Fool's Eye View

[ February 24, 2000 ]

Being Wary of FT 'Bargains'

By Maynard Paton (TMFMayn)

Carburton Street, London -- Bruce Jackson (TMFGoogly) inspired this feature. You see, Bruce can always be found at Fool HQ, running his beady eye over the 'Companies & Markets' section of the Financial Times, trying to spot candidates his next stock market foray. Indeed the FT , through its London Share Service, is one of the best places any Fool can begin their hunt for a prospective company investment.

Although the "pink paper" reports daily on each individual company's share price movement, the volume of shares traded, and its share price high and low of the year, there are two other statistics that are of far more significance to the Foolish investor. Firstly the price-to-earnings ratio (P/E), and secondly the dividend yield.

(If these two statistics mean very little to you, you may wish to take a peek at our Fool's School lessons on the P/E and dividend yields first.)

By and large, those who trawl through the FT , concentrating on these two statistics, are probably on the lookout for two factors -- a "low" P/E combined with a "high" dividend yield. A company with an attractive mixture of, say a single digit P/E, and a double digit yield, could look an enticing investment, in that it appears to be "undervalued". But some caution is needed. The FT, of course, can only use historic earnings and dividends in its calculations.

Thus, if a healthy company suddenly announces that trading is so poor that its earnings will collapse and it can't afford to pay a dividend, its share price will fall substantially. Although the FT will report the new gloomy share price, the paper will report the P/E and dividend yield using the prior "healthy" earnings and dividend. Thus the reported statistics will become distorted. A low P/E and high dividend yield will be calculated, giving the impression of a possible bargain.

Obviously what counts is the prospective earnings and dividends. One you've determined the future level of profits, then possible bargain may not be the outstanding deal it appeared at first, as the next example shows.

A Bargain On The High Street?

After having studied the General Retail sector, Bruce recently asked me about one particular High Street merchant. "So why are House of Fraser (LSE: HOF) on a P/E of 7 and have a yield of 12%?" Bruce wondered, while perusing the FT.

After immediately thinking of Storehouse (LSE: SHS), I responded cautiously: "Err... they're the historic figures, you want to be careful when looking at those."

Storehouse currently have a prospective P/E of 30 and prospective yield is anywhere between 0% and 2%, depending on which Wise forecast you subscribe to. But the FT reports Storehouse as having a P/E of 6.2 and a dividend yield of 15.9%, the well-documented financial troubles of the company not yet appearing in the published statistics.

So, back in September, House of Fraser gave details of its trading performance. Like-for-like sales for the first eight weeks to 25 September 1999 were 5.1% down on last year. Shareholders feared the worst over future profits, and the shares dropped from 100p at the time of the interim results, to 44p today.

But lately, turnover at House of Fraser appeared to have recovered. The group gave a clear picture of how the second half of their financial year had performed with their Christmas trading statement. The 22 weeks to 8 January 2000 saw sales remain flat compared to the comparable period of the year before. But very importantly, House of Fraser had managed to maintain gross margins.

So, with the FT reporting an attractive dividend yield of 12% at a share price of 44p, does the sales recovery justify buying House of Fraser shares? Can House of Fraser really afford to maintain their 5.5p dividend? For both these questions, the answer is no.

For the last two full financial years, House of Fraser have taken an average annual depreciation charge of £20m, all relating to fixtures and fittings. The cash capital expenditure tells a different story though. The same two year period has seen an average spend on fixed assets of £42m, again all relating to fixtures and fittings.

Looking at the rather flat group sales in those two years, it appears this capital expenditure on refurbishment is a necessity just to maintain House of Fraser's competitiveness on the High Street. Thus, out of any accounting profit made each year, House of Fraser requires £22m (£42m capital expenditure less £20m depreciation) of that profit to be ploughed back into the business just to keep sales at a static level. This £22m should make shareholders' eyes water, as the expected earnings per share of 5.6p equates to just £12m.

So House of Fraser are effectively digging into their savings to sustain their current level of sales, where accounting profits of £12m are completely offset by the 'additional' £20m capital expenditure required. And just to keep the shareholders happy, House of Fraser are content with delving even deeper into their pockets by spending another £11m through dividend cheques.

To make matters even worse, House of Fraser has hardly any spare cash. Cash at the interim period was less than £1m, as opposed to the £50m of debt.

It looks to me that any dividend from House of Fraser is unsustainable, as the group is effectively having to borrow money to pay for it. The 5.5p level can't really be maintained unless the group has a sudden, and huge, upturn in sales, which is very unlikely.

I suspect the stock market senses a dividend cut. It may not be immediate, but House of Fraser can't continue forever spending money it hasn't earned on dividends.

All feedback is welcome, and can be directed to the House of Fraser discussion board.

Related Links
• Blow the House Down