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Is Luceco a falling knife to catch after sinking 40% today?

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Shares in manufacturer and distributor of LED lighting products Luceco (LSE: LUCE) have dived as much as 40% lower today after it released a profit warning. Clearly this is hugely disappointing for its investors and in the near term, it would be unsurprising if the company’s share price moved lower as the stock market digests today’s trading update. However, in the long run, could there be the prospect of a turnaround? Or is the stock one to avoid at the present time?

Lower margin

The cause of the profit warning is a lower gross margin than expected. It has weakened during the second half of the year, and the company will now deliver a gross margin of around 33%. This will lead to a reduction in profit after tax of £3.5m to £13.2m. This compares unfavourably to market expectations of £16.7m.

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The weakness in the company’s gross margin was not identified sooner due to an incorrect assessment of the value of the company’s stock. Due to this error, the company’s Financial Controller has resigned and system improvements are being put in place to ensure this issue does not recur.

The main reasons for the gross margin weakness have been the strengthening of the Chinese RMB versus the US dollar, as well as the continued weakness of sterling. The company expects to offset some of these headwinds through internal efficiency savings as well as overhead reductions. The gross margin is expected to recover to long-term expectations in the second half of 2018 as a result of company action.

Turnaround potential

As mentioned, in the short run there is scope for further falls in the Luceco share price. Investor sentiment may remain weak for some time, as investors may be waiting for evidence that the company’s gross margin is back up to normal levels. This could create an opportunity for long-term investors who can cope with higher levels of volatility, since the problems the business is facing appear to be temporary. As such, over the medium term it could present an attractive turnaround opportunity.

Difficult trading conditions

Also offering the potential for a turnaround is Debenhams (LSE: DEB). Like Luceco, it has disappointed investors with profit warnings in the recent past and it has led to a major change in strategy. The company is now seeking to capitalise on the potential for ‘social shopping’. This could help it to maximise sales per customer as well as build customer loyalty in the long run.

Following its share price fall of 42% in the last year, Debenhams now trades on a low valuation. It has a price-to-earnings (P/E) ratio of just 6.4, which suggests that it offers a wide margin of safety. Certainly, earnings are due to fall by 14% this year and it faces a tough environment. But with what seems to be a sound strategy, there could be significant upward re-rating potential ahead for the retail play.

In addition, Debenhams has a dividend yield of over 9% at the present time. With shareholder payouts being covered 1.8 times by profit, they appear to be sustainable at their current level.

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Peter Stephens owns shares in Debenhams. The Motley Fool UK has recommended Luceco. 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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