The Royal Mail (LSE: RMG) share price has been a standout performer over the past couple of years. From a low of 124p printed at the beginning of April 2020, the stock pushed to a high of 600p at the beginning of June 2021, a return of 380%.
Unfortunately, over the past year, this performance has deteriorated. Over the past 12 months, the stock has returned just 7%. Year-to-date, the performance is even worse. Even though the year is just a few weeks old, the stock has declined 15%.
It seems there are a couple of reasons why the shares have slumped. However, I think this could be an opportunity for long-term investors as the stock seems to me to be undervalued at current levels.
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Royal Mail share price headwinds
Whenever I analyse a stock that has been underperforming, I always try to understand the reasons behind the decline before moving on to the valuation process.
Royal Mail is currently facing multiple headwinds. The most pressing is the disruption from the pandemic. Around 15,000 (10%) of the group’s staff were off sick or isolating in early January. That would be a considerable challenge for any company, let alone one that delivers parcels and letters daily to customers.
As a result of this disruption, costs have jumped. Between April and December of last year, the firm has had to fork out £340m on overtime and temporary staffing solutions. And even this spending has not prevented significant delivery delays.
The group is also facing growing competition from rivals. This has always been a change, but it seems as if the competition is intensifying. To try and deal with this challenge, the group recently outlined plans to cut 700 more management jobs. These cuts will incur a one-off charge of £70m but can deliver annualised savings of £40m.
Company valuation
Considering these headwinds, I can see why investors have been taking profits. Still, I think it is a mistake to concentrate on the company’s challenges without analysing the opportunities.
As demand for delivery services booms, thanks to the growing e-commerce market, Royal Mail’s profits are expected to continue to grow for the next two years. Based on City projections, shares in the corporation are trading at a 2023 price-to-earnings (P/E) multiple of 7.2.
That looks relatively cheap compared to this company’s growth potential. I think it also undervalues the business’s competitive advantages. Royal Mail is one of the most recognisable brands in the country, and its countrywide delivery network is virtually unrivalled.
I think these advantages deserve a premium evaluation. How much of a premium? Well, European peer Deutsche Post shares are selling at a forward P/E of 12.4. I do not think it is too unrealistic to say that the Royal Mail share price could command a similar multiple.
On this basis, I believe the stock could be undervalued by as much as 72%. Although this is the most optimistic scenario, and there is no guarantee the stock will rise 72% from current levels, I would buy the shares for my portfolio today, considering this valuation discount. A potential dividend yield of more than 5% also looks attractive.
