Why I’m avoiding the Royal Mail share price at all costs

Royal Mail plc (LON: RMG) shares have plunged over the past 12 months, and this could be just the start argues Rupert Hargreaves.

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Over the past 12 months, the Royal Mail (LSE: RMG) share price has plunged. The stock has slumped 49% since the beginning of March last year, underperforming the FTSE 100 by nearly 50% over the same time frame. Including distributions to investors, the stock has lost 44% over the period, underperforming the FTSE 100’s total return by 5%. 

Today, I’m going to explain why I believe these declines could be just the start of Royal Mail’s fall from grace. 

Undervalued? 

After losing nearly 50% of its value in a year, the Royal Mail share price has started to attract bargain hunters, and it’s easy to see why. At the time of writing, the stock supports a market-beating dividend yield of 8.5%, trades at a relatively attractive forward P/E of 10.4, and is changing hands below its tangible book value per share (311p). 

However, while these metrics might look attractive, in my mind they don’t tell the whole story. 

For example, while the stock’s P/E of just 10.4 might seem cheap, the City is expecting earnings per share to tick lower by around 7% for fiscal 2020. This implies that the shares are trading at a 2020 P/E of 11.1 — that’s not so cheap. 

In addition, you could argue that the Royal Mail share price does deserve to trade at a discount to book value because the company’s return on capital employed — a measure of profit for every £1 of capital invested in the business — is below its weighted average cost of capital. This implies that for every pound the business invests it pays out more than it earns from it. To put it another way, management is destroying value and, therefore, the shares deserve to trade at a discount to book value. 

And what about that market-beating dividend? Well, with earnings per share set to fall a staggering 69% in fiscal 2019, dividend cover will fall to around 1.1 times this year. That might seem sustainable by itself, but when you consider Royal Mail is under pressure to reduce its debt, invest more in the business to boost earnings growth and reduce its pension deficit, it begins to look as if the payout is on shaky ground.

I think a cut of 50% could be on the cards in the near future as this would still leave the stock yielding an attractive 4%+ and would free up more than £100m in cash a year to re-invest back into the business.

Staying away 

So overall, while the Royal Mail share price might look attractive from a valuation perspective after recent declines, I’m staying away at all costs.

I think the stock not only deserves its current valuation but also, if earnings continue to slide, there could be further declines ahead for shareholders especially if management decided to take an axe to the dividend payout, which I reckon is highly likely. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Rupert Hargreaves owns no share 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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