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I think the Royal Mail (LSE: RMG) share price is one of the most interesting stocks on the London market.
The company provides an essential service for tens of millions of people every day, yet it is constantly fighting for market share. It has an obligation to provide a delivery service across Great Britain, But it has to work through the challenges of doing so itself.
Meanwhile, competitors can pick and choose the markets they want to serve. That means they can concentrate on the markets with the greatest potential for profit, such as London, where they can serve millions of consumers with just a few key depots.
Royal Mail cannot do the same. The company has to provide the same level of service to remote islands in Scotland as it does to the rest of the country. This presents a massive logistical challenge for the group and one that is continually working to improve and streamline.
Valuable brand
Despite these drawbacks, the company has a treasured brand that consumers across the country trust. This was particularly evident when the coronavirus pandemic began at the beginning of 2020. Consumers relied on Royal Mail to send parcels and letters to loved ones.
The pandemic had a meaningful impact on how consumers interact with the enterprise and how the business operates. The boom in e-commerce deliveries and transactions encouraged the company to rethink how it does business.
It launched a stay-at-home parcel pickup service and has begun to roll out parcel postboxes across the country. These initiatives mark some of the most significant changes to the postal service in its long history.
They are just some of the changes management is trying to push through to improve efficiency and enhance the company’s standing with consumers in an increasingly competitive environment.
A hidden asset in the Royal Mail share price
I think the market often overlooks the company’s international business when analysing the establishment. The enterprise is more than just a UK postal service as it also owns a sizable international business, which management plans to expand significantly.
The GLS international division allows Royal Mail to do what its competitors are doing in the UK, but internationally. It can pick and choose profitable markets in which to operate.
While GLS has only around half the revenue of the UK arm, it is expanding rapidly. The group can leverage the experience of operating in the UK market across its international business. This will help it take on the likes of UPS and DPD.
Over the next couple of years, management wants to increase the size of this division. It is targeting an increase in operating profits to €500m by 2024-2025 and revenue growth of 12% per annum over this period. If the group can hit these growth goals, management believes the division can generate €1bn of free cash flow.
To help meet this aim, towards the end of last year, Royal Mail acquired a Canadian company Rosenau Transport.
Growth targets
Based on the growth targets for the international business and the company’s expanding presence here in the UK, City analysts believe the corporation can generate a net profit of £596m in the 2022 financial year, rising to £613m in the 2023 financial year.
It is far easier to predict a corporation’s potential over the next couple of years than it is over the next decade. Nevertheless, as a long-term investor, I always like to analyse a company’s potential over the next five and 10 years to understand how the opportunity will develop. If I can build some idea of how the enterprise will grow over the next decade, I can better assess whether or not it will be a good addition to my portfolio.
The Royal Mail share price has a lot of potential over the next couple of years. Still, it would be silly of me to ignore the company’s challenges as well.
As well as the competitive factors outlined above, the firm will also have to deal with the rising cost of living. This may push up wage costs for the group. As the enterprise has a mixed history of worker/management relations, this challenge could become a headache.
The company also faces high costs as it tries to modernise its operations. Automating the parcel sorting process is one of its key aims. Automation should ultimately reduce costs in the long run. In the meantime, it will mean higher capital spending requirements.
To help offset rising costs in some parts of the business, Royal Mail plans to lay off several hundred managers. This is all part of the group’s ambition to streamline operations and improve efficiency.
The problem with a strategy like this is that it could lead to more problems down the line. Cutting staff could hit employee morale and rob the company of vital experience.
Royal Mail share price valuation
Despite these challenges, I think the Royal Mail share price is undervalued compared to its long-term potential. The company essentially has a captive market across the UK.
As long as it can maintain its relationship with customers and employees, it should be able to build on the growth it has achieved over the past couple of years.
This suggests profits and earnings should rise steadily from current levels over the next decade. As the stock already looks cheap compared to its earnings potential, I think this means the shares could produce a solid positive return over the next decade.
Indeed, at the time of writing, the stock is trading at a forward price-to-earnings multiple of around 7.5. That is significantly below the market average of approximately 12. On top of this attractive valuation, the shares also support a dividend yield of 5.7%.
I think this is incredibly attractive in the current interest rate environment and only adds to my conviction that the stock is an attractive addition to my portfolio.
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Rupert Hargreaves 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.
