Are Pendragon plc and Dialight plc falling knives to catch after dropping 15% today?

Car retailer Pendragon (LSE: PDG) shocked the market on Monday, when it issued a profit warning and a surprise strategy update. The firm's chairman also announced that he would stand down immediately, albeit for "personal reasons".

Pendragon shares have fallen by 18% to 24p at the time of writing. In this article I want to consider what we know and whether the shares might now deserve a closer look.

Profit slump

The immediate concern is that profits appear to have fallen sharply. Full-year underlying pre-tax profit is now expected to be about £60m, around 20% lower than the £75.4m figure reported last year.

The company -- whose UK businesses include Stratstone and Evans Halshaw -- says that the drop in sales is due to falling new car sales and a consequent drop in used car prices. During the third quarter, the firm's gross profit on both new and used cars was 20% lower than during the same period last year.

What concerns me most is that the slump in profits appears to be very rapid. During the six months to June, underlying pre-tax profit was £48.5m. If Pendragon expects a figure of £60m for the full year, then that implies that second-half profit is only expected to be about £12m. That's a big drop.

Change of strategy

To try and reduce its exposure to the cyclical new car market, Pendragon wants to pivot its business towards software and used cars. The group produces a software system widely used by car dealers and is aiming to double used car revenue by 2021.

By contrast, the new car business is being placed under review in both the UK and the US. It's not yet clear what the outlook is for next year, but with new car sales falling I'd be very cautious. In my view Pendragon isn't cheap enough yet to be a recovery buy.

I might consider this one

Shares of LED lighting group Dialight (LSE: DIA) fell by 15% on Monday morning, after the firm warned that profits would be lower than expected this year.

This company ran into trouble a couple of years ago, but appeared to be on the road to recovery last year. Earnings per share were forecast to rise by 31% this year and by 44% in 2018.

However, Dialight's turnaround strategy included a shift to outsourced production. This transfer appears to be causing some "short-term challenges". As a result, full-year operating profit is now expected to be £13.5m to £15.5m.

The equivalent figure for last year was £13.1m, so Dialight is still on track to report profit growth this year. But the gain is much less than was hoped for.

Although today's news is disappointing, this turnaround does appear to be heading in the right direction. Teething problems with outsourced manufacturing aren't entirely surprising, after all. Despite these problems, the board still expects to end the year with "a strong net cash position", and is considering reinstating the dividend.

I estimate that Dialight shares trade on a 2017 forecast P/E of about 25 after today's fall. But if earnings rise as expected next year, this P/E could fall to around 15 in 2018. The shares might end up looking cheap at under 700p.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Pendragon. 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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