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Think Royal Mail’s share price is a bargain? Read this now

The Royal Mail (LSE: RMG) share price has experienced a stunning collapse over the last five months. Back in mid-May, the shares were changing hands for over 630p. However, fast forward to today and the RMG share price is at 327p, representing a fall of nearly 50%.

At the current price, Royal Mail trades on a forward P/E of around 10. Does that valuation make the stock a bargain? I’m not so sure. Here are four reasons why I won’t be buying the shares.

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Profit warning

The first thing to note about Royal Mail is that the group released a profit warning last week. It told investors that trading conditions in the UK are “challenging” and that it has “reassessed” its expectations for 2018-19. It now expects adjusted operating profit, before transformation costs, to range £500m-£550m on a 52-week basis, down from £694m last year.

One problem for the group is that letter volumes are declining, and are expected to fall 7% this year. This is due to factors such as business uncertainty, GDPR regulation, and a general ongoing structural decline. Higher costs are also impacting profitability. Furthermore, the group has fallen short on its costs savings programme, revising its 2018-19 cost avoidance target from £230m down to £100m.

So clearly, Royal Mail is struggling at operational level at present. This adds risk to the investment case and I wouldn’t rule out another profit warning down the line.

Dividend risk

The profit warning makes me concerned that Royal Mail’s dividend may not be sustainable. Recently, the group stated: “Our strong balance sheet and long-term cash generation characteristics support our commitment to our progressive dividend policy.”

However, given that the prospective yield is now up around 7.5%, it’s clear the market has its doubts about the dividend. Dividend cover last year was only 1.2 times, so a further drop in profits could put it at further risk.

Analyst downgrades

Another issue to consider is sentiment towards the stock. Overall, City analysts appear to be quite bearish on Royal Mail, going by broker recommendations sourced from Stockopedia.

Out of the 16 analysts covering the stock, five rate RMG as a ‘Strong Sell’, which is definitely not a good sign:

Strong Buy: 0
Buy: 2
Hold: 6
Sell: 3
Strong Sell: 5

Moreover, one consequence of the latest trading update is that we’re seeing some fairly chunky earnings downgrades. In the last month, the consensus earnings per share figure for FY2019 has been slashed by 5.8p (approximately 15%). That’s a large downgrade and won’t help the share price at all.

Set to leave the FTSE 100?

Lastly, it’s worth noting that Royal Mail could be set to leave the FTSE 100 index in the next index reshuffle. Right now, the group’s market capitalisation is £3.4bn, which makes it the smallest company in the FTSE 100. Yet there are more than 10 companies in the FTSE 250 index with market capitalisations currently over £4bn, meaning one of these companies will most likely soon replace RMG in the top 100 index. Dropping out of the FTSE 100 probably won’t be good for the share price either.

So overall, Royal Mail shares look quite risky at present, in my view. As such, I’ll be avoiding the stock for now.

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Edward Sheldon has no position in any 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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