COMPETITIVE MARKET REVIEW

2007 COMPETITIVE MARKET REVIEW UK POSTAL MARKET

CONTENTS 1 EXECUTIVE SUMMARY 2 2 OVERVIEW OF THE POSTAL MARKET 6 3 DEVELOPMENT OF COMPETITION 28 4 ROYAL MAIL 47 5 MARKET DEVELOPMENTS/OPPORTUNITIES 59 6 ANNEX A 71 CONTENTS 1

1 EXECUTIVE SUMMARY As the regulator of the UK mail market Postcomm needs to have a thorough understanding of the market and how it is evolving. The 2007 Competitive Market Review builds on last year s document to give an overview of developments in the mail market. It will help to inform Postcomm s policy decisions and will assist in the continued development of a regulatory framework that facilitates the development of competition in the context of a healthy, stable mail market. Market size and growth The UK addressed mail market was worth around 6.6 billion in 2006/07. Mail volumes amounted to 21.9 billion items, down 2 per cent on the previous year 1. This is the third consecutive year of mail volume decline in the UK. While there is evidence to suggest that substitution has caused mail volumes to decline for the last three years, there is also evidence of areas of growth in the market which appears to be offsetting a more significant volume decline. In 2006/07 2.4 billion items were carried under access agreements; this represents 11.8 per cent of total operational mail volumes. This is an increase from 5.6 per cent in 2005/06. Around half of these items were handled by alternative operators. Latest figures (cumulative volumes from August 2007) show that access mail accounts for 19 per cent of Royal Mail s revenue-derived volumes. 1 Based on Royal Mail operational volumes, including access. Includes all regulated and non-regulated mail, excludes door-to-door and international. 2006/07 volumes are based on operational measurement. For the financial year 2007/08 and going forward, Royal Mail volumes will be measured on a revenue-derived basis, as agreed between Postcomm and Royal Mail. 2 2007 COMPETITIVE MARKET REVIEW

There was a decrease in the volume carried end-to-end by alternative operators from 39 million in 2005/06 items to 34.8 million items in 2006/07. Table 1.1 Addressed letters market by volume 2 Total Volumes 2005/06 (millions) Total Volumes 2006/07 (millions) Volume Growth (%) Royal Mail end-to-end* 19,705 17,846-9 Total Alternative Provider Access 539 1,148 113 Customer Direct Access 618 1,292 109 Total Access 1,157 2,442 111 Other letter products 280 336 33 Total 21,142 20,675-2 Other operators end-to-end mailings 39 35-2 Source: Postcomm with data from Royal Mail Market segmentation, sectors and mail applications Businesses generate 87 per cent of all mail; the main uses of mail for business are advertising mail, fulfilment, general business mail and transactional mail. Although direct mail volumes declined slightly in 2006/07, by around 2 per cent, there are indications that direct mail use is a growing and successful medium in some industry sectors. Distinctions between advertising mail and transactional mail are beginning to blur and measuring trends in this area will become increasingly difficult. 2 Postcomm is working with Royal Mail and other licensed operators on a definition of mail volume market shares. This is a complex matter, for example Royal Mail argues that self-delivered mail (such as local authority items) should be included in these figures. To date, Postcomm s market share figures exclude document exchange mail. There is also difficulty with the treatment of parcels, most of which fell outside Royal Mail s historic monopoly. * Royal Mail inland addressed end-to-end mail comprises price controlled products (excluding downstream access) plus USO non-price controlled products. EXECUTIVE SUMMARY 3

