Why I’d dump these dangerous retailers

Things look set to get even tougher for these big-name retailers.

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With the Bank of England warning of a consumer spending squeeze as inflation bites and wage growth slows, it strikes me as foolhardy — rather than Foolish — to continue holding certain retail stocks. Here are just two companies I suspect will suffer more than most as people tighten their belts in order to make ends meet.

Ready to fall further?

At first sight, £1.2bn cap homewares retailer Dunelm (LSE: DNLM) looks an enticing investment proposition: decent operating margins, a history of great returns on capital employed and excellent free cashflow. With total sales across the group rising 11.4% over Q3 to £255m and a 4.2% dividend yield on offer, what’s not to like?

Delve a little deeper into the numbers in April’s trading update however, and things look less rosy. While online sales are positively thriving — up 20.5% to £55.4m over the last three quarters — the company’s substantial 159-store estate is quickly becoming a burden.

Like-for-like sales at its sites dipped 4.3% over Q3 to just under £191m, continuing a trend that has been apparent since the start of the current financial year. When the figures from the last three quarters (or 39 weeks) are combined, like-for-like sales are down 3.5% or a little below £21m.

Given the seemingly unstoppable migration of shoppers online, I therefore find the company’s decision to continue opening new sites concerning due to the not-insignificant overheads these generate. Dunelm opened two news stores in the last quarter and is “legally committed” to another five.

While some costs relating to maintaining existing stores are to be expected, I’d far prefer the company to concentrate resources on developing its online offering, particularly given its recent acquisition of Worldstores — the UK’s largest home and garden online retailer. With levels of debt continuing to rise (£117m in April), the strategy of continuing to expand its bricks and mortar estate looks increasingly risky.

On balance, I’m not convinced that shares in Dunelm’s are worth holding on to, even if management remains confident that the company will continue to outperform its peers. A valuation of 13 times earnings following a 38% fall in the stock price over the last year may attract contrarians but I suspect things are only likely to get worse over the rest of the year.

Off your bike?

Bike and car parts retailer Halfords (LSE: HFD) is another company I’d consider ditching sooner rather than later and not simply due to the rather sluggish performance of its shares since last year’s shock referendum vote.

A quick look at the company’s financials gives me the evidence I need to justify giving the stock a wide berth. Operating margins, returns on capital and free cashflow have all been falling over the last few years while levels of net debt at the end of the last financial year (£86m) were 80% higher than the year before.  

With earnings predicted to barely grow over the next couple of years and consumers likely to delay big-ticket purchases, I fear for the dividend. As many income investors will know, a large but stagnant yield points to a company treading water. At 5% and barely moving, Halford’s bi-annual payouts could quickly become unsustainable if economic jitters persist.

At 12 times forecast earnings, shares in the Redditch-based business look deceptively cheap, in my opinion, and are best avoided in the short-to-medium term. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Paul Summers has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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