Investing in turnaround situations can be highly profitable. But there are two risks investors need to watch for.
The first is that the company won't be able to achieve a successful turnaround. The second risk is that it may be too soon to buy.
Still too soon?
Shares of funeral service provider Dignity (LSE: DTY) have fallen by around 60% since the start of November last year. This collapse came after the company warned that intense competition meant that it would have to slash prices in order to protect its market share.
As one of the UK's largest funeral operators, I don't expect this business to fail. But I do think that it's probably too soon to invest in this turnaround. Let me explain why.
1. The shares aren't cheap enough
At just under 900p, Dignity shares are trading at levels last seen in 2012. In that year, the group generated underlying earnings per share of 62.8p. For 2018, analysts are forecasting underlying earnings of about 67.9p per share. That's roughly 8% higher than in 2012. This might suggest that the current share price is about right.
However, the group's net debt was only £299.6m at the end of 2012. By the end of 2017, this figure had risen by 72% to £516.9m.
Another concern is that in 2012, Dignity was seen as a growth business. Today that's no longer true. Earnings are expected to fall by 47% this year and be flat in 2019.
Given the uncertain outlook and high debt levels, I think the forecast P/E of 13 is too pricey. I'd want to see a figure closer to 10.
2. More cuts may be needed
Dignity has hired consultants to help it understand "the relationship between price, service and volume".
It's still too soon to say what the eventual impact on profit margins will be. But I think earnings forecasts could be cut again this year. I also have another concern.
3. Debt worries
The group's debt servicing costs are around £33.2m per year. I estimate that this could account for more than 40% of operating profit in 2018.
In my view, repaying this long-term debt may now become harder to afford. This is one more reason why I'm not keen to invest until visibility improves.
One turnaround I would buy
Shares in television group ITV (LSE: ITV) have now fallen by 46% from their 2015 peak, as investors have questioned the group's growth strategy.
Although the broadcaster has reduced its dependency on advertising by producing more of its own programmes, pre-tax profits fell by 6% to £800m last year.
However, this business remains highly profitable and generated an operating margin of 18% in 2017. Net debt of £932m also seems manageable, compared to earnings of £842m before interest, tax and amortisation.
A potential catalyst
Former easyJet chief executive Carolyn McCall took charge of ITV at the start of 2018. I suspect that Ms McCall is likely to be keen to reverse the fall in profits and return the business to growth.
Adjusted earnings are expected to be broadly flat over the next couple of years, at just under 16p per share. This leaves the stock on a forecast P/E of 9.4 with a potential yield of 5.5%, covered 1.9 times by earnings.
At these levels, I believe the shares look cheap. I'd rate ITV as a turnaround buy.
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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended ITV. 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.