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Should you buy these mid caps after slumping 50% in 2016?

Photo: Betty Longbottom. Cropped. Licence: http://creativecommons.org/licenses/by-sa/2.0/

Increased competition, shifting consumer habits and over-expansion have caused shares of Frankie & Benny’s and Garfunkel’s owner The Restaurant Group (LSE: RTN) to plummet 50% since the start of January. The upshot is that board is taking steps to right the ship by replacing the CEO and CFO as well as closing down a slew of underperforming shops. But is now the optimal time to buy into what will be a long turnaround plan?

What lurks beneath 

Before we answer that we need to examine the business, and what went wrong with it. We’ll start with the good news- the company is still very profitable if we exclude impairment charges related to writing off the value of restaurants. In the first six months of 2016 operating profits came in at £37.5m on sales of £358m, good for operating margins of 10.5%. That said, operating profit was down 4.4% year-on-year and like-for-like sales slumped 3.9%, telling us that there are indeed major problems lurking beneath the surface.

There’s a laundry list of problems. One is that the group expanded too quickly, which led to new stores cannibalising sales from existing ones. This is why management has already marked 33 stores for closure, a figure which I wouldn’t be surprised to see rise in the coming quarters.

The bigger problem is shifting consumer habits. The rise of online shopping is causing lower footfall to the shopping centres where the Restaurant Group places its branches. Likewise, increasing consumer desire for unique, non-branded restaurants is sending them to local restaurants when they do eat out.

Reversing declining footfall will be a long, expensive and arduous task. It’s not impossible but it will require overhauling menus, changing pricing points and re-engaging with lost customers for several different brands. The Restaurant Group may still be profitable, but until signs emerge that it has solved this core problem I won’t be buying shares.

Clipped wings

Former FTSE 250 darling Sports Direct (LSE: SPD) has quite publically had its wings clipped as MPs and corporate governance groups have put founder and CEO Mike Ashley through the ringer in 2016. A series of issues ranging from undisclosed family business transactions and underpaying staff combined with stagnating sales have caused shares to drop over 55% in the past year.

But, Ashley is still the King of Retail, so should investors buy shares and hope for him to work his magic? Personally, I find it difficult to look past the glaring corporate governance problems that have caused such a ruckus, but more hardy contrarian investors may view this as an optimal time to begin a position.

In the latest fiscal year the company’s sports retail like-for-like sales fell 0.8% and EBITDA fell short of target, but the company is still comfortably profitable. And, although net debt rose to £100m, this is still less than a third of full year EBITDA, meaning the balance sheet is quite healthy. If Ashley can concentrate on fixing lagging sales at the core Sports Direct brand I wouldn’t be surprised to see shares climb from their current position. But, at 16 times forward earnings, they’re still far from a screaming bargain.

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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended Sports Direct International. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.