the UK, and its recent privatisation was the subject of intense scrutiny in the media and political sphere, and among investors. CFO Matthew Lester was part of the team overseeing the flotation, and he spoke to Jim Banks about the challenges and opportunities the sale brought.

It is hard to live in the UK without interacting in some way with the Royal Mail Group. Whether it is through buying stamps at the post office on the high street or using the company's UK-based logistics services for sending or receiving parcels, it is a business that touches everyone's lives. Floating the £9-billion postal services and logistics company to private ownership, therefore, was a highly public and heavily scrutinised task.

From a finance perspective, that job fell to a person who not only had past experience in privatisations, but also had broad-ranging business experience gleaned from years in the fast-moving consumer goods sector, as well as long stints in the City. Matthew Lester, group CFO at Royal Mail, needed that rounded view to manage the sheer complexity of the transition.

"The reason Royal Mail was such an appealing option was that, having been a very junior adviser on previous large privatisations and then learning how to be a very good finance business partner at Diageo - and there is no better company for teaching people how to do that - you put all those building blocks in place, and you are in a very good position, I think, to genuinely add value to what is a complicated process at the best of times," he says.

Having begun his career as an accountant at Arthur Andersen, Lester moved to the City with Kleinwort Benson (later Dresdner Kleinwort Benson) before becoming group finance controller and treasurer at Diageo - the world's largest producer of spirits, and a major force in the beer and wine markets.

After ten years at the company, Lester moved on to the role of group CFO at ICAP, the world's largest interdealer broker with more than $1 trillion traded daily between financial institutions.

Four strong winds

During his time as a merchant banker at Kleinwort Benson, Lester was involved in the privatisation of UK electricity businesses in the late '80s and early '90s, so his transition to the government-owned Royal Mail Group in 2011 was not entirely new territory despite his commercial and City background. The intensity of those working environments fed his appetite for the scale of the task the run-up to privatisation presented.

"This privatisation process was particularly complicated, because of myriad government desires for an enterprise that was in a very tricky business environment," says Lester. "The key thing is to recognise that the government that came in during 2010 was benefitting from the learning of previous attempts.

"If you read our prospectus, you see that the backbone of the Royal Mail runs on software that is quite old, and this means systems need to be upgraded to be more effective and robust."

"It learnt a few things, one being that a historic pension liability of the scale they were facing was always going to represent far too big a risk for any private purchase of a company that had negative free cash flow in its recent track record," he notes.

"Other than the government's own, you were probably looking at liabilities bigger than any other pension fund in existence, stuck on the back of a business that had very small cash flow. So, the pension was a big piece.

"Second, the Post Office is part of societal infrastructure and there is a clear political requirement to have a large number of post offices. From a purely commercial privatisation point of view, its privatisation was not something that was ever going to work, so it needed to be separated off," he adds.

The reorganisation of the company to separate the Post Office was one of the first issues to be dealt with, together with obtaining approval for state aid, following Lester's arrival. A preference for doing the hard things is in Lester's blood, however, and the scale and complexity of the task was what drew him to the job.

"The third thing the government had learnt was that they needed to establish a sustainable business, and we were able to spot that the parcel phenomenon - driven by the growth of internet shopping - meant we were able to offset the decline in letter revenues.

"You had a business model that was viable without wholesale cost-cutting, though you still needed very tight cost management in a business like this. That is true of any business, but it is absolutely vital at Royal Mail," says Lester.

"The fourth complicating factor is that you need a sense of the regulatory framework, which would give investors sufficient confidence that the business would be able to earn a reasonable rate of return.

"So, there were four pretty big issues that needed to be dealt with if you were going to be able to get the float away, which is why people see it as a complicated process. All this needed to be dealt with when I arrived, which is why the job was very attractive," says Lester.

The future starts here

With the sale complete, Lester's task now is to work with the senior management on a significant programme of investment that will modernise the company. Billions of pounds are going into technology, infrastructure and process improvement to ensure more efficient delivery, improve the speed and safety of logistics operations, update sorting machinery and enhance tracking capability.

"We're only halfway through the transformation, and these are massive investments we are talking about," Lester says.

"The first stage of it was a programme to bring some automation to letter sorting to enable us to handle more parcels. From a logistics point of view, we were reconstructing the network, which in itself has a significant IT component in it.

"At the same time, we are working our way through upgrading all of the operating systems in the company.

The cash drain on the company, particularly through having to support this massive historical pension liability, meant there was insufficient cash to invest in the IT infrastructure," he adds.

"I'm not talking about customer-facing elements but rather the technology for things like finance, operational and billing processes, which are all in need of a lot of work. We have a large number of applications that need to be reviewed, renewed and made safe, so it is a very big part of the programme.

"While we've started to do this, we've also begun to actually deliver more customer-facing applications, so now our web services are properly configured so they can be changed quickly," he adds.

