N Brown Profit Warning: Shares Slide As Market Declines

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Fashion retailer N Brown (LON:BWNG) shares declined 25% in morning trade today as a trading update saw revenues decline 5.0% year on year, leading to a first N Brown profit warning of this year:

The bigger picture is not great either. Although the shares are not at the lows seen last year, the shares have lost most of their value over the last couple of years. As little as two years ago this was looking at the 350p range, and five years back, over 500p. Clearly this N Brown profit warning is an isolated one.

But considering their retail segment they operate in, this comes as no surprise and poor performance has been mirrored by the likes of Debenhams, Superdry, Moss Bros to name but a few. Even diversified retailers like Marks and Spencer are struggling and closing stores. The outlier appears to be Next, which is going from strength to strength, perhaps at the expense of all the others.

What’s gone wrong at N Brown?

This is indeed a good question and is covered by the trading update today. There is plenty of clarity here as we get a breakdown on performance by brands:

The ‘Product Brands’ clearly shows the worst performance and perhaps this is to be expected as the company runs off many of its non-core brands. Ambrose Wilson (a plus-size ladies specialist) also suffered. Financial services revenue also declined as lower balances and associated interest income decreased. This appears to have significant headwinds:

In addition, changes to our policies and procedures, specifically the embedding of new measures around affordability and the introduction of new rules concerning credit limits – effective March and December 2019 – and persistent debt, which is due to take effect in March 2020 and December 2020, will have a significant influence on the size and shape of our debtor book. The Group continues to assess its strategies to mitigate the impact of these changes, including the phased introduction of new financial products and further reductions in its operating cost base.

This is helpfully quantified into the profit warning:

Predominantly due to a lower than expected benefit from the IFRS9 non-cash provision estimate, combined with lower Financial Services revenue and a highly promotional market, we now expect FY20 adjusted profit before tax to be in the range of £70m to £72m.5 Furthermore, we expect that the reduced scope for bad debt provision improvements, combined with industry-wide regulatory changes, will result in FY21 adjusted profit before tax being at a similar level to FY20 adjusted profit before tax.

Previous consensus was £78.0-£84.1m, so this is a c.10% miss.

N Brown: Finance or clothing business?

Many businesses issuing profit warnings could be said to be in the middle of change, and N Brown are no exception to this. N Brown’s financials for the last few years just shows how tough a market this is:

This decline in profits comes as no surprise on a backdrop of increasing costs, increasing competitors discounts and reduced footfall in shopping centres. N Brown’s response to this has been to transition to an online-only business and focus on its better brands.

And those brands do have some value, being slightly differentiated in the market by virtue of serving the plus-sized customer: something that is underserved, especially in menswear. Brands such as Simply Be, Jacamo, and JD Williams are perhaps not the top in the market, but solid nonetheless. Operational leverage appears high due to the large costs required in logistics. Thus, a small change in revenues can adversely affect profits. N Brown’s venture into the USA market is perhaps an example of this, and the company is now cutting back to address the core UK market which accounted for virtually all revenues.

Financing revenues have become increasingly important. In something quite common in the home shopping industry, goods can be sent to the customer up-front and paid off over time, usually at very high interest rates. An excerpt from the account shows:

Less goods were sold, but financial services income increased – that is perhaps an unsustainable combination to have. It could be easy to envisage that the company makes just as much, if not more profit from its credit accounts than it does from selling actual goods.

Such large incomes from finance are not anomalous: Next’s average outstanding debtor balance was over £1bn this year, which generates over £100m of profits, a large proportion of overall profits. For N Brown, this is likely to be similar although items such as bad debt, overheads and the cost of funding have to be deducted off. Some £390m of N Brown’s debt is secured on these customer receivables and results in a relatively low £15m interest charge on a £500m debt pile.

As the trading update says, there appears to be significant headwinds in this area, and new rules could come in to either limit customer exposures, cap interest rates, or both. In an era where interest rates are incredibly low, not much has changed for the catalogues, with credit account rates typically at 25% – a huge profit margin relative to the cost of borrowing.

The balance sheet here is heavily dominated by the fact that many goods are paid for at a later date. The last accounts showed most of its assets relate to receivables (money customers owe for their goods), and most of its debts relate to the finance taken out in respect of this.

Are N Brown shares good value?

Given these facts, the key question may be: how reliably are these receivables converted into cash? Bad debt can be expensive: not only does the loan have to be written off, but there may be incremental expenses associated in the initial attempts to recover the debts.

The losses booked in the past year are not likely to be repeated any time soon: some £145.6m of exceptional items were charged to produced this. It does not seem there is a great deal of headroom for borrowings to increase, but with the adjusted profits being at the level anticipated there should be no need for this to happen.

Arguably N Brown’s valuation is made worse by treating its debt as normal business debt. Eliminating the £390m secured against customer goods, even accounting for some bad debt it could be the case that the core businesses are only trading at modest valuations.

There may be headwinds in the near-term as winding down underperforming brands may lead to adverse comparatives, and legislation regarding shopping debts would hurt N Brown as this generates a significant part of income. But I do believe their niche brands have some value. I would not be a buyer just yet, but would await further share price weakness (below the lows seen last year). It is entirely possible though that the price will not get there. 4/5.

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