This week’s speech by Theresa May indicated a ‘hard’ Brexit is becoming increasingly likely. This may be a cleaner result than the potential for years of negotiation to keep bits and pieces of EU membership. However, it could also lead to greater uncertainty in the short run as the UK goes it alone. The end result could be a volatile and potentially weaker pound, higher inflation and trouble ahead for UK-focused retailers such as Debenhams (LON:DEB).
The problem Debenhams has is its status as a mid-market operator. It lacks the brand loyalty of Next or M&S, while also being more expensive than no-frills, budget operators such as Primark. Therefore, I feel Debenhams could experience a difficult year even though its valuation is low and its recent performance has been impressive.
Retail challenges
While sterling’s value versus the dollar has fallen to levels not seen in over a decade, things could get worse before they get better.
Investors may have been reassured by Theresa May’s speech in so far as she promised a ‘clean’ Brexit. But in my opinion she also promised a ‘hard’ Brexit on her terms and I believe this will cause weakness in the value of the pound over the course of 2017 and 2018. Just as the appeal of the UK economy has deteriorated and caused the pound to weaken since the referendum, I believe the trend for a weaker pound will continue.
Further, there is uncertainty regarding the future of the UK in its current form, with Scotland pushing for a second referendum and doubts emerging about the prospect of an open Irish border. Access to the single market may be possible, but if it’s a bad deal then Theresa May has indicated she would rather have no deal. All of these details must be discussed, debated and decided with different groups within a two-year timeframe. Therefore, uncertainty could easily turn to fear.
Impact on retailers
A weaker pound is good news for exporters, but for UK-focused retailers it brings problems. Higher import costs will put upward pressure on prices at the same time as consumers’ disposable incomes fall in real terms.
The end result of this is likely to be lower sales, with consumers more likely to trade down to lower priced substitutes. Alternatively, if retailers wish to absorb higher costs themselves in order to stay competitive on price then their earnings are likely to take a hit.
…Debenhams lacks a clear competitive advantage versus rivals.
The last time wage growth lagged inflation was during the Global Financial Crisis and in its aftermath. That’s a main reason why discount retailers have become more popular in recent years.
As wage growth has returned to being above inflation in the last couple of years, mid-tier operators such as Debenhams have seen their performance improve. For example, the company’s EPS increased by 3% per annum in the 2015 and 2016 financial years after falling by 25% during the previous two years. Now, though, the company’s performance could revert back to a declining bottom line.
Good value but a difficult outlook
In FY 2017 and 2018, Debenhams is forecast to register a total fall in EPS of just over 20%. This means its prospective P/E is 8.9. That’s undoubtedly low, but I feel there could be downgrades to its forecasts ahead.
Still, the business enjoyed a strong Christmas period where LFL sales increased by 1% in the UK. Its digital transformation continues and online sales of over 25% in the last two years is impressive. Similarly, sales outside the UK could benefit from a weaker pound and help to correct what may prove to be disappointing UK performance.
However, in my view Debenhams lacks a clear competitive advantage versus rivals. It sells a wide variety of goods and is therefore not a specialist, has a range of designers but lacks clear brand loyalty and its pricing is neither premium nor budget.
This isn’t a criticism of the company’s business model, since the markets and price points in which it operates have growth opportunities during more normal economic periods. However, I feel 2017 and 2018 in particular will be tough on UK consumers and Debenhams may lose out to retail rivals who can more obviously show consumers why they should shop there.
For instance, low prices or a premium brand are obvious differentiators. Debenhams may be able to shift sales towards non clothing items in order to preserve margins, or maintain market share through a policy of discounting. Similarly, efficiencies may be possible to improve its overall financial performance. Therefore, in the long run it may be a sound investment, but I believe there is a lack of clear upside over the near term.
Strategy
In my view, Debenhams faces a difficult outlook. The UK economy could perform far better than expected in 2017, 2018 and in future years. However, given the tough stance taken by Theresa May, a ‘hard’ Brexit seems increasingly likely.
While this would probably be a ‘clean’ Brexit, it may also lead to uncertainty as the UK gradually addresses the challenges it faces. These include both the status of the current makeup of the UK, with Scotland keen on a second referendum, as well as defining the relationship in economic and other terms which the UK will have with the EU.
During this period of uncertainty, I believe sterling will remain relatively weak and higher import prices will cause Debenhams to either maintain prices and see margins fall, or raise prices and lose sales.
I believe the company lacks a clear competitive advantage versus its peers and while in the long run its current strategy could deliver improving performance, in the short run I think it will struggle to compete with rivals. Therefore, despite having a positive Christmas trading period and a low valuation, it’s a stock I’m not buying into at the moment.