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 |
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.
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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