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Thinking of buying the Royal Mail share price? Read this first

08 Oct 2018, 12:23 ... his-first/

Royal Mail‘s (LSE: RMG) life as a public company has been defined by volatility. In 2014, the firm’s first full year as a PLC, the stock declined 21%, including dividends.

Following the shaky start, management efforts to stabilise the business started to pay off in 2015. For the last three and a half years, the stock has produced a positive return.

However, at the beginning of last week, Royal Mail crashed after the company issued an unexpected profit warning.

Shares in the company have since plunged to an all-time low and are currently changing hands for less than 10 times earnings. At first glance, this low valuation might appear too good to pass up. But if you’re thinking about buying Royal Mail after recent declines, there are several factors you should be aware of first.

The first red flag that jumps out at me when looking at Royal Mail is the group’s growth, or rather the lack of it.

The number of letters posted in the UK has been declining for many years and this trend is unlikely to reverse anytime soon. According to the company’s latest trading update, letter volume declined 7% in the first half of 2018.

To a certain extent, declining letter volumes have been offset by rising parcel volumes — a side effect of the boom in online shopping. The company’s latest update reports a 6% increase in revenue and parcel volume in the first half.

Management has also been diversifying the business overseas. This has further helped offset the letter business decline. Sales at GLS, Royal Mail’s international business, jumped 9% during the period.

The bad news is that parcel volumes and revenues are not growing fast enough to offset rising costs. The firm now expects operating profit, before transformation costs, to come in between £500m and £550m in 2018-19, that’s down from £694m for the year ended March 25. It’s all very well that Royal Mail’s parcel sales are growing, but if profits are falling, investors should be concerned.

Dividend strain
Secondly, I’m worried about Royal Mail’s dividend. After recent declines, the stock supports a dividend yield of 7%, and the payout looks comfortably covered by earnings per share (1.5x on a forward basis). But with profits set to fall this fiscal year, payout headroom will shrink.

Analysts at JP Morgan believe that, in the worst case scenario, Royal Mail will have to borrow to fund its current dividend payout for four of the next five years. This is a concerning forecast and one that hints at a possible dividend cut in years to come.

Still expensive
Thirdly, even those shares in the Royal Mail might look cheap after recent declines, when compared to European peers, they’re not that cheap at all. Indeed, a recent article published in the Financial Times noted that the shares are trading at a valuation premium of about 17% to European peers.

Overall, after considering all of the above, I’m in no rush to buy Royal Mail after recent declines. The stock might look cheap compared to its past trading history, but there are plenty of issues overhanging the business that could lead to further declines.

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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