Transactional mail is estimated to be declining by around 2-3 per cent per year, due largely to businesses encouraging their customers and other business to move physical bills and statements on-line. However, while businesses are trying to reduce the volume of physical statements they send, they tend also to be committed to offering customers a choice of communications channels. Some of this decline is predicted to be offset by household growth and the increased volume of transactional mail generated by internet sales. The use of blank spaces on transactional mail for advertising messages may also extend the lifecycle of transactional mail. Fulfilment and publications remain potential growth areas in the mail industry and both tend to be customer driven. According to IMRG, e-retail which drives fulfilment mail now accounts for over 4 billion worth of sales a month, which is driving small parcel and packet growth. In the publications sector, customer magazines are exhibiting the strongest growth. In the last 12 months the industry has seen 16 per cent year-onyear growth as companies invest in customer magazines as a marketing tool. Market developments As of September 2007 there are 18 licensed operators including Royal Mail. Since the last Competitive Market Review two new long-term licences have been granted by Postcomm, and the UK market now has its first franchised operator. End-to-end networks are in evidence in the UK market, however mainly in niche areas, but there is potential for this to grow. The different operators in the postal market do have different customer bases, target markets and business models which are outlined in this report. The role of mail value chain innovation and suppliers to the industry is increasing in importance year on year, and recent developments in hybrid mail are particularly interesting for the future of the market. Royal Mail s performance Royal Mail s financial performance for the year ended 25 March 2007 was weaker than in the previous year, with operating profits from Royal Mail s Letters business falling from 344 million to 194 million, caused by increasing costs, falling mail volumes and constant revenues. In 2006/07, quality of service targets changed to better reflect customer needs. Royal Mail achieved 11 out of 12 of its targets, compared to 10 out of 16 in 2005/06. Royal Mail s failure to meet the target for the number of postcode areas delivering at least 91.5 per cent of first class mail the day after posting was due to industrial action in two postcode areas. 4 2007 COMPETITIVE MARKET REVIEW

International, VAT and the environment Competition is developing at different rates and in different ways across Europe depending in part on the regulatory regime in place from country to country. Liberalised European markets are broadly characterised by relatively stable mail volumes and nationwide competition developing in delivery. Competitive market shares range from 8-12 per cent in Germany, the Netherlands and Spain, which have had elements of mail liberalisation for several years. On VAT, Postcomm continues to support a level playing field for all postal operators, with no significant price rises for customers. It therefore believes that a reduced rate of VAT (of 5 per cent) should be applied to all mail services. However, in light of the European Commission s ( the Commission ) ongoing infringement proceedings against the UK, Germany and Sweden on the interpretation of the VAT exemption for postal services, Postcomm has modelled the effect that different VAT exemption scenarios might have on the UK postal services market. The result of this modelling has shown that the imposition of the full rate of VAT on mail services (17.5 per cent) could result in around 5 per cent decline in Royal Mail volumes, while the imposition of the reduced rate would only result in a 1 per cent decline. Given that Postcomm s preferred option of 5 per cent VAT applied to all services would require unanimous Commission Member State agreement, Postcomm intends to wait for the outcome of the current infringement proceedings before deciding whether to continue to support this option, or whether there is another option available. The environment is an issue with an increasing impact on the mail industry, and those involved in the industry, from trade bodies to operators, are beginning to develop solutions to minimise the environmental impact of mail production and delivery. This is a relatively new market dynamic in the industry, and Postcomm intends to monitor developments in this area. EXECUTIVE SUMMARY 5

2 OVERVIEW OF THE POSTAL MARKET This section offers an overview of the mail market in the UK, including market size, growth, structure and competition. It discusses market segmentation, mail flows and applications of mail in detail, looking at trends where appropriate. The chapter also looks at the related markets of unaddressed mail, express deliveries and international outbound mail. Market size and growth The UK addressed mail market was worth around 6.6 billion in 2006/07. Mail volumes amounted to 21.9 billion items, down 2 per cent on the previous year 3. This is the third consecutive year of mail volume decline in the UK. As domestic letter volumes have been in decline for the past three years, there is growing industry concern that this may be a structural decline based on a mature mail market subject to impacts such as e-substitution. While there is evidence to suggest that substitution has caused mail volume decline, there is also evidence of areas of growth in the market and significant moves away from mail have not materialised. This appears to be due, in part, to the fact that while email and the internet are a substitute to physical mail, there are areas in which they also drive mail volume growth, where there is, in other words, convergence between electronic and physical mail. Physical delivery of on-line orders is an example of such convergence, as is using multi-channel advertising where a customer acquired by email may then be retained via direct mail. Indeed, according to Pitney Bowes, internet users in the UK receive up to 65 per cent more mail than those who do not use the internet. 3 Based on Royal Mail operational volumes, including access. Includes all regulated and non-regulated mail, excludes door-to-door and international. 6 2007 COMPETITIVE MARKET REVIEW

