Why I’d dump this struggling turnaround stock in favour of this growth monster

With earnings surging, this growth monster could smash the market going forward.

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Dialight (LSE: DIA) was once one of the market’s hottest growth stocks. Between 2009 and mid-2013, shares in this lighting products manufacturer rose more by more than 1,000% as revenues blossomed and profit margins widened.

However by 2013, competitors had started to cotton on to Dialight’s success. Increased competition, coupled with Dialight’s own failures, resulted in a tidal wave of problems for the group. Profits slumped from a high of £14m in 2012 to a lowly loss of £2.8m by 2016, even as revenues continued to expand, hitting a high of £182m for 2016.

And to me, it looks as if these issues are going to continue into 2018. 

Uncertain year

Even though management issued an upbeat forecast for 2018 alongside the 2017 numbers, reading between the lines, it seems as if a cloud of uncertainty is going to continue to hang over Dialight throughout the year. 

Specifically, CEO Marty Rapp said: “We are taking corrective action and in the near term are wholly focused on the manufacturing challenges which will continue to impact our results in H1.” He then went on to say that “results for 2018 will be heavily weighted to H2.

So until the company can prove that it’s back on track in the second half, I believe the market will continue to view the business with a degree of scepticism, especially considering it’s been struggling to turn itself around since 2012.

Moreover, even if management does manage to right the ship, the stock’s valuation of 15.5 times forward earnings is too costly in my view for a turnaround situation.

Keeping it in the family 

Considering the above, I would dump Dialight in favour of sector peer Dewhurst (LSE: DWHT).

As Dialight has struggled, Dewhurst has pushed ahead over the past five years. For the year to the end of September, the company reported sales growth of 12.2% and profit before tax of £6m, up 17.3% year-on-year.

As well as this growth, there are two other key reasons why I like Dewhurst as an alternative to Dialight. 

Firstly, nearly 50% of the company’s shares are still owned by the Dewhurst family, which means that management is more likely to act in the best interests of shareholders… because they are the shareholders.

Secondly, the company has a more unique product offering than Dialight. Rather than mass producing LEDs, Dewhurst designs and manufactures critical products for equipment such as lifts and so-called ‘street furniture’ such as traffic management bollards. These products are not interesting but they are specialist, and Dewhurst’s strong relationship with its existing customers should help it maintain a leading position in the market.

Unfortunately, the one downside to this stock is its price. Shares in the company currently trade at a forward P/E of 22 and support a dividend yield of 1.1%. With earnings per share set to grow by just 1% for 2018, it’s difficult to justify the premium valuation.

That said, after stripping out cash balance worth 213p per share, the shares trade at a more modest multiple of 17.6 times forward earnings which, in my view, is a much more appealing valuation.

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.

Rupert Hargreaves owns no share 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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