Debenhams PLC is yielding over 6% that is three times higher than the UK deposit rate. Does this make it a dividend income stock?
As one of Britain oldest department store. (it has over 200 years of history) It knows a couple of things about being competitive. It survived more than seven generations, so it must be durable. The company is so old, the customers were arriving at their stores on horseback!
But, there are counterarguments about the risk of high-yield, more on that later.
A Brief Background
Debenhams was taken over in 2003 by three private equity firms. It got loaded up with debt in three years and was back in the market. In 2006, the IPO price was £1.95/share, it raised £950m, and within two years the stock lost 80% of its value.
The reasons given are the UK got caught up in a financial crisis. This led to Debenhams making less money, whiles it tries to reduce debts on its books.
Reasons to buy or not to purchase a “high-yielding” dividend stock
The reasoning for the purchase of a high-yielding dividend stock are:
- It puts a floor on the stock price;
- Dividend paying stock don’t rely completely on capital gains;
- Dividends can give you staying power;
- The company may be solid;
- They pay you to hold them (a trivial point);
- They outperform the market;
- Instil discipline in management;
- Shareholder friendly;
- Their value is easy to understand;
- Dividends income gives you extra income (£5,000 tax-free).
On the flip side, there are valid reasons to avoid high dividend stocks.
These can be:
- The business no longer has a competitive advantage over rivals;
- It is no longer generating cash and has a lot of debts in their books;
- The company is cyclical in nature, as the dividends are likely to get cut;
- Government policies change affect the fundamentals of the business;
- It can go bust!
So, which camp does Debenhams belong in?
Does Debenhams PLC High Yield Represent Value or a Value Trap?
The Debenhams “deleveraging” Process
One reason why people consider dividend stock a value trap is too much debts in the balance sheet.
Debenhams shares never recovered back to £1.95/share. Since the financial crisis, the stock trade in a range between £0.25/share to £1.10/share. Now, it fetches £0.52/share. The three private equity firms leverage the department to the tune of £1.9bn. It couldn’t survive as a private business. So, there was one option left, and that was moving back to the LSE to seek financial institutions and retail investors cash.
(N.B. The IPO raised a total of £950m with £250m shared among the owners, and the rest used to reduce debts.)
After ten years, total debt got reduced to £335m.
Explaining the level of debt during Debenhams IPOs
Debenhams was not a flourishing business when it got relisted. The company had a high debt to capital ratio surpassing 150%, due to negative equity.
Now, debt represents less than 30% of total capital.
To express this solvency concerns for Debenhams, I used two simple ratios. One is the Time Interest Earned ratio, that is earnings over net interest costs, and the other is total debt to earnings ratio.
In 2006, the Time Interest Earned ratio covered two times net interest. Meanwhile, total debt is over 15 times greater than its earnings. My preference is four times interest cover and approximately 6 times debt to earnings.
There is no right answer, and different investors have their favourite preferences!!
So, what I would do is to invert both the time interest earned and debt/earnings ratio to get a percentage (%). Why?
Because of this rule:
If the “inverted” Time Interest Earned (%) is greater than the “inverted” Debt to earnings (%), then a business is occupied paying off their loans.
It effectively means Debenhams is working for the debtholders, and not the shareholders, period! Here is the “Inverted” ratios chart:
As you can see, Debenhams missed 3 out of 6 dividends payment when inverted time interest ratio (orange line) was above the blue line. After the crossover in 2010, the retailer never missed a dividend payment as debt levels become manageable.
Now, Debenhams net earnings cover interest over 9 times and total debt is under four times greater than net income.
Lessons Investors should take away from Debenhams IPO
Turning on your business mindset and avoiding IPOs hype is critical. You need to take into account, the size of Debenhams’s debts and annual interest charge. Then, ask yourself these following questions:
- Is the company able to pay shareholders a dividend after financing its debts?
- What were the size of the retailer’s debt before its takeover from three private equity firms?
- What was the purchase price of Debenhams when it got taken over?
- Debenhams didn’t pay a dividend for two years since floating back to the market.
- Before the private equity takeover, Debenhams has total debt of £100m.
- They paid £1.7bn for Debenhams, but during the three-year period, the owners took out a total of £1.3bn and left them with the debt!
(This is a great article from Business Insider on IPOs: “5 Reasons Investing In An IPO Could Be A Terrible Idea”)
Sales at Debenhams are steady, but slow, like a mature business.
