Pre-tax profit fell by 10% to £105.8m at Debenhams (LSE: DEB) last year, despite sales remaining broadly flat. It was a similar story at fashion-focused rival Next (LSE: NXT), which recently reported a 1.5% fall in half-year profit, despite a 2.6% rise in sales.
These figures highlight how much pressure big high street chains are under at the moment. Large store networks, the national living wage and a weaker pound are making it harder to cut costs. A growing shift online means that investment is also needed in this area.
Debenhams shares have edged higher after today’s results, but they’re still worth 24% less than at the start of 2016. Next has fallen by 35% over the same period. Both stocks now look relatively cheap, but it’s clear that the market is pricing in an uncertain future.
Am I right to be cautious, or do these firms offer a contrarian investors an opportunity?
Will Amazon know-how deliver growth?
Debenhams’ new boss Sergio Bucher started work earlier this month. The former vice-president of Amazon‘s European fashion division has promised to update investors on his plans for Debenhams’ development in the spring.
It seems reasonable to expect that these will include a more aggressive online strategy. But what will be more interesting is to see how Mr Bucher decides to develop the group’s network of large stores.
One option is that he will continue to shift Debenhams away from seasonal clothing and towards what the store describes as “leadership in destination departments such as Beauty, Gift and Occasionwear.” I’d imagine these areas offer more incentive for customers to buy in-store.
Whatever he decides, Mr Bucher will need to maintain a tight focus on costs. Debenhams’ operating margin fell from 5.8% to 5.1% last year, according to today’s results.
However, underlying earnings were almost unchanged at 7.5p per share (2015: 7.6p) and the dividend rose by 0.7% to 3.425p per share. These figures give Debenhams’ stock a P/E of 7.3 and a yield of 6.2%.
Today’s figures could be a good buying opportunity. My concern is that the retail sector is going through a period of change that could have unpredictable consequences.
Clothing sales are key for Next
Debenhams may be able to pivot away from such a heavy focus on clothing, but this isn’t likely to be an option for Next. A huge chunk of the group’s business is based around clothing sales, most of which are seasonal,  and it already has a sizeable non-fashion interiors offer.
Next shares have now fallen by 40% from their October 2015 peak of £80. This collapse hasn’t been mirrored by a fall in profits, which only fell by 1.5% during the first half of the year. What’s happened is that Next stock has been de-rated to reflect a shift in Next from growth to maturity.
On paper, Next ought to be a more attractive business for investors than Debenhams. A consistent 20% operating margin means that free cash flow has always been strong. Shareholder returns have historically been generous.
Next shares currently trade on a 2016/17 forecast P/E of about 10.5 and offer a prospective yield of 4.3%. As with Debenhams, they ought to offer good value. However, I’d like to learn more about recent trading and the impact of the weaker pound before considering a purchase.