Don't get caught in N Brown value trap

Falling margins (see graph) means operating profit last year was actually marginally down on 2010 levels, despite a 26 per cent increase in revenues over the period, and comments from the company in 2016 suggest there will be little let-up. The company first hinted at a poor start to the new financial year as part of its full-year results outlook statement. This was confirmed by a first-quarter update in June, which reported a 1.6 per cent drop in product sales. A bright spot was the group's finance business, which provides high-cost credit to N Brown's customers and accounts for about 30 per cent of both sales and gross profits. While the division faces the uncertainty of a change of regulator to the FCA, success at reducing bad debts helped increase the division's first-quarter revenue by 3.4 per cent. Nevertheless, overall first-quarter sales declined 0.2 per cent.

N Brown's operating margin woes

While management gallantly stood by full-year guidance, the first-quarter update triggered an all too familiar round of broker downgrades. Indeed, based on Bloomberg data, analysts' EPS forecast for the current year are down from a peak of 36.7p two years ago to just 23.1p today. Sales forecasts are also being marked lower and with this comes the potential for a greater level of markdown across the group's product lines, potentially adding further pressure on margins. In fact, management already admitted during the first-quarter report that it ran "successful targeted promotions" in order to drive revenue growth during the period. For now, management expects gross retail margins to fall by 50 to 150 basis points, while finance gross margins should be either up or down by 50 basis points.

The company took action on its currency exposure ahead of the referendum, which should mitigate recent sterling weakness, but foreign exchange still represents a "significant challenge". A currency-related headwind of around £3m is already expected in the current year. Other items could impact margin growth this year, including a one-off decision to clear old stock and higher operational and marketing costs. The group has decided to invest more heavily in online and digital channels to promote its wares, and believes operating costs will climb between 2 per cent and 4 per cent over the course of the financial year.

Investment in a 'digital first' business model is having a profound affect on cash flow. Capital expenditure totalled £58.2m last year, which was more than double the £25.2m deprecation and amortisation charge. Along with some exceptional costs, this turned free cash flow (cash generated before paying dividends). Given that capital expenditure is expected to remain high this year at £38 to £40m, there are grounds to be worried about the sustainability of the dividend, which cost the company £40.2m in 2016.