During 2018, my investment portfolio suffered more dividend cuts than I would have liked. As an occasional high yield investor I realise that dividend cuts come with the territory, but seeing three out of thirty holdings cut their dividend was more than a little annoying.
To reduce the odds of seeing future dividend cuts, I have been looking at some alternative measures of quality and value. I’d like to outline some of my early thoughts here, using N Brown (LON:BWNG) (which I own and which announced a 50% dividend cut in its recent interim results) as a case study.
The review will be based around a handful of Buffett-like questions which cover some key aspects of dividend investing:
1) Does the company have a simple and understandable business model?
N Brown is a clothing retailer focused on niche markets (size 20+ and age 50+) which are not well-served by high street stores. It has long had a home shopping business model, where customers can order clothing from home (using paper catalogues in the good old days, but more commonly using the company’s websites today). Customers can also pay in instalments and return goods easily.
The company makes a profit from a mixture of margin on the clothes it sells and from interest charged on the monthly payment plans that many customers use.
This is not a terribly complicated business, so yes, I think N Brown does have a reasonably simple and understandable business model.
2) Does the company have a successful operating history?
There are lots of different factors that make a company ‘successful’ and I don’t have the space here to cover all the ones I look at, so I’ll focus on earnings growth, dividend cover and profitability.
When I bought N Brown in 2014, I measured its growth by looking at the growth of its revenues, normalised earnings and dividends. I used normalised earnings (which are calculated by various data providers such as Morningstar or SharePad) because they strip out one-off or ‘exceptional’ income or expense items in an attempt to show the ‘underlying’ earnings of the company’s core business. In theory that makes sense, but over the years I’ve found that normalised earnings are often consistently higher than reported earnings and free cash flows (i.e. spare cash generated by a company).
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In N Brown’s case, its normalised earnings have declined very slightly from a peak of around 28p per share in 2011-2013 to around 23p per share over the last couple of years. Over ten years, its normalised earnings have only declined from 24p to 23p; not exactly a great result, but hardly an obvious sign of an impending dividend cut.
However, the picture given by reported earnings is entirely different, with a far more dramatic decline from around 24p a decade ago to just 4.4p in 2018. And it wasn’t as if 2018 was a one-off bad year. N Browns’ reported earnings have declined at a steadily increasing pace every year since 2012. This is a much clearer sign of a company in serious trouble.
Turning to dividend cover, the company’s normalised earnings covered the dividend comfortably in every one of the last ten years, making the dividend appear safe. But reported earnings barely covered the dividend in 2017 and were significantly below the dividend in 2018. So again, reported earnings were giving a clear ‘red flag’ about the dividend’s safety at least a year or two ahead of the cut.
In term of free cash flows per share, the picture is even worse, with average free cash flows of barely more than 3p per year over the last few years compared to an average dividend of 14p, and negative free cash flows in 2016 and 2018. In other words, the company hadn’t generated enough free cash to pay the dividend for several years and the difference was being made up with additional debt.
So why were normalised earnings so bad at conveying the company’s decline over the last few years? The answer is that they excluded ‘exceptional’ costs which were deemed to be unrelated to the company’s core business. These excluded expenses included store closures, reorganisation costs, legal and professional fees relating to an ongoing VAT case with HMRC, as well as expenses relating to mis-sold PPI and other insurance products.
While it may be helpful to exclude these items in order to gain a better view of a company’s core business (selling clothing in this case), I now think completely ignoring these ‘exceptional’ expenses is a mistake.
That’s why one of my strategy updates will be to shift my attention away from normalised earnings per share and towards reported earnings and free cash flows, both of which I think are more useful measures of dividend safety.
Switching from normalised earnings to reported earnings also impacts my view of N Brown’s profitability, which is another key measure of corporate success.
Historically, I’ve measured profitability by looking at a company’s ten-year average net return on capital employed (net ROCE). Net ROCE shows the returns generated by a company relative to the amount of money (capital) raised from shareholders and debt holders (net ROCE is calculated as net profits divided by the sum of shareholder equity and total borrowings).
When averaged over ten years, N Brown’s net ROCE is 9.6%. That’s slightly below the 10% average for dividend-paying UK-listed companies on my stock screen.
However, that 9.6% is what N Brown produced in terms of normalised earnings and, as I now realise, normalised earnings often provide an overly rosy and potentially misleading picture. Switching to reported net returns on capital employed sees N Brown’s average return decline to 8.4%, which is comfortably below the 10% average for UK-listed dividend payers. So in terms of returns on capital raised from shareholders and debtholders, N Brown has been decidedly below average.
This is relevant to the dividend because companies that cannot produce competitive rates of return on capital are unlikely to have any sort of durable competitive advantage (or economic moat), and as such they are potential fodder for stronger competitors.
With hindsight, I think I should also have been looking at return on sales (i.e. profit margins) as well as return on capital. The reason is that companies with thin profit margins are sensitive to downward pressure on sales prices from customers, or upward pressure on input prices from suppliers. With thin profit margins, there is no margin of safety to soak up increasing expense costs or declining sales prices. This makes thin profit margin companies potentially volatile and fragile, neither of which is good if you’re after reliable dividends.
