I think this undervalued penny stock has serious potential to outperform

Penny stocks are a very particular type of company. They have a market cap below £100m and a share price below £1. That means they’re small, but have plenty of potential to jump in value if the business starts to take off. Or they could be companies that used to be large but have fallen out of favour. Here’s one I’ve spotted that I think looks undervalued.

Undergoing transformation

I’m talking about Mulberry Group (LSE:MUL). It’s a British luxury brand best known for designing and selling high-end leather goods, particularly handbags. It has a big focus on its ‘Made in England’ heritage and was a much larger brand a decade ago.

Yet over the past year, the stock has risen by 13%, with it currently at 95p. Despite the company still being loss-making, the rise in the share price reflects growing optimism about the turnaround at the business. In the H1 results from last November, losses narrowed significantly to £6.9m from £15.7m, while gross margins improved to around 69%.

This was thanks to a shift away from discounting and tighter cost control. Operating costs were cut by 16%, and management has been actively closing underperforming stores and streamlining the business. In classic turnaround fashion, the company is becoming leaner, a stance I like to see that typically then leads to profitability further down the line.

There’s also a strategic reset under way. Management is refocusing on Mulberry’s core strength, which I agree is its British heritage. It’s pulling back from weaker international markets and focusing on driving growth in key regions like the UK, Europe and the US. In fact, some channels have already returned to growth, even as the broader luxury market remains soft. And only last week it announced a return to the publicity-generating ready-to-wear segment with headline-grabbing designer Christopher Kane in charge.

Undervalued when looking ahead

With a market cap of £68m, the stock is trading at well under 1x annual sales, which I use as a fair benchmark. The price-to-sales ratio is just 0.58. For comparison, Burberry has a ratio of 1.58. This highlights to me that the stock could be undervalued.

If the company can simply return to modest profitability, the earnings recovery could be significant, and the rating could expand quickly. In other words, the share price is still factoring in a lot of bad news.

But when I look ahead, I actually see plenty of reasons why the company could do well. First, cost savings (targeted efficiencies at around £5.9m annually) should feed directly into margins. Second, even a stabilisation in luxury demand could help, given how weak the recent period has been. And third, the brand still carries intangible value that isn’t fully reflected in the current share price. It’s a classic British brand that I think still resonates with many people.

Of course, there are risks involved. The biggest issue I see is that the business is still loss-making, with negative margins and declining revenues. This ultimately can’t continue if the company is going to survive (and thrive). And its share aren’t very liquid with the vast majority held by controlling shareholder Challice and by Frasers Group. Yet even with this concern, I think it does look good value and could be considered by investors.

The post I think this undervalued penny stock has serious potential to outperform appeared first on The Motley Fool UK.

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Jon Smith has no position in any of the shares mentioned. The Motley Fool UK has recommended Burberry Group Plc. 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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