Why I’d buy this retailer despite its profit slump

Today’s first half results from online fashion retailer N Brown (LSE: BWNG) show that trading conditions are tough. Sales are marginally up and profit is down on last year. However, I’m still upbeat about its long-term prospects.

N Brown’s first half results are in line with expectations and this has caused investor sentiment to dramatically improve. Its shares are up 18% today and could keep on rising. That’s despite the company reporting only a 1% rise in sales and a fall in adjusted pre-tax profit from £39.4m to £31.6m.

A key reason for this fall in profitability is a challenging wider retail sector, with consumer spending in the UK coming under considerable pressure. Brexit may not have helped, but 2016 was already proving to be a difficult year for the retail sector before the EU referendum on 23 June.

Looking ahead, N Brown has the potential to improve as a business. Its new strategy is sound and involves making a rapid transition to a digital business model. This should create a more efficient business that excels in being agile and innovative. For example, N Brown’s online revenue increased by 7.5% year-on-year and online penetration was up 5 percentage points at 68%.

N Brown is also expanding outside of the UK and recently launched a new US website. This should help it to successfully roll out its Fit 4 Future systems project and boost customer reach over the medium term. Importantly, N Brown has maintained its guidance for the full year. It’s forecast to record a fall in earnings of 6%, followed by growth of 3% next year.

Clearly, those figures are somewhat disappointing. However, N Brown offers significant upward rerating potential. For example, it trades on a price-to-earnings (P/E) ratio of just 9.2. Clearly, it’s enduring a difficult period but it has clear turnaround potential and could continue to rise after today’s gains.

A better buy?

Despite N Brown’s appeal, sector peer Debenhams (LSE: DEB) could prove to be an even better buy. It’s also in the midst of a turnaround period as it seeks to overcome the challenges associated with being a mainly UK-focused retailer at the present time. As such, Debenhams is forecast to post a fall in earnings of 3% in the current year, followed by a further fall of 5% next year.

However, Debenhams offers even greater upward rerating potential than N Brown. It trades on a P/E ratio of only 7.6. Given its financial strength and long-term growth potential, this is difficult to justify. And with Debenhams yielding 6.3% from a dividend covered 2.1 times by profit, it offers superior income prospects to its peer. That’s because N Brown’s dividend payments have less headroom than those of Debenhams. N Brown’s dividends are covered 1.6 times by profit, which makes its higher yield of 6.8% less sustainable given the uncertain outlook for the UK retail sector.

Both companies offer an uncertain future, but could be the subject of significant share price gains as well as excellent income returns.

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Peter Stephens owns shares of Debenhams. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.