The company has recently launched a barcode application for letters that will enable better tracking of post through the network. One of the advantages is that it helps to combine direct marketing with an internet marketing campaign approach, as it is possible to see who has received letters and when.

"A common theme you are going to hear throughout the Royal Mail story is about combing the 'e-world' with the real world, and that is where we operate. We've got a lot more to do, because we have to sort out the IT infrastructure behind our parcels to a much higher degree than today.

"There are certain services that we only offer through our Parcelforce operation, for example, that need to be made available through the rest of our Royal Mail network," adds Lester.

The technology overhaul goes right across the back office, in recognition that nothing can run without the right technology to support modern processes. Lester notes that, in many organisations, notably some banks, legacy systems that are often more than 20 years old are still supporting core business processes.

"Businesses need to have robust and reliable technology behind key services, and you could look at the ATM services banks provide as an example of where that has been challenged in the recent past," explains Lester. "If you read our prospectus, you see that the backbone of the Royal Mail runs on software that is quite old, and this means systems need to be upgraded to be more effective and robust.

"It doesn't matter what your business is, we are all facing this kind of challenge, except for those businesses that have essentially been created in the internet age," he says.

In delivering the kind of investment that is needed to change the technological backbone of the Royal Mail Group, Lester does benefit from the fact that the finance function has already taken a forward-looking view of shared services in order to improve efficiency.

The enterprise had already adopted a shared services model for finance and HR before he joined, and he was immediately pleased to see how well it was performing.

"That was one of the pleasures of joining Royal Mail, and the model works very well. The shared services centre is all owned and operated by the company itself, and it is very efficient from a control point of view.

"While there are people who are actually business partners who have accountability to ensure compliance with our procedures and controls at the front end of the business, the accounting and finance processes are handled in one centre in Chesterfield. The team there have been performing very successfully," Lester says.

Investing for the long term

Group CFO is not the only hat that Lester wears. As part of the 100 Group, which brings together the finance directors of the FTSE 100 and other large private companies, he is chairman of the Investor Relations and Markets Committee.

In this role, he is a key voice in the debate surrounding integrated reporting, which aims to redefine how companies communicate with investors. A critical issue in this debate is the integration of planning, forecasting and budget management into the reporting process as part of a drive towards long-term planning for sustainable businesses.

"Good entrepreneurs are brilliant risk-takers: they know exactly the risks that they want, they are able to identify and arbitrage undervalued risk, and areas where they don’t want any risk."

For Lester, such an approach to reporting is nothing new, because Royal Mail Group, and many enterprises like it, has no choice but to pursue long-term targets in developing its business.

"The best businesses do this instinctively," he says. "Going back many years to when I was a banker, I worked with a very small company, and the entrepreneur behind it did integrated planning, budgeting and forecasting effectively by himself.

"Why? Because good entrepreneurs are brilliant risk-takers. They know exactly the risks they want, they are able to identify and arbitrage undervalued risk, which are areas they can exploit and make money, and areas where they don't want any risk.

"They don't just do it in the moment, they think about how those are likely to develop and set their business up in a particular way that reflects how they feel those risks are going to develop over time," he explains.

"Good businesspeople have always done it, but what is happening intuitively is becoming more institutional in nature and is being applied more universally throughout organisations, where, often, the planning process is more about negotiation than about coordination and resource allocation.

"Companies must look at where they are likely to seek investment in the future and at areas that should become sources of funds that can be invested in other areas."

The key message is that good companies must recognise that they have to be able to continue to be allowed to do business.

There is deep suspicion in some circles around big business and its motives, and, in a competitive industry such as postal services and logistics, public perception can have a significant impact on performance, but consistently improving levels of service is also essential to long-term survival.

"Companies must work hard to be allowed to do business, and that is the core of sustainability. The impact we have on society at a broader level has to be taken into account as a key element of risk and a determinant of where a company is going to put its investment in the future. That needs to be planned in; you can't retrofit it," says Lester.

"Sustainability is a major priority at Royal Mail now. This business is one that is in a highly competitive environment the whole time, and sustainability is a very big word. It is about identifying the proposition that gives us the right to be allowed to do business.

"We have to ask what we can do to encourage the right regulation of our industry. As a regulated business, we have a natural situation where the regulator has a consumer and small-business focus, so we feel we have to justify to the regulator what we are doing. We have to defend the company in an incredibly intense competitive environment," he says.

As the company's letter business comes under pressure from other means of communication - in the form of email, texting, tweeting and whatever social media morphs into being in the next few years - and the parcel space continues to become more competitive, major investment in its long-term future is essential.

The business is spending big and will invest more than £600 million this year alone. Lester knows, however, that it is not the size of the budget that matters, but how wisely it is spent.

Matthew Lester is the group CFO for Royal Mail Group, having been appointed to the board in November 2010. Previously, he served as finance director of ICAP for five years and held a number of senior finance roles at Diageo, including group financial controller.