When a growth stock issues a profit warning, it's not always easy to know whether it's a short-term blip or the start of a major decline.
Today's news from Tracsis (LSE: TRCS) is a good example. Shares of this transportation software firm have risen by 480% over the last five years. But they fell by 14% on Wednesday, after the group issued a cautiously worded trading update.
The bad news
Although first-half sales of £15.5m were 18% higher than last year's comparable figure of £13.1m, the outlook appears uncertain. Tracsis warned that the timing of "anticipated" software sales meant that profits would be weighted towards the second half of the year.
The group also said that in order to hit full-year profit forecasts, it would need to rely on the "timely conversion of new sales" and on delivering savings from cost-cutting initiatives. In my view, these comments suggest Tracsis is getting close to issuing a profit warning. The firm is hoping to win enough new sales to avoid this fate, but hasn't done so yet.
The good news is that Tracsis has historically been profitable and highly cash generative. Net cash was £11.4m at the end of July last year, and the group has no debt.
A shortfall in new sales is unlikely to cause financial problems. This should limit the downside risk for shareholders, who will still have the value of the group's established business to fall back on.
However, that doesn't mean that Tracsis shares won't have further to fall. As I write, the stock is trading at 408p. That's equivalent to a P/E of 17, based on consensus forecasts for earnings of 24p per share this year.
That still looks too pricey to me, especially as these forecasts may be cut following Wednesday's update.
I believe a profit warning is more likely than not after this week's news. In my view, the sensible thing for potential buyers to do is to stand back and await further developments. Existing shareholders may want to reduce the size of their holdings.
Will this stock warn on profits?
FTSE 350-listed NMC Health (LSE: NMC) has risen by 244% over the last two years. This little-known group operates healthcare services in the United Arab Emirates.
NMC's adjusted profits rose by 48% to $67.8m during the first half of 2016, thanks partly to five major acquisitions between June 2015 and June 2016. However, the majority of these deals were funded with debt, and net debt has now risen from $113m in 2014 to $790m.
To put this in context, the group made a net profit of $77.5m in 2014. In 2017, it's expected to report a profit of $199.5m. Looked at in this way, the increase in net debt isn't unreasonable and may well be justified by future growth.
Despite this, I'm not sure that NMC is a compelling buy at these levels. The stock currently trades on a 2017 forecast P/E of 22 times. The shares could fall sharply if earnings growth falls below forecast levels. Debt could also become problematic.
There's no way for us to know whether NMC is likely to issue a profit warning. But debt-fuelled growth and an aggressive valuation make this stock a risky bet for equity investors, in my opinion.
Don't make this costly mistake
It's not always easy to know how to react when political events and profit warnings hit the stocks in your portfolio. But making the wrong choice can be costly.
To help you avoid common mistakes, our experts have revealed some of their biggest errors. In Worst Mistakes Investors Make, you can find suggestions to help you protect the value of your investment portfolio.
Roland Head has no position in any shares mentioned. The Motley Fool UK has recommended Tracsis. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.