You can make a lot of money from cyclical stocks. But you also need to pay attention to timing if you want to avoid being caught up in costly cyclical downturns.
I believe that ITV (LSE: ITV) is a good case in point. The group's shares have now fallen by 19% from last year's all-time high of 255p. Although the stock is still worth 1,031% more than when it hit a record low of 18.5p in 2009, I think the signs of a cyclical downturn are increasingly clear.
ITV published its 2016 results this morning. The group's revenue rose by 4% to £3,527m, but reported pre-tax profit fell by 14% to £553m. Reported earnings were down by 10% to 11.2p per share. According to the firm, the main reason for this was deferred payments to shareholders and employees of Talpa, the company which produces The Voice, and which ITV acquired for £355m in 2015.
Arguably these are one-off costs that can be ignored. Stripping these out, along with other adjusting items, gives an adjusted earnings figure of 17p per share for 2016. But deferred consideration is normally paid in cash. ITV returned all of its free cash flow to shareholders as dividends last year and is increasing its debt levels to fund acquisition costs.
The group's net debt isn't excessive at current earnings levels. But ITV expects advertising revenue to be 6% lower during the first four months of this year. The business is increasingly dependent on programme production revenues to support profits. I'd prefer to see management scaling back borrowings and building a cash buffer.
We've no way of knowing how reliably ITV's hit programmes will continue to churn out cash. But analysts expect adjusted profits to be flat in 2017. Although the shares look cheap on an adjusted P/E of 12.5, I think this rating understates the risks facing the firm. I'd be tempted to take profits.
This situation could worsen
Educational publishing group Pearson (LSE: PSON) has lost 20% of its value over the last six months. The group claims to have been surprised by the scale of the downturn in demand for its US college textbooks. This triggered a 28% fall in operating profit at the North America division, which accounts for 65% of sales.
I'd suggest that this setback reflects a lack of management control of this business. Press reports suggest that Pearson's sales reps were paid commission on gross orders, not net sales. This reportedly encouraged retailers to order too much, and then return unsold books.
The firm is hoping to turn things around by cutting prices and focusing on e-books and a print book rental programme. Other parts of Pearson's business are apparently trading well. However, the success of Pearson's turnaround strategy is not yet known. In the meantime, the group's financial profile looks average at best.
Adjusted earnings are expected to rise to 49p per share this year, putting the stock on a forecast P/E of about 14. A 50% dividend cut to 26p per share is expected, giving a forecast yield of 3.9%.
Although these figures seem reasonable, they aren't exceptionally cheap. I believe the outlook remains uncertain and would rather invest my cash elsewhere.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has recommended ITV. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.