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Is it game over for the Asos share price after 40% drop today?

Online fashion retailer ASOS (LSE: ASC) shocked investors this morning, with a profit warning that triggered a 40% share price drop.

ASOS shares have now fallen by more than 60% so far this year. To help you make sense of this sickening drop, I’m going to explain what today’s news means for shareholders and give my view on what you should do next.

Tough November hits online

Until this morning, there was a clear divide between high street retailers and online-only operators. Bricks-and-mortar stores were reporting poor sales, but online sellers seemed to be doing fine.

That’s no longer the case. ASOS said this morning that although sales rose by 14% to £656m during the three months to 30 November, the firm saw “a significant deterioration” in November. Conditions are said to “remain challenging”.

The company says that sales are now only expected to rise by 15% this year, compared to previous guidance of 20%-25%. More shocking is that management expects the group’s operating margin to halve from 4% to 2% this year.

Management hopes to offset reduced cash flow by cutting capital expenditure by about 20% to £200m this year. But this could end up hitting profits — for example, the automation of a US warehouse is going to be delayed, which will delay expected cost savings.

How bad is it?

Although ASOS continued to take market share in the UK during Q1, with sales growth of 19%, this required heavy discounting. It was a similar story in Germany and France, where trading conditions were “significantly more challenging”.

Sales growth in the US was lower than in the UK and EU. And the “rest of world” countries actually saw a sales fall, putting further pressure on profits.

I say stay away

My sums suggest that ASOS’s operating profit could fall by 45% to about £55m this year. I estimate that earnings per share could fall by about 55% to around 50p. At the last-seen share price of 2,454p, that puts it on a forecast price/earnings ratio of 49.

That’s not cheap enough to tempt me, given the newly uncertain outlook for profit growth. I plan to avoid this stock for now.

One fashion stock I’d buy

In uncertain times, I think it pays to focus on quality. In fashion terms, what this means to me is a luxury brand with proven pricing power and a long history. My top pick in this sector would be Burberry (LSE: BRBY).

Founded in 1856, this firm doesn’t depend on cut-price fast fashion sales online for its profits. Instead, Burberry has a valuable luxury brand that attracts buyers from all over the world, including growth markets in Asia.

Profit margins reflect this. The business generated an operating margin of 17% over the 12 months to 30 September. Although earnings are expected to be broadly flat this year, the forecast yield of 2.5% should be covered by free cash flow and backed by the group’s chunky £647m net cash balance.

Quality doesn’t come cheap. But Burberry’s share price has fallen by 25% since the summer and now looks quite reasonable to me, on 21 times forecast earnings. I see this stock as a long-term buy at current levels.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended ASOS. The Motley Fool UK has recommended Burberry. 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.