Whatever the pace and extent to which mail volumes may be declining, the role of the postal sector is evolving, as it finds itself influenced by communications, advertising and delivery, all of which now use multiple channels to access receivers, and which are sometimes substitutes and sometimes complementary to mail. The extent to which mail has growth potential will be determined, in part, by the behaviour of mail operators. The pricing and commercial policies of operators, particularly Royal Mail, will undoubtedly impact volume trends, as will operators ability to add value to mail for customers, and to provide innovative solutions and incentives for businesses to continue to use mail. The chart below illustrates the changing dynamics of the postal market. The fact that the postal market is now driven to some extent by different dynamics has meant the economic and demographic link has weakened and volumes are more difficult to predict. Figure 2.1 Inland letter traffic compared with economic and demographic growth 8.0 BREAK POINT 5 year average year-on-year growth (%) 6.0 4.0 2.0 0 86/87 88/89 90/91 92/93 94/95 96/97 98/99 00/01 02/03 04/05 Inland letters Economic and demographic growth Economic growth is weighted by letter demand; demographic growth is measured by growth in number of households Source: Royal Mail OVERVIEW OF THE POSTAL MARKET 7

This trend appears to be consistent with mature mail markets across Europe. Figure 2.2 shows that letter volumes have grown less than the economy in real terms, even in the new member states, illustrating that letter volumes are less related to GDP across most European countries than in the past. Figure 2.2 Member states domestic letter post per GDP: average annual growth, 2000/02 and 2002/04 5.0 2.5 0.0 SK AT EE DK FI MT SE DE FR LU IT EU NL PT ES CY UK GR CZ PL HU SI LV Average annual growth (%) -2.5-5.0-7.5-10.0-12.5-15.0 2000/02 2002/04 Notes: BE, IE, LT confidential Source: WIK Figure 2.3 shows that, in 2004, the UK was the highest per capita mailer in Europe. If the UK mail market is the most mature in Europe, does this indicate limited room for growth? In the United States in 2005, the average household received 1,800 items of mail, while the average UK household received 850. This could indicate per capita growth potential beyond that seen in Europe, although patterns of mail use differ markedly between Europe and the US due to a variety of differences in culture and infrastructure. 8 2007 COMPETITIVE MARKET REVIEW

Figure 2.3 Member states domestic letter post, items per capita 2002 and 2004 350 Domestic letter post, items per capita 300 250 200 150 100 50 0 LV PL SK GR CY EE HU CZ IT MT PT ES SI EU DE LU AT FI FR DK UK NL SE 2002 2004 Notes: BE, IE, LT confidential Source: WIK Because mail trends are impacted by new forces making the market increasingly difficult to predict, it is instructive to examine the different mail sectors to understand their relative size and characteristics in order to understand the underlying factors impacting mail volume trends in the UK. First we look at the overall structure of the market, 18 months after full liberalisation. Market structure The UK addressed mail market has been fully liberalised since January 2006 and, as of September 2007, there are 18 licensed mail providers including Royal Mail. Competition has so far taken two main forms in the UK, access competition and end-to-end. Access Most competitors have entered the market by using third party access to Royal Mail s delivery network. This is known as access competition, and it refers to the process by which an alternative operator collects, sorts and trunks its customers mail to Royal Mail s inward mail centres, turning it over to Royal Mail for final delivery. Around a dozen of Royal Mail s large customers also have customer direct access agreements whereby they arrange directly with Royal Mail access to Royal Mail s inward mail centres. Access customers and operators typically pay Royal Mail around 13p per letter for delivery. OVERVIEW OF THE POSTAL MARKET 9

In 2006/07, mail carried via access arrangements (both operator and customer direct access) accounted for 11.8 per cent of total operational mail volumes for the year. This is an increase from 5.6 per cent in 2005/06. Current access competition As of August 2007, access mail accounted for 19 per cent of addressed revenuederived letter volumes. Just under half of this is carried through access agreements directly with Royal Mail s customers. Figure 2.4 Access volumes April 2006 August 2007 400 (Millions) 300 200 100 0 Apr 06 May 06 Jun 06 Jul 06 Aug 06 Sep 06 Oct 06 Nov 06 Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Total Access volume Operator access CDA 10 2007 COMPETITIVE MARKET REVIEW

