Debenhams may need to cut dividend after profit warning, analysts caution

Debenhams is likely to be forced to cut the dividend it pays to shareholders after the department store chain lowered its full year profit guidance due to poor trading over Christmas.

Group like-for-like sales fell 1.8% and dropped 2.6% in the UK in the FTSE 250 group's crucial festive period, while management's promotional action to keep stores competitive resulted in a big decline in gross margins.

Despite £10m of extra cost cuts and a pledge to accelerate restructuring, full year profit before tax is projected to fall to £55-65m from £95m last year, which would leave earnings per share only just covering the dividend.

Analysts at Liberum said the "significant decline" in gross margin and an outlook clouded by structural challenges, a soft consumer environment, rising costs and increasing capex demands, meant it was cutting full year forecast for profit before tax 35% from £80.8m to £52.1m.

Liberum noted that while the dividend remains covered by earnings per share "it is uncovered by free cash flow". The investment bank reiterated its 'sell' recommendation and slashed its target price to 25p from 40p previously.

RBC Capital Markets said the warning may force Debenhams to cut its dividend and review its high capex investment strategy.

RBC said earnings downgrades in the order of 30% were likely given the group's low margins and high fixed cost base.

While the company blamed challenging market conditions and a tough post Christmas sale period, RBC said it believes Debenhams "has suffered from having a sub-optimal clothing and gifts offer and from being overly reliant on promotional activity to drive footfall and online spend".

Debenhams' cash generation before taking account of the high capex "is interesting given its lowly valuation", acknowledged RBC, though analysts think "it will continue to be impacted by structural pressures on department stores, including competition from well merchandised specialty and online retailers".

While the valuation is lower than the sector, Debenhams "has a very mixed track record, and we think some other UK stocks are better positioned right now and offer more upside", RBC said, though viewing the statement as a negative read to other UK store based chains such as M&S and Next, "although Next has benefited from its much higher online exposure and M&S has been much less promotional than Debenhams".

Eight months after launching his Debenhams Redesigned strategy, Bucher "must be wondering what he has let himself in for by taking the job" said broker AJ Bell, noting that Bucher was brought in to focus on full-price sales and the online business.

Not only that, the group's large format stores are "not sufficiently local or convenient for customers to use them as click-and-collect stop" and "worst of all" are locked into some very long-term leases.

Last year ended with just £9.3m property on its balance sheet "offering little asset backing to the balance sheet with which to tempt a bidder", while lease expenses on the store estate, warehouses and other properties came to £221m. Future payments on “non-cancellable” existing leases are estimated to be £4.5bn, based on current terms and conditions.

“This is a considerable burden on the company and one that investors must take into account as they ponder whether Debenhams’ shares are now looking very cheap or are nothing more than a classic value trap. Such liabilities are likely to deter anyone from viewing Debenhams as a potentially cheap acquisition, even if on the face of it the shares come with a tempting valuation," AJ Bell said.

“Based on the company’s new pre-tax profit guidance and a 20% tax charge, Debenhams looks set to make earnings per share of 3.9p. That puts the company of a forward price/earnings ratio of 7.5 times, with a dividend yield on a 29.8p share price of 11.5%, assuming the payout is unchanged at 3.425p - although the market is clearly already discounting a dividend cut as an 11.5% dividend yield is not a credible proposition.”