This Neil Woodford favourite isn’t the only stock I’d sell today

G A Chester discusses two stocks that could be set to disappoint.

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The consensus among my Foolish colleagues on engineering support services group Babcock International (LSE: BAB) is uniformly bullish. Two of my fellow writers named it as their top stock in October and the view that it’s oversold and offers strong long-term value is shared by renowned fund manager Neil Woodford, who holds it in both his Equity Income and Income Focus funds.

City analysts are forecasting earnings per share (EPS) of 82.55p for its financial year to 31 March 2018, followed by 86.4p for fiscal 2019. At a share price of 675p, the price-to-earnings (P/E) ratios are in the bargain basement at 8.2 and 7.8, while well-covered forecast dividends of 29.45p and 30.85p give tasty yields of 4.4% and 4.6%. Why so cheap?

Aggressive accounting?

There’s some fretting about the UK’s exit from the European Union and UK defence spending but the bigger concerns for me are the questions raised in a broker note put out by Morgan Stanley (MS) earlier this month.

I’ve previously looked in some detail at signs of aggressive accounting at other outsourcers (which have recently come home to roost), and MS raises similar concerns about Babcock. These include the trend in unbilled receivables, where certain balances, such as accrued income, have been growing well ahead of revenue, “suggesting that some form of credit extension is being used to drive sales.”

In a statement yesterday, Babcock emphasised it takes “a prudent approach to contract accounting,” but the market gave this reassurance only a muted response and I remain concerned about the numbers in the accounts. MS downgraded Babcock from Overweight only as far as Equal Weight in its note but, personally, I’m inclined to err further on the side of caution and view the stock as a ‘sell’.

Floored

Carpetright (LSE: CPR) is a stock I’ve been bearish on for a good while and first-half results from the company today have done nothing to change my view. It reported underlying profit before tax of £2.1m for the 26 weeks ended 28 October, which was about £1.4m below market expectations. Meanwhile, the balance sheet moved to net debt of £22.8m at the period end from net cash of £0.4m at the same time last year.

Furthermore, management said that after a “challenging” first half “we are taking a more cautious view of the second half and now expect underlying profit before tax for the full year will be towards the bottom end of the current range of market expectations.”

A lot further to fall?

Admirably, the company states explicitly what those expectations were: namely, “consensus … £15.2m, with a range from £13.8m to £16.5m.” I calculate we’ll see EPS of sub-15p on the new guidance, which, with the shares down 5.6% on the day at 175p, gives a P/E of no lower than 11.7.

Amidst the unfolding Brexit story, the company acknowledges “declining consumer confidence and an increasingly competitive landscape.” With consumer debt at historically unprecedented levels and the cost of living squeeze intensifying after figures today revealed inflation hit a near six-year high of 3.1% in November, I believe Carpetright’s earnings are likely to come under still more pressure in the coming months and that its shares could have a lot further to fall. On this basis, I rate the stock a ‘sell’.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

G A Chester 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.

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