Dixons faces short circuit

Analyst Philip Dorgan at broker Panmure Gordon recently summarised the investment outlook for Dixons Retail in one succinct statement: "it is a binary situation". In other words, it's a 50:50 bet whether the business pulls through its current slump or doesn't. That's reflected in the range of analysts' recommendations on the shares - six buys, five sells, and 12 others sitting on the fence and rating the shares a hold.

Mr Dorgan is in the buy camp on the basis that the store transformation programme and other business improvements, put in place by chief executive John Browett over the past three years, have helped boost its share of the highly competitive UK consumer electronics market and that there's likely to be a retrenchment ahead by more challenged competitors.

That capacity hasn't come out of the market yet, though, and with consumers battening down the spending hatches, Dixons faces a difficult future. Its management will be hoping that the likes of Comet, Best Buy, Argos or even the supermarkets don't embark on an all-out price war to lure cautious shoppers out of the woodwork, because it would have a profound effect on profitability. As Simon Irwin at broker Liberum recently pointed out, every one percentage point shift in like-for-like sales is worth £10m, or 12 per cent of pre-tax profits, and that "forecasts are no more than a coin toss."

And while the investment in reformatting its store portfolio is helping boost market share, Dixons is operating in a rapidly shrinking market. The decline in Dixons' UK sales accelerated sharply throughout 2010-11, down 7 per cent in the second half after an increase of 2 per cent in the first six months of the period thanks to the World Cup boost and its selection as launch partner for Apple's iPad - there are few such catalysts on the immediate horizon.

Dixons also has the millstone of a 600 store estate to worry about - that's down from a peak of 758 in 2007, and it plans to exit another 150 stores over the next four years, including 50 high street stores with leases of less than three years and around 130 larger format stores with an average lease length of 10 years. Overall lease liabilities during the next nine years amount to a hefty £3.3bn.

Which raises the concern that, if there isn't a major pick-up over the all-important Christmas trading period, the debt problems that almost brought Dixons to its knees in 2008 may resurface. Dixons is due to repay a £160m bond in November 2012 along with £65m in hedging costs and, while most analysts currently give Dixons the benefit of the doubt that it will be able to remain within its debt covenants, any significant deterioration in profitability could prove problematic.

Cashflow is already under pressure and it may need to flex its capital expenditure programme to meet its capital requirements, which could delay completion of the renewal programme and may affect its ability to deliver the £150m of cost reductions targeted over the next three years. Capital expenditure will be limited to £160m this year, but could be as low as £100m, less than half the level of last year - yet, so far, only 250 UK stores have been reformatted. Losses are being reduced in Europe, though, notably in Spain where it's closing its PC City operation, while its Scandinavian business Elkjop continues to perform, delivering trading profit growth of 8 per cent last year.