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At under 500p, should I buy Royal Mail shares?

A Royal Mail GLS delivery man
Image source: GLS

Since the stock market crash last year, Royal Mail (LSE: RMG) shares have recovered extremely well, rising from 124p to highs of 600p in June. But this recovery has slowed in the past couple of months, with shares falling around 18% to the current price of 494p. But does the dip offer the perfect time for me to buy this FTSE 100 stock?

Trading updates

One catalyst for the rise in the Royal Mail share price was its excellent full-year trading update in May. This showed that revenues had managed to rise over 16% from the previous year to over £12bn. Operating profits also reached £702m, a rise of 116% from the year before. This full-year performance far exceeded initial expectations and was mainly due to the strong parcel growth at both Royal Mail, and its subsidiary, GLS.

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But I was slightly less impressed with the recent first quarter trading update, which I feel has contributed to the recent dip. Although revenues were able to increase further in comparison to last year, parcel volumes for Royal Mail decreased. This was due to the reopening of shops, which has led to reduced demand in e-commerce. As such, there is some uncertainty whether last year’s excellent performance was a one-off for Royal Mail. Therefore, I expect that profits may be lower this year.  

Valuation

From a valuation perspective, Royal Mail shares are cheap. This can be shown by its price-to-earnings (P/E) ratio of 9.5, which is lower than the majority of other FTSE 100 stocks. But as already pointed out, the company has recently suffered lower parcel volumes, and this may cause profits to dip this year. This may mean that the current P/E ratio may be slightly misleading.

Furthermore, management are also having to invest a large amount of money on infrastructure and modernisation. This is essential for the business, especially due to the large amount of competition it faces. Nonetheless, it will also have a negative impact on profitability, especially in the short term. Accordingly, this may cause volatility in the Royal Mail share price, and it could easily dip even lower.

Would I buy Royal Mail shares?

Despite these risks, I still feel that this modernisation is essential for the company’s long-term future. The group also used last year as an opportunity to slim down, and this entailed mass restructuring. This should help the company improve its profit margins over the long term. Poor profit margins have held the group back in the past, so this is an essential step forward for the company.

I feel that parcel volumes are also likely to rebound, due to the continuing rise of e-commerce. This means that 2020 may not have just been a one-off, and the group will hopefully be able to replicate this performance again at some point.

Accordingly, although I can see the Royal Mail share price falling back further in the short term, I still believe that it’s a solid long-term buy.

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Stuart Blair has no position in any of the shares mentioned. The Motley Fool UK has 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.

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