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Royal Mail is set to be kicked out of the FTSE 100, but could it be time to buy?

Royal Mail (LSE: RMG) has just seven trading sessions left to save itself from being dumped out of the FTSE 100 in the last quarterly index review of 2018. According to my sums, as things currently stand, the troubled company has to leapfrog six higher-ranked FTSE 250 firms to get itself above the automatic demotion threshold. That looks a tall order. And I expect insurer Hiscox — currently in pole position for promotion to the top index — to replace the letters and parcels carrier.

Today, I’m looking at the fix Royal Mail’s got itself into. And the question of whether this could actually be a good opportunity to snap up shares in the company.

Profit warning

Over £1bn has been wiped off the value of Royal Mail since the last index review. At a share price of 340p, its market capitalisation is £3.4bn. The reason for this state of affairs is a massive profit warning issued at the start of October.

Management said UK productivity performance had been “significantly below plan.” As a result, it slashed its cost savings guidance for the year ending March 2019, to £100m from its previous £230m. It said it expects adjusted operating profit, before transformation costs, to be in the range of £500m-£550m. At the midpoint, this would be 24% below last year’s level. And the consensus among City analysts is that it would feed down to a 40% collapse in earnings per share (EPS) to 27.3p, giving a price-to-earnings (P/E) ratio of 12.5.

Potential double whammy

In my view, Royal Mail’s P/E is demanding. I see high risk of a further profit warning and a double whammy of deeper EPS downgrades, and a derating of the P/E to single digits.

The group’s letter business is in structural decline, with volumes currently falling at 7%, versus the company’s continuing medium-term expectation of declines of between 4% and 6%. The size of the productivity miss is a big concern, in my book. A gain of just 0.1%, reported with the profit warning, was revised to minus 0.2% in the company’s half-year results, management explaining it had “refined the calculation of workload.” The failure to make £130m of productivity gains this year, and in excess of that amount required next year just to offset ‘known knowns’ in cost inflation, makes this a company running at full pelt and struggling just to stand still.

The balance sheet is decent enough at the moment, but I can see current net debt of £470m rising quite dramatically in coming years. And while this year’s forecast dividend of 24.6p (yield of 7.2%) looks safe, I wouldn’t be at all surprised if management has a rethink on the future payout level.

The demotion of Royal Mail to the FTSE 250 looks very much on the cards. But this is a minor negative, compared with the severity of the downside risk should the aforementioned double whammy of lower EPS and a P/E derating materialise. As such, it’s a stock I’m happy to avoid.

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G A Chester 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.