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Debenhams faces squeeze of weaker pound

Debenhams faces squeeze of weaker pound

An optimistic tone prevailed in global markets following the Brexit-driven turbulence, with global equities rebounding towards recent highs and sterling recouping some of its losses.

Investors continue to adjust to last week’s referendum decision, with the initial concerns subsiding, sending the S&P 500 index back into positive territory for the year. Meanwhile, Brent Crude Oil rose over $50 barrel after trading at $47.26 earlier in the week and sterling climbed above the $1.35 level against the dollar having hit $1.312 last Friday.

Some argued that markets have been pricing in the possibility of Brexit since the Conservatives won the last election in May 2015 and UK stocks have underperformed the world since then. The decision brings some certainty and there is some belief that the longer-term result may not be as bad as some of the scaremongering has led the public to believe.

The Bank of England’s assurances and those from other central banks have played an important part in starving off panic and limiting the contagion. The suggestion that central bank policy will have to remain or perhaps become even more accommodative buoyed investor sentiment, although I would argue that is a short-sighted mentality.

Market pricing reflected the belief that Brexit would not happen, right up to the day of the referendum, yet following some wild swings in sentiment, the FTSE 100 now stands higher than it did before the vote and at its best level since August 2015.

The future is, however, uncertain and is likely to remain unclear for several months, perhaps years. I worry that investors are failing to face up to the severity of the political and economic issues that now confront the UK.

There is little guidance on the political front and even when a new prime minister is appointed and article 50 of the Lisbon treaty has been triggered, there will be a fog of uncertainty that will threaten investment flows and weigh on the value of the pound.
With Brexit developments dominating the headlines, there was little impact from news of a slight upward revision to US first quarter gross domestic product growth. Recent data from the US has been encouraging and Britain’s rejection of Europe is unlikely to have a strong economic effect on the US.

The dollar’s appreciation, however, may weigh on inflation and growth, although investors will probably welcome this as it preserves the ‘goldilocks’ scenario of sustained economic growth and low inflation that markets have thrived on for years.

Technical analysis of the FTSE 100 illustrates the volatility as investors attempt to price-in the implication of the UK exiting the EU, with the blue-chip index dropping by 11% and subsequently rallying by 14% in the space of a week. Equities are likely to remain choppy over the coming month, although with the oscillators entering acutely oversold territory, renewed downside could be the most likely short-term move. Support is seen at 6455, 6270 and 6000 while resistance at 6800 could limit any further sentiment driven rally.  

In conclusion, Brexit ensures a prolonged period of political and economic uncertainty in the UK, which could hamper the domestic economy as companies delay investment spending, consumers feel uncertain and sterling remains weak. As a result, I feel an 11-month high for the FTSE 100 could be a good level for investors to reduce their exposure to UK equities and focus on overseas economies that should continue to outperform the UK market.  

The UK high street has struggled over recent months, with the high-profile failure of BHS in April and profit warnings from companies such as H&M, Marks & Spencer and Next, who warned of a ‘potentially wider slowdown in consumer spending’. Brexit now brings the additional threat of a collapse in consumer confidence and the cost of a weaker pound.

Retailers predominately buy from outside the UK, so the 5%+ drop in sterling makes input costs more expensive and at a time when confidence is low due to political and economic turmoil, executives at several large retailers have expressed concern that they might not be able to pass the full cost on to customers. The evolution of internet-based retailers has squeezed margins for high-street retailers and several will struggle to absorb anything of the additional 5%+ inflation.

The UK apparel market contracted by 4.1% in the 12 weeks to 8th May, according to quarterly data from Kantar Worldpanel, and this may have deteriorated further given that June was the wettest on record.

Debenhams (Epic: DEB), the UK’s second-largest department store chain by revenue, behind John Lewis, was the latest high-street store to warn that profit margins will be lower than expected this year as its chief executive steps down after five years at the helm.

In a trading update on 22nd June, Debenhams reported that like-for-like sales fell 0.2% or 1.6% if we strip out the effect of currency fluctuations, in the 15 weeks to 11th June. The focus on digital was a positive step, as online sales increased by 7% over the same period, with half of orders coming from mobile devices.

The increase in the number of promotions led the retailer to downgrade its gross margin guidance for the full year, saying margins were now likely to be flat. The onset of weaker sterling and a higher minimum wage, however, may further squeeze margins.

Debenhams problems, however, are more structural as the private equity consortium that purchased the company back in 2003 sold the freehold property for £66 million and an expansion plan was funded by more than doubling the debt burden, before floating it back on the stock market.

The company has focussed on reducing its debt pile, but it still carries net debt of £224 million against net assets of £853 million, while it is tied into long-term leases for stores, warehouses and office space, many with escalating rent clauses. Liabilities for future lease payments are more than £200 million a year, representing almost a third of the company’s market capitalisation per annum.

At face value the fundamentals look cheap on 9.4 times earnings, while offering a dividend of 5%, yet with little or no growth forecast for the next couple of years it looks like a value trap. Any further pressure on margins from higher cost inflation or faltering sales could push margins into negative territory for the year, forcing a cut in the dividend.

The chart of Debenhams captures the deterioration in the business, with the shares falling below the 2014 low of 56.8p. While a short-term oversold bounce could occur, I feel the previous low will now become resistance and the longer-term downward trend is likely to continue.

In light of my earlier analysis of the FTSE 100 combined with the impact of a weaker pound and lacklustre consumer confidence I fear the outlook for Debenhams is bleak. At the time of writing the share price is 55.3p and traders might consider short-selling the shares with a tight stop-loss above the resistance at 57.2p. Near-term targets are seen at 52.5p, 50.3p and 22p, where it may find some support from the financial crisis trough.

This report was written by Michael Allen, equity specialist. The writer does not hold a position in Debenhams. The material in this report has come from web-based data sources and Debenhams corporate website.



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