Stockwatch: Exciting times as this share nears a crux

At 79p, shares in fashion and household retailer Debenhams are of interest for long/short traders: potentially either way, according to the outlook presented with mid-October prelims.

The value of underlying sales has recently flattened which may relate to promotional discounts, while UK wages are rising at the fastest rate in six years - a double-edged sword because it raises the prospect of an interest rate rise at a time when UK personal borrowing has soared. The lowest-ever interest rates on loans have promoted some areas of consumer spending, but it does beg the question why Debenhams is challenged. Such conflicting factors start to explain why broker price targets vary from 60p to 100p.

In the mid-tier of a highly competitive sector

Debenhams' principal dilemma is marketing. Quite like supermarket chain Morrisons, it faces the challenge of how to respond to cheaper rivals while not having the same perceived quality of others.

Mike Ashley was severe in calling Debenhams "crap", but he hit the nail sardonically. When publishing a "sell" note at end-August, UBS cited its own survey suggesting customer intention to buy from Debenhams in the next 12 months has seen the most significant decline amongst its peers. It may relate to customers being inundated with promotions and therefore unwilling to pay full price.

Meanwhile, Debenhams does not have anything like the asset backing Morrisons has developed as a result of vertical integration (e.g. owning suppliers and warehouses). The table shows persistent negative net tangible assets, and the end-February balance sheet had intangibles representing 106% of net assets, whereas Morrison shares trade at around net tangible asset value. Debenhams also has an average of over 20 years on its leases, encumbering the group to adjust, and UBS reckons the stores are about 15% too large.

The chief prop is a 4.4% prospective yield, over twice covered by historic and forecast earnings. Given a forward PE of about 10 times and a stronger-than-earnings cash flow profile (see table), the rating looks roughly fair – but the chart shows plenty of scope for volatility, probably due to a lack of confidence.

Recent performance has flattened

A 25 June trading statement cited flat like-for-like sales for the group for the 15 weeks to 13 June (Debenhams' second half-year) and 0.9% growth over 41 weeks. Besides ongoing promotions compromising sales values, the broad sense is that these numbers reflect Debenhams' stagnation in the mid-tier. And that's despite 2015 possibly being the best year for consumer spending since 2005.

Online is flourishing, however, with sales up 16.7% over 15 weeks and 13.9% over 41 weeks, although that may reflect Debenhams catching up with "click-and-collect" where consumers browse and buy from an extensive online catalogue, then collect at a nominated store. This may be a vital sales modernisation to be competitive, than a genuine growth driver.

More positively, fine September weather ought to be helping sales of autumn-wear hence the start of Debenhams' new financial year, which could benefit sentiment. The longer-term still depends largely on how UK consumer confidence pans out, versus any wider downturn like we initially see in manufacturing, some engineers and plant hirers. Even if the business cycle is already turning down, it's natural to see employment/wage growth continue for a while. Debenhams' challenged position may make it a sensitive indicator, which makes it of wider interest.

Cenkos puts pressure on board

The shares have enjoyed a fillip after a downtrend from 96p last June, rising from about 73p to 79p in response to 21 September reports of an attempted boardroom coup by broker Cenkos Securities.

This appears another manifestation of a lack of confidence surrounding the stock. Like with Morrisons again, management is a lightning rod for shareholder frustration with the dilemmas of mid-tier retailing.

Yet Debenhams' situation also reflects legacy issues from previous US private equity ownership - cash was stripped out rather than investments being made, and the group is still reducing debt. Its last balance sheet shows long-term borrowings down 12% over 12 months to £209.3 million and short-term borrowings down 24% to £125.3 million. Net interest costs clipped 10.6% off interim operating profit, which is manageable. This Cenkos initiative seems unlikely to progress given other institutions appear more patient and the board is likely to resist change – leaving a messy proxy fight the only option, and putting Debenhams' difficulties under a spotlight.

No insider selling, only buying

In fairness to the directors also, they have not sold any material shares this year - last May a non-executive director bought 40,000 shares at 94.3p and on 1 July a senior manager bought 28,000 shares at 89.3p.

It appeared both men were motivated by a sense of value, there not being any subsequent option grant or matching share award for the executive (to motivate a cash buy). Notably the chief executive owns 6.6 million shares and another non-executive director owns 589,000 shares. Dealings are prohibited ahead of prelims, but this is respectable equity ownership, hardly as if management senses stress.

Next is also targeted by sceptical brokers

Reflecting the challenge for clothing and homeware retailers to grow in a highly competitive market, Credit Suisse has cut its rating on Next – an otherwise respected FTSE 100 stock with a firm and rising chart – on the grounds that its means to growth are slowing and the new National Living Wage could hurt margins. So times may simply be becoming harder for general retailers.

Ahead of Debenhams' prelims, which were announced on 23 October last year, the shares are likely to trade with the ebb and flow of sentiment towards the sector.

For more information see Debenhams' investor relations.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.