Royal Mail’s share price is rising. Should I buy the stock now?

The Royal Mail share price is soaring, but are the shares still cheap enough to buy? Roland Head thinks the business still faces some tough challenges.

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The Royal Mail (LSE: RMG) share price has risen by 175% since 8 September. That’s when the company said parcel volumes had increased by 34% since the start of the first UK lockdown. The postal operator’s shares are now worth 170% more than they were one year ago.

Positive trading updates in December and early February have strengthened my view that Royal Mail is on track for a recovery. It’s a stock I’ve thought about buying, but I’m a bit surprised by the speed of the share price gains. Have I left it too late to buy the shares — or is there still plenty of runway ahead?

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Record-breaking numbers

I think it’s worth starting with a look at Royal Mail’s February update, which covers trading during the nine months to 30 December. The group handled a record 496m parcels during the final three months of 2020, as Christmas shopping moved online for most of us.

Parcel volumes have remained high and Royal Mail says it’s kept on 10,000 of the 33,000 temporary workers hired at Christmas. An additional, 6,000 vans have been added to the fleet and temporary parcel centres have been kept open.

Group revenue rose by 30% to £9,312m during the nine-month period, despite a 16% drop in letter revenue. As a result, Royal Mail expects to report an adjusted operating profit of more than £500m for the year ending 31 March.

I’m not surprised Royal Mail’s share price has rallied. But, as a potential buyer, I need to look ahead. Are the shares still cheap based on their growth potential?

What happens next?

I think it’s safe to assume parcel volumes will continue to rise over the next few years. But I don’t expect to see a repeat of the kind of growth seen during the pandemic.

The good news is that Royal Mail’s main union has agreed to support the changes needed to shift the group’s focus from letters to parcels. This will include new measures such as parcel-only hubs and dedicated parcel delivery vans.

I’m pleased with this news. What worries me is that these changes could take longer to deliver and cost more than expected.

The reality is that Royal Mail’s core UK business isn’t very profitable. Last year, the group’s GLS parcels business generated 64% of adjusted profits. My analysis suggests the results will be similar this year, even though GLS revenue is only half that of Royal Mail.

Press reports have suggested GLS could be sold. This would provide funds for modernising Royal Mail. However, I think selling GLS would also reveal the weak profitability of the core UK business. I’m not sure if I’d want to own shares in Royal Mail without GLS.

Royal Mail share price: what I’m going to do

The stock’s recovery has taken Royal Mail’s share price back to where it was in September 2018. Looking ahead, analysts expect earnings growth to continue over the coming year. Their estimates value the shares at about 13 times forecast earnings, with a possible dividend yield of 2.8%.

That may seem like good value at first glance, but I’m not convinced. In my view, Royal Mail still has a lot to prove. I see the shares as fair value at the moment, but that’s not enough to convince me to buy.

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