End-to-end A second type of competition in the mail market is end-to-end competition, where a competitor provides the entire mailing process from collection to delivery. End-to-end competition is much less developed in the UK licensed mail market to date, representing only 0.2 per cent of licensed mail volumes. While a few operators currently offer end-to-end services, they tend to be local or high-value networks. There are a few operators with stated ambitions to establish national end-to-end networks in the UK, and they may achieve this either by ensuring items are of a high enough value or by having adequate drop-density to make lower priced items profitable. End-to-end networks have been established in other European countries with liberalised mail markets; however, these markets have been open to this type of competition much longer than the UK. The development of competition in European markets is discussed further in Chapter 5. Market segmentation A breakdown of mail flows in the UK domestic market is shown in Figure 2.5. Businesses send around 87 per cent of all mail and their main uses of mail are split between advertising, transactional mail, general business mail, and fulfilment, each explained briefly below. Figure 2.5 Mail flows, domestic v business Domestic-to-domestic 10% Domestic-to-business 3% Business-to-business 27% Business-to-domestic 60% Source: Royal Mail OVERVIEW OF THE POSTAL MARKET 11

Mail applications Advertising According to Royal Mail, 5.03 billion items of direct mail were sent in the UK in 2006, a decline of 2.1 per cent in volume on the previous year. In the past few years, direct mail has shown a slight year-on-year decline, following strong growth from 1996-2003. This growth was driven by large advertisers such as banks and retailers employing national direct mail campaigns to acquire new customers, however, in the past few years, mass direct mailings have tended to give way to smaller, more targeted campaigns which are blended with other media. Direct mail is being used for retention and cross-selling, which amount to lower mailing volumes, although the return on investment of these campaigns may well be higher. Declining volumes have fostered speculation about whether direct mail is approaching market maturity and is destined for long-term decline, as happens in some markets in which products become commoditised, or whether the decline is simply a result of changing posting patterns, with the medium itself presenting further growth opportunities. It could be argued that the postal industry has the main responsibility for ensuring that direct mail remains a valuable marketing medium, particularly as postage costs can account for up to 60 per cent of a direct mail campaign. As other costs come down (input costs such as print, and the cost of alternative media), mail must be seen to be competitive. The mail industry should be in a position to lead on ensuring that mail is a trusted and valuable direct marketing tool. 12 2007 COMPETITIVE MARKET REVIEW

Figure 2.6 illustrates the recent decline in direct mail volumes, which is occurring in both business-to-consumer, and business-to-business mailings. Volumes have been declining in both categories since 2003. Figure 2.6 Direct mail volumes 6000 5000 4000 Millions 3000 2000 1000 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Consumer Business Total Source: Direct mail information service OVERVIEW OF THE POSTAL MARKET 13

The chart below shows the percentage of business-to-consumer direct mail sent by industry sector. Financial services and home shopping account for 45 per cent of all business-to-consumer direct mail. Both these sectors have tended to move away from mass mailings toward mailing to more targeted audiences, which may go some way to explaining the recent volume decline. Although overall direct mail volumes have fallen, Royal Mail has pointed to strong growth in certain market sectors. In the last quarter of 2006, for example, direct mail spend from building societies grew by 18.8 per cent on the same period in 2005, while the charity sector was up 9.1 per cent, government by 6 per cent and health by 5.7 per cent 4. Figure 2.7 Consumer direct mail volume share by sector 2006 (%) Financial 31% Home shopping/mail order 14% Retail 9% Charity 10% Utilities 6% Media/publishing 5% Travel/tourism 5% Government 2% Leisure/entertainment 2% Manufacturing 3% Health 1% Car dealers 1% Education 0% Other 8% Not specified 3% Source: DMIS 4 Royal Mail accentuates positive as mail volumes dip, Precision Marketing, 30 August 2007. 14 2007 COMPETITIVE MARKET REVIEW

