Dignity plc isn’t the only cheap stock I’m avoiding

When funeral service provider Dignity (LSE: DTY) crashed 50% in one day on 19 January, I was tempted. This historically profitable company now trades on a 2018 forecast P/E of just 10, with a well-supported forecast yield of 2.9%.

However, I’ve resisted the temptation so far, and in this article I’ll explain why. I’ll also highlight another stock I’m avoiding after recent news.

Falling market share

For some time, Dignity’s management has been happy to trade off a falling market share for higher profit margins. Between 2004 and 2014 this strategy worked well, with only a modest decline in market share. However, the rate of decline has almost doubled since 2015, forcing the firm’s management to start cutting prices.

Management blames “an over-supplied industry” and “increasingly price-conscious” customers for these changes. But the reality is that businesses which generate unusually high profit margins always attract extra competition eventually, driving down these margins. I think the board has been complacent.

Uncertain profits

In its profit warning, Dignity’s management warned that it expects “substantially lower profits in 2018”. How much lower is uncertain, as the company plans to experiment to see how different price levels affect volumes and profit margins.

I’m also concerned about the group’s net debt of £520m. This is nine times 2018 forecast profit of £55.9m, and requires payments of about £33m each year. Although this will probably remain affordable, I think it will severely limit the amount of spare cash available for further acquisitions, limiting future growth.

I’m surprised that broker forecasts for 2018 have only been cut by an average of 17%. I’d have expected a reduction of 20%-30%. In my view, the risk of another profit warning is quite high. I plan to watch from the sidelines for now.

Just too big?

Until recently, I’ve rated cinema firm Cineworld Group (LSE: CINE) as an excellent growth stock with a successful business model. But the planned $5.8bn acquisition of US cinema chain Regal Entertainment has left the group at risk of indigestion, in my opinion.

To pay for the deal, Cineworld will issue £1.7bn of new shares and raise an extra £3bn in debt. The shares don’t concern me, as earnings from the enlarged group should easily offset dilution.

But extra borrowing means that the combined group’s net debt is expected to be four times earnings before interest, tax, depreciation and amortisation (EBITDA). That’s well above the 2.5 times level that’s often considered to be a sensible maximum.

There’s also a risk that Cineworld will struggle to achieve the same success with Regal’s US business that it’s managed in the UK. In fairness, the omens look good to me. Regal has a 20% market share in the US, where cinema attendance rates average 3.7 visits per year — one of the highest rates in the world.

It could work

Cineworld’s acquisition of Regal may well be an operational success. The group’s management does have a good track record. And with the stock trading on 12 times forecast earnings and with a 4.2% yield, there could be some value here.

However, I’m concerned about the level of debt required to fund this deal. Reducing this could put pressure on cash flow, so I’d like to see evidence that net debt is falling before I consider an investment.

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Roland Head 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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