Stockwatch: "Look to buy" this share if wages rise

An attractive yield near 5% covered twice by earnings should limit a stock's downside, right? Well, Debenhams appeared to offer that last January - even closer to 6% on a 12-month forward view - but the shares still fell by a third from 85p to 58p by September/October.

A bounce to 72p currently shows how awareness of the dividend yield can be useful even for capital-growth traders, but unless UK wages pick up consistently I would remain wary about retailers like this. Ahead of a trading update likely end-December it is still worth being aware of the situation for possibly another bout of dynamics.

This looks one of the safest dividends offered

The table shows a dividend covered over twice by earnings and about five times by cash flow in the 2013/14 financial year, the longer-term cash flow record also being robust. The dividend has recovered from 2011/12 after financial abuse by American private equity owners who over-loaded the company with debt and cut investment.

The current British management has achieved a pretty good turnaround in highly competitive retail conditions. Not surprisingly the stockmarket still prices the shares to exact a useful dividend yield as compensation for risks whether Debenhams can compete effectively.

Last January I drew attention with a "potentially over-priced" stance around 85p noting signs of strain in the business. Suppliers were being put under pressure and shortly before Christmas in Lincoln city centre I had seen deserted clothing isles and Christmas gift offerings heavily discounted. Up the road, Next and Poundstretcher were doing well. Watching the stock last autumn, I should have picked up on a chart "double bottom" which tends to be seen as a bullish formation and may have helped the recovery-rally. The fundamentals' carrot is UK personal earnings growing by more than inflation for a second month after lagging behind prices for five years.

Real evidence is needed from the company though.

Expectations have reduced this year amid pressures

Current forecasts look for about £112 million pre-tax profit and EPS of 7.3p for the 2014/15 year, compared with £166 million and 11.2p when I wrote 11 months ago. Uncertainties will continue, such as the May General Election, then whatever cold truths about higher taxes to support public services and interest payments on national debt as it soars towards £1.5 trillion.

While retailers to the affluent may be less exposed and discounters continue to flourish, mid-tier discretionary goods could remain a difficult market. So I regard the £120 million consensus profit forecast for 2015/16 as pinning the proverbial ass.

Macro signals quite conflict. Consumer borrowing via credit cards, personal loans and overdrafts increased by 6.4% in October, year-on-year, the fastest rise since July 2006; yet high street prices fell by 1.5% in October, year-on-year, the biggest fall since 2002. This reflects deep discounting, a situation that hit Debenhams at this time last year. Retailers playing to the hysteria of "Black Friday" in late November may only have helped those best-suited to a low-margin game.

Just recently, Costco and Walmart shares have surged in the US, mainly because falling fuel price triggered expectations of a boost to disposable incomes, hence better demand for relatively low-cost discretionary goods. Yet, British motorists pay the highest fuel tax in the world - 61% compared with 13% in the US - so pump prices are down only modestly. Real wage increases are needed for the likes of Debenhams to flourish better.

Management has not commented on trading since the 23 October prelims gave a challenging outlook: "Customers tell us that although they are encouraged by economic improvements this has yet to translate into higher disposable income and the market remains tough... We therefore remain cautious about the outlook and will continue to plan prudently..."

2013/14 results conveyed a testing situation

Like-for-like annual sales were up only 1%, while profit/earnings fell in the region of 20%, the UK seeing a 24.3% fall in operating profit while the international side grew it by 14.5%. The sales/profit disparity was mainly due to lower sales in the run-up to Christmas resulting in high discounting during January sales; hopefully management has learned from this.

The 2013/14 geographic revenue profile was 82% UK, 8% Denmark, 6% Ireland and 4% rest-of-world, so the consumer outlook here remains dominant. The situation was quite saved by online sales growing nearly 18% to represent 15% of group sales. Mobile represented 38% of online sales i.e. Debenhams is getting its act together as regards "multi-channel" sales, a rising trend generally.

In October, the flagship Oxford Street store was said to be trading as expected after a transformation, although ahead of the update I would mind there is plenty of discounting around there. Four new stores took the UK total to 160, two more will open in 2015 and another ten in the next three years.

Outside Magasin du Nord stores in Denmark and 11 Debenhams stores in Ireland, the international stores are franchises and opening progressively; international online saw a near 42% sales jump in 2013/14 albeit from a small base. Overseas sales are another potential saviour besides online/multi-channel, worth watching.

Current risks may overall weigh on the downside at 72p

It's a close call, but I'd steer clear before the update. Debenhams is highly relevant in showing the need to be attuned to companies' current trading than be enticed by the dividend: unless a management is coping well then a stock can easily slip by more than its dividend is worth. More positively, these shares have shown ability to recover, and if the wider context includes rising wages then fundamentally Debenhams rates "look to buy".

Considering net operational cash flow rose in the last financial year near £207 million from £200 million, and much of this was applied to repay debt - only £42 million needed for the dividend - the dividend ought to be secure. This adds to interest if the stock gets unsettled by the update.