Key points
- Royal Mail looks cheap against a key European rival
- RMG shares offer a tempting 5.4% dividend yield
- But I can still see some turnaround risks
As the New Year rolled in, the Royal Mail (LSE: RMG) share price was happily bumping along at over 520p. One month later, the shares are down by 13% or so, at around 450p.
At this level, Royal Mail shares look cheap to me — and as I’ll explain, I think there are some good reasons to suggest that a fair value for the business could be much higher.
The pandemic has put pressure on Royal Mail’s staff, but it’s been a massive success for the group’s parcel business. Parcel volumes during the final quarter of 2021 were 5% lower than during the same period in 2020 but were 44% higher than in the final quarter of 2019.
Royal Mail boss Simon Thompson is convinced that there has been a permanent shift in parcel volumes since before the pandemic. I think there’s still a risk that volumes could fall further, as people return to the shops in more normal numbers. That wasn’t the case before Christmas, in my experience.
I’m also concerned that cost pressures may end up being worse than expected. Royal Mail has a large workforce and significant energy costs — both areas where costs have risen sharply over the last year.
Could the Royal Mail share price hit 780p?
Despite these concerns, I think Royal Mail shares could be seriously cheap at current levels. My view on this is based on the valuation of rival firm Deutsche Post, the German group which owns DHL and operates the German postal system.
Although Deutsche Post is a larger business, I think there are many similarities with Royal Mail and its GLS international parcels business (which owns Parcelforce in the UK).
Deutsche Post shares are currently valued at 13 times forecast earnings, with a 3.3% dividend yield.
In contrast, Royal Mail shares currently trade on just 7.5 times forecast earnings with a 5.4% dividend yield. If the UK firm was valued on the same P/E ratio as Deutsche Post, then Royal Mail’s share price would rise to around 780p. That’s more than 70% above its current level of 450p.
A massive bargain?
I think there are a couple of reasons why Deutsche Post deserves to be more expensive than Royal Mail. One is that the German group is larger and has slightly higher profit margins. Another advantage is that Deutsche Post has a much longer record of strong performance — Royal Mail is a very recent turnaround.
Even so, I would be comfortable valuing Royal Mail on at least 10 times forecast earnings. That would price the stock at around 600p — well above current levels.
If Royal Mail continues to perform as well as it has done over the last year, I think the share price is likely to recover steadily. At today’s price, I’d consider Royal Mail a possible value stock for my portfolio.
