It's been a rough summer for Provident Financial (LSE: PFG) and Carillion (LSE: CLLN) as both companies have been forced into issuing damaging profit warnings that have sent their respective share prices down over 30% and 70% respectively over the past three months. But are either of these stocks falling knives to catch or should investors flee for the proverbial hills?
It was a long time coming
First off, let's look at Carillion. The troubles surrounding the much-maligned construction services group are well known to most interested investors by this point in time. Problems with contracts caused an £845m writedown and deteriorating cash flows lead to net debt rising to £695m on average in H1. All of which was followed by the swift exit of the incumbent CEO, a suspension of dividend payments and the initiation of a strategic review.
In the weeks since this announcement the group has secured several large long-term contracts, but I'm still steering clear of the shares for several reasons. The first is simply that until the findings of the strategic review are released, we won't know for certain whether there are more unprofitable contracts lurking in the shadows or if management will pursue a complete sale of the construction division. I won't be investing in a company whose strategy is completely up in the air.
Second, the problem of fixing the balance sheet is of the utmost importance. With the company's debt load swamping its market cap of just £260m, Carillion runs the risk of breaching debt covenants if cash flow deteriorates even more rapidly. And with a business model that owns few assets and mainly outsources the actual construction work to other firms, it's unclear how much can be raised through asset sales.
Finally, it operates in a competitive and extremely cyclical market. It is not alone among peers with its profit warning and with signs emerging that the UK construction market is going into reversal just as its Middle Eastern markets have, I'm avoiding Carillion like the plague.
Problems of its own making
I'm much more interested in Provident since its profit warning is not due to structural market issues or economic headwinds but rather a bungled restructuring in its home lending division. The company's move to transition from self-employed agents to in-house employees at the doorstep lending business ran into trouble with higher than expected agent attrition, which led to lower client retention and lower collections.
This caused H1 profits from the division to fall from £43.5m to £6.3m year-on-year. However, the rest of the business remains in very good health. Pre-tax profits from the Vanquis Bank credit card arm grew to £100m in the period and those from its Moneybarn auto loan business grew to £16.9m.
Furthermore, while the issue affecting the doorstep lending arm will be felt for the rest of the year the underlying credit quality of customers remains sound and the transition will be completed in July. This means if we see signs of stabilisation or resumed forward progress in H2, the worst should be over.
At the end of the day the company is still growing, has high margins, a large competitive advantage and offers a stellar dividend, all of which are enough to interest me if full-year results show a rebound in trading conditions.
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Ian Pierce has no position in any shares mentioned. 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.