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The Royal Mail share price has surged: here’s why I’d buy

GLS van in front of building
Image source: GLS

When the Royal Mail (LSE: RMG) share price hit 600p in June, I started to wonder if the stock’s rally was getting overcooked. Sure enough, the stock had fallen back down to the 400p mark by October.

This drop didn’t last long. A strong set of half-year results last week saw the stock rally back to over 500p. I wouldn’t normally expect such a roller-coaster ride from such a mature business. But I have to admit that I’ve been excited and impressed by Royal Mail’s recent performance. At current levels, it’s a stock I’m considering for my own portfolio. Here’s why.

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A strong turnaround

Royal Mail’s turnaround ran into trouble under former CEO Rico Back. The German exec — who was one of the founders of Parcelforce owner GLS — stepped down in May 2020. He’d struggled to deliver the pace of modernisation required and was making slow progress with union negotiations.

Back’s successor, Simon Thompson, has fared much better so far. Together with Chairman Keith Williams, Thompson has overseen a boom in demand for parcel services and delivered a raft of modernisation measures. Royal Mail’s relationship with its staff unions — often a difficult area — have also improved.

It’s possible that Williams and Thompson have enjoyed some luck with their timing. UK parcel volumes rose by 33% during the six months to 26 September. I don’t think this would have happened without the pandemic.

I suspect this shift in activity has made it easier to gain workforce agreement to modernise Royal Mail and refocus the business on parcels while reducing letter-handling capacity.

The shares could still be cheap

Royal Mail’s share price has risen by 65% over the last 12 months. But I think the stock could still offer value.

The group is expected to report a pre-tax profit of £791m for the current year, which ends on 28 March 2022. At this level, the stock trades on 8.3 times forecast earnings. A return to normal dividend payments means shareholders can expect a useful 4.1% dividend yield.

In addition to this, the company has promised to pay a one-off £200m special dividend early in 2022. I estimate this should add a further 4% to the payout, giving a total yield of 8%.

What could go wrong?

We’ve all heard a lot about inflation and supply chain problems recently. Rising fuel costs and higher wage bills are putting pressure on profits at many businesses. Williams admits that “we are seeing upward pressure on costs in all of our markets”.

Another concern for me is that the group’s growth will remain sluggish. Last year was exceptional, but broker forecasts for the next two years suggest profits will remain broadly flat.

Despite these concerns, I believe the group is performing well under its new management. The shares look affordable to me and I’m very tempted by this year’s potential dividend yield of 8%. In my view, this enhanced payout should provide a quick cash return to offset the risk of slower growth.

For these reasons, I’d be happy to buy Royal Mail shares for my portfolio today.

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Roland Head 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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