Tuesday, 28 March 2017

Why Debenhams (LON:DEB) has all the hallmarks of a Value Trap

Given the general downturn in the fortunes of high street retailers at this point (both in the UK and the US) I noticed Debenhams is trading rather cheaply. I had a quick look through the Annual Report on my hunt for value. My conclusion is Debenhams is most likely a classic 'value trap.'

Debenhams is a mid market department store chain. They mostly sell clothes but also a variety of other home wares and items. They have neither the exclusivity of special stores like Harrods and Selfridges nor the middle class popularity of the John Lewis partnership. They are unfortunately a bit like BHS - just a bit better.

Debenhams have no particular sustainable competitive advantage to my mind - they have neither the top end brand equity of the aforementioned department stores nor the bottom end low costs of say Primark (part of LON:ABF) or H&M. They also have a weak online presence unlike one of my top picks Next (LON:NXT) or  the rather overpriced growth story that is ASOS (LON:ASC). 

So essentially Debenhams exist in a sort of mid market no man's land. So this begs the question; if the company is not a Buffet style 'moat' business could it be a Graham style 'cigar butt' ? Maybe.

The way I see it Debenhams shareholders have a problem because they are too far down the end of the trough to be adequately compensated for the risk of holding the shares. Here is my pecking order for the economic returns that Debenhams generates;

1.       Commercial Lessors
2.       Pension Fund
3.       Debenture holders and Bank
4.       Debenhams shareholder

Now let me explain.

Debenhams first problem is it leases its stores - no big deal Next does this too, it can enhance flexibility - except Debenhams has £4.58bn future lease payments over the next 20+ years and from what I can see the weighted average lease term must be longer than 10 years given that more than half the contracted lease payments fall in more than 10 years time. By comparison Next discloses the weighted average lease term is 7.5 years. If we capitalise the £216m lease cost Debenhams paid in 2016 with a simple factor of x7 and treat it as debt (it is debt like due to raising operating leverage) then Debenhams would have around £1.5bn in additional debt. That is a lot of leverage for a company struggling to generate £100m in profit per annum. Debenhams is paying out £200m+ a year to its landlords:

Debenhams Annual Report 2016
Now the next thing is the Pension Fund. Debenhams has a defined benefit legacy pension fund. This closed to future accrual in 2006. It is currently a small net deficit on the balance sheet of £4m. But this is the tip of the iceberg as that deficit is made up of £1.062bn in liabilities and £1.058bn in assets. That means the pension liability is more than 10x profits (Next for instance is 1x profits). So imagine a scenario where assets fall 10% or liabilities rise 10% (they even disclose that a 0.5% increase in inflation all things being equal would increase the deficit by £117.8m!); now Debenhams are potentially on the hook for more than 1x annual profit to make up the shortfall. This company is therefore a pension scheme with a retailer attached:

Debenhams Annual Report 2016

Debt holders are the third in line to the returns of Debenhams. The debt holders will always rank above equity in capturing returns. Debenhams has a modest debt of £335m as at Sept 2016. This is composed of £200m of debentures due 2021 paying 5.25% - junk bond coupons in this low rate environment - and £135m of bank credit. This debt is offset by £56m in cash. Interest payments appear manageable 8.5x operating profits but if you factor in adjustment of lease payments as interest (with no adjustment for depreciation) this ratio rises to 1.5x -  a very tight fixed expense base!

Debenhams Annual Report 2016

Now all of this would be manageable if Debenhams were a growing business able to expand profits. But unfortunately Debenhams is a shrinking business! Revenue growth has flat-lined which is somewhat cyclical but margins have been falling for years. Distribution and admin costs keep eating into the profitability of the company.

Amiable Minotaur Model

Amiable Minotaur Model

Therefore when investors look at Debenhams it may look cheap on 8x trailing P/E (12.5% earnings yield) with a 6.3% dividend yield but that P/E is likely to expand due to falling earnings over the long term and that dividend yield is heavily under threat if any cash flow has to be redirected to the pension scheme, higher borrowing costs or escalating rents. 

The dividend is a lure to investors who are presently chasing yield. The dividend looks unsustainable in the medium term if profits continue to shrink along with the flat to down operating cash flow. The dividend probably explains why the share price has not collapsed more completely as it is currently, but precipitously, covered by cash flow and earnings. 

Taking a quick dividend discount model with 3.40p a share in dividends at 6.3% cost of equity (Rf 1.5%, MRP 6%, beta 0.8) and with a growth rate of 0% gives a fair value of 53.97p - exactly the price it trades at today. Risks to the dividend are to the downside though not the upside.

Is there one puff left of this 'cigar butt'? I would say no at the present share price value. The company trades at a discount to book but too much of the book value is essentially illiquid and worthless (leasehold fixtures, software etc) and the company has net current liabilities not assets!  Debenhams could be a trade if the whole sector starts to improve but unlike Next Plc you are not acquiring a quality business at a low value - you are acquiring a speculative leveraged option on a better overall retail environment in the future. And that option is not cheap enough as this is a company whose margins have been declining during the entirety of the last cycle.

Debenhams in the long run is going the way of Sears without some miraculous turnaround in its offering. They have no financial flexibility due to all the different claims on their earnings detailed above. This is a classic value trap. NXT offers a relatively similar valuation level (div yield, P/E) with far healthier metrics and better growth and margins. I would not short Debenhams as it is cheap anyway and may take many years to reach zero.

If I were an employee or ex employee with a DB pension with Debenhams I would be very worried.

Disclaimer: I have no interest in Debenhams plc shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

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