Investors are always told to run their winners and cut their losers. But when you're investing in turnaround stocks, problems often get worse before they get better. It's not always easy to know when to hold, and when to fold.
On the cusp of a turnaround
Agricultural group R.E.A. Holdings (LSE: RE) is in the palm oil business and operates a number of plantations in Indonesia. This previously profitable business slumped to a loss in 2015, as difficult weather and community relation problems caused a fall in production.
According to today's half-year results, these problems are now largely in the past. Revenue rose by 18% to $46.3m during the half year, and the company says crop production in July and August was "more than double the same period last year".
Although the first-half crop was only 241,235 tonnes, management expects a strong second half to result in a full-year crop of "around 600,000 tonnes", up from 468,000 tonnes last year.
With costs largely fixed, profitability should improve. Do the numbers support this optimistic view?
Debt is a worry
Earnings before interest, tax, depreciation and amortisation (EBITDA) rose by 10% to $8.3m during the first half. Cash flow from operations before working capital movements improved from $8.6m to $10.7m.
However, this cash flow was swamped by the $16.1m of interest payments and preference dividends paid during the six-month period. Net debt rose from $205m to $235m, and I believe this remains a significant risk to shareholders.
Management hopes to be able to reduce interest costs over the next year. But I believe debt levels are far too high when compared to 2018 forecast profits of $5m -- or to historical profits, which averaged about $25m per year between 2011 and 2014. In my view further losses for ordinary shareholders are almost certain.
Today's top turnaround buy?
The recent collapse of Provident Financial (LSE: PFG) made headlines. But now that the dust has settled, I think it's worth taking a fresh look at this 137-year old business.
The shares have bounced back somewhat, but Provident's share price is still down by 73% so far this year, providing investors with an opportunity to buy at a historically cheap price.
Provident's failed attempt to restructure its workforce seems to suggest two big risks. The first is that the group will have lost market share, as rivals have swooped into offer loans to stranded Provident customers.
The second problem is that many of the firm's loans must now be in substantial arrears, as collection rates fell from 90% to just 57% last year. I suspect Provident will have to write off a lot of bad debt if it wants to win back customers and move forwards.
What about the future?
These risks are all public knowledge. So they should already be factored into analysts' earnings forecasts.
On this basis, the shares could be cheap. Earnings are expected to fall by 52% to 78p per share this year, putting the stock on a forecast P/E of 9.8. This is expected to mark a low point, and forecasts suggest earnings will recover to 115p per share next year.
If correct, this would put the stock on a forecast P/E of 6.6. I'd argue that this is probably too cheap for a business which has historically been highly profitable.
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Roland Head has no position in any of the 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.