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Is this as good as it gets for these battered growth stocks?

Image: HSS Hire: Fair use

Even the best growth stocks don’t usually have a smooth path upwards. There are often setbacks along the way.

Spotting a good growth stock that’s temporarily out of favour can give us an opportunity to buy into a strong story we missed the first time round.

A quality business

Shares of Jet2 holiday business owner Dart Group (LSE: DTG) rose by more than 5% today, after the company said underlying pre-tax profit for the year ending 31 March would be ahead of expectations. According to Dart, winter losses were lower than expected, boosting full-year results.

As a package holiday specialist, Jet2 makes all of its profit during the summer season. A loss during the winter is normal. However, Dart stock has fallen by 20% from an all-time high of 684p over the last year, due to concerns that the group’s earnings growth could stall.

That’s still a risk. The group has been investing heavily recently. It’s opened new operating bases at London Stansted and Birmingham airport and ordered a number of new aircraft. Capital expenditure rose by 33% to £80.1m during the first half of the current year, as payments were made on aircraft deliveries and upgraded facilities.

Dart’s 2016/17 earnings should beat current forecasts of 49p per share. But profits are still likely to be lower than they were in 2016 and a further fall is expected for 2018.

However, while capital expenditure is pushing down the group’s profits, sales are still rising fast. Revenue is expected to have risen by 20% to £1,681m last year, and similar sales growth is forecast for 2017/18.

I expect the group’s increased spending to support for medium-term profit growth. With the stock trading on a 2018 forecast P/E of 14, I believe now could be a good time to buy.

This stock is down for a reason

Equipment hire firm HSS Hire Group (LSE: HSS) is down by 7% at the time of writing, thanks to a very poor set of 2016 results.

Although sales rose by 9.6% to £342.4m, adjusted pre-tax profit was unchanged at £5.8m. This means that HSS’s profit margins were lower. In this case, the operating margin fell from 6.5% to 6.0%. No final dividend will be paid for last year, a decision that is inevitable given HSS Hire’s biggest problem — debt. In my view, shareholders should be much more concerned about this than about any change in sales or profit margins.

HSS Hire ended last year with net debt of £219.4m. To put this in context, the group’s property portfolio and its entire fleet of hire equipment were only worth £178m at the end of 2016.

I’d normally expect a business of this kind to finance 50%-75% of the value of its fixed assets. But this group’s assets are worth less than the debt used to buy them. That’s an unsustainable situation, in my opinion. HSS Hire’s balance sheet looks very strained to me and I believe the firm needs refinancing. Additional debt is not an option, so a big rights issue seems the most likely option.

I estimate that £50-£100m would be required to put the group on a sound footing. Given that HSS Hire’s market cap is just £106m, a fundraising of this size would cause major dilution for existing shareholders. In my view, HSS Hire is a strong sell.

You could make 41% on this small-cap

I'm confident there are better buys elsewhere. One potential example is this stock, which our experts believe is significantly undervalued. The company in question is a UK business with a solid record of growth and sound finances.

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Roland Head 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.