Turning back to N Brown, its ten-year average normalised net return on sales (net margin) is 8.7% while its reported net margin is just 7.6%. There are companies out there with much thinner profit margins (supermarkets and energy suppliers are two that spring to mind), but most successful clothing retailers (such as Next or Burberry, both of which I own) have double digit profit margins as well as double digit returns on capital.
So did N Brown have a successful operating history? I would say no. I’d say it was a mediocre one at best – and in more recent years, even that may be too kind.
Insert BWNG chart
3) Does the company have a consistent operating history?
By consistent I mean did the company produce its track record of growth and profitability (neither of which, in this case, is particularly impressive) by applying essentially the same business model? This is relevant to the dividend because companies that must change direction or transform themselves are much more likely to cut their dividend due to falling profits and/or internal demands for cash that outweigh the external demand for dividends.
Here’s a quick summary of what N Brown has been up to these past ten years or so:
Historically, N Brown was a catalogue home shopping business. Its customers would sign-up and then receive a new catalogue every three or six months or so. They would browse through the catalogue from the comfort of their home and then order (say) a shirt or three, perhaps in a couple of different colours and sizes. Having done that, they could then try on the clothing when it arrived, choose the item they preferred, return the rest and then pay for the chosen shirt on a monthly basis, rather than up front.
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For N Brown’s core market of size 20+ and age 50+ customers, this was an excellent proposition. It meant they didn’t have to trudge around high street stores where most clothes are for young skinny people. And it meant they could try on lots of different clothes in the comfort of their own home without having to pay for any of them in advance, and then only pay monthly on the items they eventually chose.
In the pre-internet era, this business model was very successful, and I can remember ordering many things from the somewhat similar Littlewoods catalogue in the 1980s. But somewhere in the mid-1990s this business model started to look obsolete.
Where once the idea of shopping for clothing from home was a niche activity, it became ubiquitous thanks to the Web. And the idea of buying lots of items, returning whatever you don’t want and paying for the rest on a monthly basis is also now ubiquitous, thanks to credit cards and local parcel pickup and collect services.
Put simply, N Brown is a classic buggy whip manufacturer. Its traditional business is a dead man walking and the rapid decline of that business is the main reason for the company’s recent struggles.
For many years now, N Brown has been working through an extensive transformation project. This project is, unsurprisingly, intended to move the company away from its historic catalogue business and towards being an online-first business where, unfortunately, most of N Brown’s legacy brands have no competitive advantages whatsoever.
So no, I don’t think N Brown has a consistent operating history. Instead, its recent history is one of transformation from a once successful but now obsolete business model to a new business model with low barriers to entry and fierce competition. This need to transform its business model is the main reason why the company has now cut its dividend.
4) Does the business have favourable long-term prospects?
As you might have guessed from my answer to the previous question, N Brown’s traditional business does not have favourable long-term prospects. In fact, I would be surprised if its catalogue business even exists ten years from now.
But that doesn’t mean N Brown’s future is entirely bleak. The company has one saving grace, which is its ‘power brands’ portfolio.These are Simply Be, JD Williams and Jacamo, and between them these three brands have continued to grow while the rest of the company’s brands have declined.
With these three brands now generating almost 60% of the company’s product revenues (up from about 50% in 2015) the company has now finally, and very sensibly, decided to stop propping-up its offline catalogue business and focus almost entirely on its online-first power brands.
Another positive is the fact that N Brown has closed all its (relatively few) high street stores, which puts it one step ahead of many other clothing retailers which are struggling with too many physical outlets in an age of mobile internet shopping and same day delivery.
Overall then, I’ll go out on a limb and say that N Brown’s power brands do have the potential for favourable long-term prospects, but it has a very difficult five or so years ahead as it winds down its legacy business.
5) Was the business available at an attractive price?
I bought N Brown in 2014 for 347p per share and with a dividend yield of 4.2%. That’s a decent dividend yield, but following the recent dividend cut the shares have fallen to just 89p; so no, with hindsight I don’t think I paid an attractive price.
Other than N Brown’s declining reported earnings and relatively weak profitability, I think my biggest error was not being sufficiently wary about the company’s ongoing transformation. As Buffett has said, turnarounds seldom turn, and it’s much easier to make money when companies don’t have to solve massively difficult business problems, such as transforming from an offline catalogue business to an online-first retailer.
So what about today’s price of 89p? This price is incredibly low relative to the company’s historic earnings and dividend payments, and it only makes sense if you think very bad things are about to happen.
That could mean the suspension of the dividend, as and when the new CEO arrives (the old CEO departed during 2018); or it could be a rights issue to pay down the company’s debts, which have ballooned to almost half a billion pounds in recent years; or it could mean a split of the company’s clothing and finance businesses in order to satisfy HMRC’s recent demand that N Brown pay more VAT (due to the different VAT rates applied to clothing and financial products). Or it could be all of those and more.
My hunch is that the current price is extremely low, but with so much uncertainty and difficulty ahead, this isn’t a company I would want to invest in today.
Reported earnings, net margins, transformations and debt
In summary then, N Brown has taught me to focus on reported rather than normalised or adjusted earnings; to measure return on sales (profit margins) as well as return on capital; to avoid companies going through life-or-death transformations; and to be wary of companies where debts are ballooning to dangerous levels.