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Royal Mail share price crashes 25%, but could it be time to load up?

Shares of Royal Mail (LSE: RMG) fell by 17% on Monday following a profit warning. They’ve opened lower again on Tuesday, and are down by about another 8% at the time of writing.

The postal operator’s stock has now lost more than 40% of its value since peaking at 632p in May. As a shareholder, I’m concerned. Today I want to take a closer look at what’s happened.

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Is this collapse justified by the firm’s poor performance, or are the shares now too cheap to ignore?

What’s gone wrong?

One problem is that profit margins are coming under pressure in both the group’s parcels and letters business.

Letter volumes are expected to fall by 7% this year, below the group’s guidance for a 4%-6% decline. Although parcel volumes rose by 6% during the first half of the year, higher costs are limiting gains.

However, the biggest issue seems to be that hoped-for cost savings and productivity improvements are not being achieved.

Productivity problems

As part of the wage and pensions deal struck with trade unions earlier this year, Royal Mail agreed to cut working hours. In exchange for this, it would make changes that would generate £230m of cost savings and productivity gains.

This is no longer going to be possible, at least not this year. In Monday’s statement, the company said that its “cost avoidance target” has been lowered from £230m to just £100m for the year ending 25 March 2019.

As a result, the group’s adjusted operating profit before transformation costs is now expected to be between £500m and £550m. The equivalent figure last year was £694m. Subtracting the missed £130m of cost savings gives a figure of about £564m, so it seems that the group’s underlying profitability is also expected to be lower this year.

Is the dividend safe?

In yesterday’s statement, the firm said that it remains committed to its progressive dividend policy. This suggests the payout should be safe. But this year’s forecast payout of 24.9p per share will cost the firm around £249m.

Is this affordable? Ultimately, a dividend is sustainable if it’s backed by free cash flow. Royal Mail has a good track record in this area. In 2016/17, my sums suggest the group generated free cash flow of £419m. In 2017/18, this figure rose to £499m.

Yesterday’s profit warning suggests to me that cash costs will be higher than expected this year. This could result in a sharp reduction in free cash flow. The problem is that we don’t know how much this figure will change.

For now, I’m going to say that the dividend can be held. But I don’t think the payout looks as safe as it did last year.

Should you buy, sell or hold?

I estimate that the shares now trade on a forecast P/E of about 10, with a prospective yield of 6.9%.

That looks cheap enough. But profit warnings rarely come singly. There’s a risk that Royal Mail’s new chief executive, Rico Back, will be forced to issue another profit warning later this year.

I’m probably going to hold onto my shares until November’s half-year results, when we’ll get more detail about the group’s financial performance. But I won’t be buying any more shares just yet.

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Roland Head owns shares of Royal Mail. 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.