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One unloved turnaround stock I would buy today, and one I would not

It has been a day of disaster for Merlin Entertainments (LSE: MERL), whose share price is down a stomach-churning 17.68% as I write after today’s trading update.

Stormy weather

The Dorset-based leisure group is the second largest visitor attraction operator in the world, with brands including LEGOLAND, Madame Tussauds, Sea Life, Alton Towers and Thorpe Park. However, the fun stopped with the publication of its trading performance for the 40 weeks ended 7 October, which included the key summer trading period of July and August.

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The report started off sunny with 12.4% revenue growth, or 5.9% at constant currency, helped by the successful opening of LEGOLAND Japan. Then the heavens opened, with management reporting flat like-for-like revenue performance on 2016 due to difficult summer trading in Midway London and European theme parks.

Terror alert

CEO Nick Varney said the summer started strongly but peak season trading was ruined by poor weather in Northern Europe and extreme weather in Italy and Florida. He added: “Our markets continue to be impacted by certain external shocks, not least terrorism which is currently at record levels of intensity in Europe. We also continue to face significant cost pressures, largely brought about by employment legislation, particularly in the UK.”

Merlin also downgraded forward guidance, predicting like-for-like growth in the low single-digits, offset by stronger new business development. The group also plans to cut spending by £100m and concentrate on expanding its successful accommodation portfolio. So is today’s drop a buying opportunity?

Ride the roller coaster

I am concerned by this drop in UK attendances, given that weakened sterling has driven record visitor numbers over the last year. Could Merlin have lost its magic touch? Another concern is that the group is highly exposed to weather and terror and has zero control over either of these threats.

However, it is fighting back with planned new attractions, including LEGOLAND New York in 2020, and planned Peppa Pig and Bear Grylls-themed locations. City analysts remain optimistic, forecasting earnings per share (EPS) growth of 16% in 2018. However, given its valuation of 21 times earnings, and lowly yield of 1.7%, you should belt up for a roller coaster ride.

Education, education, education

Education specialist Pearson (LSE: PSON) also reported today with its shares trading 50% lower than five years ago. However, they are up more than 8% on publication of its nine-month trading update, which detailed a good competitive performance as it accelerated its digital transformation.

It is a mark of low expectations that the stock is flying despite a 2% drop in underlying sales due to the continuing decline in its North American education market, partially offset by increased digital revenue. Trading is tough, but the market knew that already. Investors decided instead to concentrate on the positives, such as the third trading update in a row without a profit warning, and the company’s £300m share buyback programme.

Textbook case

My big fear is that this is a company in structural decline, as the rise of Open Education Resources (OER) in the US makes it much easier for universities to share course material and cut down on textbook costs. In direct contrast to Merlin, Pearson trades at just 10.57 times earnings and yields a whopping 7.75%. However, future growth prospects look fragile at best. Merlin wins by a magic mile, despite that pricey valuation.

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Harvey Jones 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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