Some industry experts suggest that the direct mail decline is due to the increased use of more integrated, multi-media campaigns rather than a significant whole-scale switch to other media, suggesting that direct mail has become just one of many media used in a typical campaign. Indeed, direct marketing budgets overall are growing. The latest Bellwether Report from the IPA, a quarterly survey of marketing spend, suggests that marketing budgets have increased for the second quarter in a row, to the greatest extent since 2004. The report revealed that business confidence is growing and budgets are being revised upward across all marketing sectors. The strongest growth was in internet advertising, which now accounts for 6 per cent of all advertising spend, however, there seems to be evidence of media integration, combining email, direct mail, DRTV (direct response television marketing), and on-line advertising 5. Indeed, email marketing overtook direct mail in terms of volume for the first time in the last quarter of 2006, when 1.6 billion emails were sent, compared to 1.2 billion items of direct mail, according to the DMA s Email Marketing Council 6. A similar trend is shown in the table below. Table 2.1 Advertising expenditure by medium Q1 2007, m current prices, and Q1 2007 on Q1 2006 percentage changes in current prices Q1 2007 adspend Current prices ( m) change year/year (%) National newspapers (Includes supplements) 492-1.8 Regional newspapers 705-3.8 Consumer magazines (Excludes supplements) 188-1.4 Business magazines 203-6.6 Total press of which display of which classified 1,589 869 720-3.3-2.1-4.8 Television 962-0.8 Radio 127-1.8 Outdoor 237 7.7 Cinema 30 9.9 Internet (Internet figure is a WARC estimate) 648 42.0 Direct mail 615-3.6 Total measured adspend (excludes directory advertising) 4,208 3.0 Source: AA Quarterly Survey of Advertising Expenditure June 2007 5 The Q2 2007 Bellwether Report, IPA, 16 July 2007. 6 Email overtakes print in DMA s latest report, Print Week, 16 August 2007. OVERVIEW OF THE POSTAL MARKET 15

This points to a complex, multi-channel direct marketing environment that has altered the underlying business models of agencies and suppliers. A recent article in Marketing Week explains that whereas direct marketing agencies used to rely on a single channel for most income, they now need to spread their activity across a range of marketing channels. Companies are tending to move away from volume mailings toward servicebased offerings, using customer data to tailor messages and offerings, and direct mail is a strong medium for this type of marketing. Email marketing is also good for tailored messages, however, nine out of ten email messages are spam 7, making legitimate email marketing difficult to deliver. Direct mail is a good complement to email here, and helps maintain the integrity of channels to market as a personalised, trusted medium. Often email is used for large acquisition mailings, and direct mail tends to be used for customer retention and brand building. Where large mailers used to use three or four channels to reach their customers, they now spread their marketing budget among up to 15 different media. Although direct mail has declined in overall volume the last two years, there are opportunities for growth, particularly if the medium can add value to customers in a multi-channel environment. Direct mail continues to grow in the United States, for example, aided by organisations such as the National Postal Forum a not-for-profit educational corporation that provides education to business mailers and facilitates communication between USPS and its business customers. There is evidence to suggest that the UK postal industry can encourage mail use and add value to mail as a medium, leading growth in mail volumes. 7 Quality replaces quantity, Marketing Week, 30 August 2007. 16 2007 COMPETITIVE MARKET REVIEW

Case Study BSkyB Company background BSkyB is a media and broadcasting company with 8.5 million direct customers. Mailing profile BSkyB sends significant amounts of transactional mail pieces each year, including bills, statements and welcome letters to its customers. It moved all its transactional mail to TNT Post in 2004. BSkyB also has a direct mail programme, targeting customers and prospects via both addressed and unaddressed mail, the majority of which is also handled by TNT Post. BSkyB sends monthly magazines to its customers and still uses Royal Mail for all its magazine distribution. Why did you switch? BSkyB switched because it receives a 95 per cent day-two drop rate with TNT Post compared to Royal Mail, and it finds TNT Post more flexible to work with. What have been the benefits/experiences to date? BSkyB has received very good benefits from gradually moving most of its mail to TNT, driving valuable savings in its overall postal budget. Although BSkyB has had a few issues with late delivery, they are promptly investigated and dealt with. What would you recommend other mail customers to consider when thinking about switching? You must decide to switch for the right reasons and remember that downstream access is a new product. What are your thoughts on the mail market? BSkyB is concerned about the lack of innovation in the market. It feels that the growth in the internet will have an impact on the mail market, but that mail and the internet can be complementary. Internet and direct mail work well together. The internet raises awareness, whereas people like to respond to direct mail. Our direct mail budget has not been cut. What would you like to see in the mail market in the future? BSkyB would like to see more choice and innovation. Source BskyB OVERVIEW OF THE POSTAL MARKET 17