Since making a comeback, Debenhams saw incremental sales increase more than £50m each year till 2011. And from then on it never broke that £50m barrier. With output stagnating, surely management is focusing on margins improvement?
Here is the funny thing, operating profits at Debenhams declined by 60% since 2006. But it didn’t stop operating cash flow from remaining consistent. (More on that later)
One reason behind Debenhams lack of earnings growth or decline is down to increasing rental expenses. That doubled in ten years from £100m to £220m, so adding unnecessary expenses to the business.
Looking deep into the department store leasing policies. It showed total leases peaked in 2011 with steady declines the years after. But the problem lies in the duration of the leases due. What I mean is:
Leases, due within a year doubled (SEE GRAPH 3), but leases due within two to five years’ duration, also doubled. Then, future rental costs will remain high for longer. (Refer to the graph below)
Not everything is bad news, as Debenhams has operating lease incentive close to £350m, marked under “Non-Current Liabilities” on their balance sheet. The mechanics behind operating lease incentive is future discounts on rents when agreeing to long-term lease contracts.
What we don’t know is the period the amount covers, therefore we can’t assess the positive future impact it would have for Debenhams. For example, if this covers 10 years, then Debenhams enjoy a £35m discount to rents per year. If its 20 years, this falls to £17.5m per year, therefore less meaningful.
Quality in Earnings
As mentioned earlier, operating cash flow been performing consistently. Debenhams didn’t take advantage of delaying payments to suppliers as cash cycle days remain stable. This is one positive aspect because it helps the firm to continue paying off debts and having enough left over for dividends payout.
Debenhams increase spending not translating to increase sales growth
Online represents 15% of Debenhams total sales, and that is low. Rivals NEXT PLC online sales represents 48% of total sales. From their annual reports, I can say they were spending more to boost their online division, as intangibles spending rose from £19m in 2011 to £47.2m in 2016.
Despite, reports of online sales growth in the double-digits. I get the feeling that online is cannibalising the retail division. And yet, Debenhams didn’t have online vs. retail revenue breakdown at hand.
Summary of Debenhams fundamentals
- Debenhams shares are still 75% below IPOs price, despite most of the company’s debt getting paid off.
- Since being back in the market, Debenhams saw the biggest deleveraging of debt reduction from £1.9bn to £330m (most of the money are from investors).
- It currently yields over 6%.
- Operating profits have fallen by 67% since 2006.
- Debenhams has superior net cash earnings over accounting income. It makes for a robust business making dividend payments.
- Debenhams online sales represent 15% of total sales, and the firm is spending more to build up its online presence.
Presenting Debenhams’s MARKET METRICS RATIOS:
The idea is to use a range of market metrics to gauge the undervaluation/overvaluation of Debenhams. This is done by taking an average and by comparing it to the current valuation of the business.
For Debenhams, there are 13 market metrics, and from the ten-year averages, the shares are undervalued by 44.86%. Meaning at £0.53/share, Debenhams should trade around £0.77/share.
As ever, markets are forward-thinking and is forecasting weaker profitability for the department store. (See, my opinion for share forecast and reasoning)
A more direct (or active) approach is assessing the company’s likely directional share price movement.
But looking at the weekly chart, there could be short-term buying opportunities if the share price goes below £0.51/share. The is signal a weak.
(P.S. Judge for yourself!)
First, the latest trading update is an improvement in gross margin by 25 basis points. But no mentioning of profits guidance.
On the fundamentals, Debenhams is getting back in shape with low leverage and strong cash earnings. But, markets factor in the future. And this is a challenging year for retailers with rising input costs from the weaker pound, as well as high domestic bills such as the increase in the National wage, business rates revaluation and energy bills. All this leads to increasing costs and lower profitability margins.
Instead of giving a share price target for Debenhams, it is best for me to give a share price guidance for 2017 of between £0.35/share and £0.65/share.
Finally, would I recommend investing in Debenhams shares for income? Yes, I would advocate for the long-term. That is because the department store valuation is marked down heavily, despite the deleveraging process.
The opinions are expressed independently by the writer for entertainment and research purposes and not taken as investment advice. Data is correct on available information at the time.
Finally, the writer does not own the company’s stock, unless stated otherwise.
Call to Action
Do you agree with my Debenhams piece, if so why?
What are your thoughts on Private Equity?
Also, does Debenhams make a good income stream stock to hold and live off the rest of your days?
Please comment below, and have a great day!
For more similar articles, read why French Connection could see upside to its share price by tweaking one thing.