Shareholders of Revolution Bars Group(LSE: RBG) woke up to a shock profit warning on Friday morning, which led to shares in the company collapsing by as much as 40% during the day.
These losses have sent shares in the former growth champion down to their lowest level on record, and after such declines, it is only natural for investors to ask if this is a company that can turn itself around, or is it a falling knife that should be avoided?
Buy, sell or hold?
According to last week's press release, Revolution's management now expects profit for 2017 to be roughly flat. Previously, the City had pencilled-in earnings per share growth of 7% for the year ending 30 June 2017. Management is blaming higher than expected costs as the reason for this revision.
Before the profit warning, shares in the bars group were trading at a forward P/E of 14, a relatively expensive multiple but one that was justified by Revolution's projected and historical growth. For the last fiscal year, earnings per share grew by 14% and for the year ending 30 June 2018, analysts have pencilled-in EPS growth of 16%.
The problem with highly valued growth stocks is that they tend to fall quickly back to earth if they fail to meet expectations. Revolution is the prime example. The company's high-growth multiple, coupled an illiquid market for the shares, exacerbated declines. However, it seems these declines are, for the most part, unwarranted.
Revolution's profit warning was unexpected, and the revaluation of the shares is justified considering growth has now ground to a halt. But assuming the company repeats last year's earnings performance and earns 14.6p per share after declines, shares in the company are currently trading at a forward P/E of 8.6.
What's more, Revolution is flush with cash. At the end of fiscal 2016, the company reported a cash balance of £2.8m and operating cash flow per share of 28.4p. Most of this operating cash flow was spent expanding the group's footprint, leaving a free cash flow per share of 2.7p.
These figures show that Revolution isn't going out of business anytime soon, and the company has plenty of financial firepower to fund its recovery. Even if, in the worst-case scenario, growth stagnates for the next few years, management can dial back capital spending and instead return cash generated from operations to investors, which would result in a substantial increase in the company's dividend yield.
For fiscal 2016, the company paid out 3.3p per share in dividends, covered 4.4 times by earnings per share. Analysts are expecting a total dividend of 5.3p per share this year for a dividend yield of 4.3%. The payout is covered three times by earnings per share.
So, should you buy, sell or hold Revolution? Well, it's clear that while the company does have problems, management has plenty of financial headroom to engineer a turnaround.
The company is highly cash generative and if a turnaround does fail this money may be returned to investors. Also, at the time of writing shares in the company trade at a deeply discounted valuation of only 8.6 times forward earnings. Considering these facts, it looks to me as if Revolution Bars is somewhat of a contrarian buy.
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Rupert Hargreaves owns shares in Revolution Bars Group. 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.