Royal Mail (LSE:RMG) shares closed last week just above 500p. This is down over 10% on the levels seen a month ago. At the same time, the share price is up 133% over the past year. This makes it one of the top performing stocks in the entire FTSE 100 index. So with this relatively small dip, is it worth me taking the opportunity to buy some shares now?
Reasons for the rally in Royal Mail shares
Over the past year, there have been many reasons to be excited by the operations at Royal Mail. The first was the new strategy that the business undertook to slim down and become more efficient. Sadly, this did entail around 2,000 job cuts that were announced last summer. Yet the move towards automation (and estimated cost savings of £130m) meant that it was needed for the future.
After all, the letter and parcel space is very competitive. One key metric showing this is the slim operating profit margin. This measures revenue minus direct costs and also indirect costs. Last year it stood at 5.6%, the year before it was just 3%. It highlights that Royal Mail needs to be sharp on costs in order to preserve profitability and keep Royal Mail shares trending higher.
The above restructure wasn’t the only help over the past year. Due to the pandemic, we all ordered a lot more stuff online. I can use may household as a very valid example here! Thanks to this, parcel volumes shot through the roof, with Royal Mail seeing the benefits.
With the above two key reasons helping to put Royal Mail shares above 500p, I can start to see why it might have started to stall after the large gains.
Concerns going forward
One of my concerns going forward is the outlook for parcel and letter growth. In the latest trading update, parcel volume was down 13% versus the same period last year. The worry here is that as we get back into shopping in-store, parcel volumes are naturally likely to shrink. So the bumper performance from 2020 for Royal Mail is unlikely to be replicated going forward.
Another concern I have with buying Royal Mail shares now is the thin operating margins. The restructure last year helped to cut costs, but going forward the business will need to grow top-line revenue to help the slim margins. If it can’t, I don’t see much more room to further reduce costs. The combination of potential stalling revenue and stable costs will only put pressure on razor-thin margins.
Ultimately, only time will tell if Royal Mail (and the shares) can take the next leg higher. Two-year parcel volume growth (pre-pandemic) for Q1 was still up 19%. Group revenue managed to grow by 12.5% versus the same period last year. So there are definite signs that 2020 wasn’t just a flash in the pan.
From my point of view, I won’t be buying Royal Mail shares just now. I’d prefer to see a larger pullback before I think the risk and reward stack up in my favour after such a strong move in the shares.
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jonathansmith1 and The Motley Fool UK have no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.