Unaddressed mail Unlike addressed direct mail, the unaddressed advertising mail market has continued to grow through 2006, although at a decreasing rate 8. Although not part of the regulated mail market, it is interesting to look at the door-to-door market as it is a complementary medium to direct mail, and its continued growth suggests there is sustained demand amongst advertisers for physical, through-the-letterbox communication. Figure 2.8 Size and growth of the door-to-door market 1200 1000 Expenditure ( m) 800 600 400 200 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Distribution expenditure Print and production expenditure 8 DMA door-to-door Council. 18 2007 COMPETITIVE MARKET REVIEW

Table 2.2 UK door-to-door market estimates of size, growth and spend per household 1997 1998 1999 2000 2001 2002 2003 2004 2005 Volume (Items millions) 6,500 7,000 7,950 8,470 9,250 10,170 11,880 12,560 13,045 Year on year increase in volume (%) 7.7 13.6 6.5 9.2 9.9 9.2 9.7 3.9 Average Volume Per GB Household Per Week (items) 5.3 5.6 6.3 6.7 7.3 8.0 9.2 9.7 10.0 Year on year increase (%) 6.8 12.5 5.4 9.0 9.2 16.0 5.0 3.1 Source: DMA door-to-door Council Growth is predicted in door-to-door through 2007, although growth rates are considered to have broadly reached a plateau. According to the DMA door-to-door Council, the door-to-door market has sustained growth for a variety of reasons. Firstly, it is considered to be the most cost-effective way to reach mass audiences, particularly considering the fragmentation that has been occurring in other media such as television and press. On the other hand, it can be targeted to specific audiences when postcode details are overlayed with demographic and lifestyle data, and it can be targeted to retail catchment or government authority areas. Finally, the emergence of companies that monitor door-to-door performance means that efficiency levels can be monitored and the reputation of the industry as a whole has improved. OVERVIEW OF THE POSTAL MARKET 19

Transactional mail Transactional mail volume estimates range anywhere from 6 billion to 10 billion items per year in the UK 9. The portion of this that constitutes bulk mailings from large firms has been one of the main arenas of the competitive postal market, and constitutes a substantial proportion of the 2.4 billion items in access traffic handled by competitors last year. Transactional mail is estimated to be declining by around 2-3 per cent per year, due largely to businesses encouraging their customers to move physical bills and statements on-line. However, while businesses are trying to reduce the volume of physical statements they send, they tend also to be committed to offering customers a choice of communication channels, so the extent to which this drive in cost savings actually reduces transactional mail volumes will depend on customer willingness to move these items on-line. Most large transactional mailers expect to maintain 90 per cent of their transactional mail volumes in the medium term due to customer choice 10. There is evidence to suggest that the predicted decline in transactional mail will be offset, to some extent, by other factors. Transactional mail experiences organic growth from the continued growth in household numbers, which is estimated to continue at around 1 per cent a year for example. There is also evidence that many large mailers are integrating their transactional and advertising messaging using inserts or printing messages on the white space of bills and statements. This adds value to the bill or statement as a communication medium, and sales generated in this way offset the expense of the transactional delivery. All these factors combined suggest that transactional mail volumes will continue to decline gradually in the short term as observed over the past few years, at a rate of around 2 per cent. UK experience and European data suggest that transactional mail is subject to electronic substitution 11 ; however, it is also true that internet-driven sales do, to some extent, generate physical, transactional mail. The use of advertising on transactional mail pieces is blending the uses of mail. Perhaps it is because of the complementary nature of these media that a more significant decline in physical transactional mail has not occurred. 9 OTM discussion paper, OTM Website Estimates that in the UK, 20,000 firms issue 6.7 billion statements, and a further 7,500 telecoms, financial services and utilities firms issue 3 billion bills each year. Triangle Management Services, UK Transactional Mail Survey, 2006, estimates 6.4 billion items of transactional mail sent in the UK in 2004. 10 Based on Postcomm interviews with large transactional mailers, 2006/07. 11 Main Developments in the Postal Sector, 2004/06, WIK-Consult, May 2006. 20 2007 COMPETITIVE MARKET REVIEW