An early warning sign to help spot struggling UK retailers
We flagged up the importance of having an analytical process that can, on a consistent basis, help you distinguish between companies that deserve to be cheap and ones that don't.
We also touched on seven questions we ask about every company we analyse, which help us distinguish those likely to remain permanently cheap from those whose share prices have the potential to bounce back.
These questions relate to the quality of a business, say, or the strength of its finances but this time we are going to drill down to one particular measure we use when analysing one particular industry – UK retail.
UK retail in decline
With this sector in broad decline, it has become increasingly obvious any operating leases – that is, leases a retailer holds that do not have to be recorded as debt on its balance sheet – will be an essential component to the success of a business and its ability to survive an economic downturn.
The metric we use to assess this aspect of a retail business is called fixed charge cover.
If you felt moved to calculate this yourself, it is a companys EBITDAR (earnings before interest, depreciation, amortisation and rent) divided by total debt service costs (net interest and rental expenses).
At its heart, however, this ratio illustrates the ability of a business to service its debt and rental obligations. Our rule of thumb is that when a fixed charge cover approaches 2x or 2.5x, serious alarms bells start to ring.
Take a look at the following chart, which ranks a dozen of the UKs household-name retailers by their fixed charge cover and also shows the total returns on their share prices over the last six and 12 months.
As you can see, there is a huge correlation here, with all the companies with a fixed charge cover of less than 2x, seeing their share price falling by a half or more over the last 12, and indeed the last six, months.
Retailer returns versus the fixed cover charge over the last 12 months
1yr total return
6m total return
Fixed charge cover
MOSS BROS GROUP PLC
MULBERRY GROUP PLC
PETS AT HOME GROUP PLC
SPORTS DIRECT INTERNATIONAL
MARKS & SPENCER GROUP PLC
JD SPORTS FASHION PLC
DUNELM GROUP PLC
Source: Bloomberg to 27 March 2018. Securities mentioned are for illustrative purposes only and are not a recommendation to buy or sell.
One curious twist about this metric is that it appears to be very UK-specific, failing to translate once, say, it crosses the Atlantic.
Nevertheless, the fixed cover charge does produce some strikingly clear results in the British retail sector, with a low ratio very much a warning sign in our eyes – and one that the wider market may well have missed.
- Roberta Barr is an author on The Value Perspective, a blog about value investing.It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.
Important Information: The views and opinions contained herein are of those named on this article and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The sectors and securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. This communication is marketing material.
This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.