Is Debenhams plc a falling knife to catch after sinking 15% today?

A Debenhams store at night.

Shares of department store giant Debenhams (LSE: DEB) fell by 15% this morning after the group surprised the market with a profit warning.

Pre-tax profit for the year ending 30 September is now expected to be between £55m and £65m. That’s similar to last year’s figure of £59m, but is around 25% below consensus forecasts of around £83m.

Did you grab a bargain?

Those shoppers who did visit Debenhams over Christmas would have found plenty of bargains. After experiencing slow trading at the start of the first quarter, management decided to slash prices. This delivered a 1.2% increase in like-for-like sales over the six-week Christmas period, but it also resulted in a sharp fall in profit margins.

The group’s gross profit margin for the first half is now expected to be 1.5% lower than last year. That’s a big downgrade from October’s guidance for a 0.25% reduction over the full year.

A falling knife to catch?

Like most retailers, Debenhams is hoping that falling store sales will be offset by rising online sales. The group’s digital sales rose by 9.9% during the first quarter, so there’s some hope here.

However, the group has a large store estate, with many big shops on long leases. Reshaping this portfolio and cutting rents could take time. Another concern is that the group’s operating margin is already low, at just 3.1%.

Debenhams’ shares looked very cheap before today, on a forecast P/E of 6.5 with a prospective yield of 8.7%. Today’s news shows why — the risks were high.

After this update, I estimate that these shares trade on a forecast P/E of about 7.5. I’d also suggest that a dividend cut is now very likely. Debenhams looks likely to remain under pressure in 2018. Despite the stock’s apparent cheapness, I believe there’s better value elsewhere in the retail sector.

One more stock I’d avoid

Theme park operator Merlin Entertainments (LSE: MERL) has had a difficult year. In October’s trading update, management blamed “terror attacks and unfavourable weather” for a disappointing summer season.

The group’s shares now trade at around 345p, largely unchanged from when the company floated on the London market in 2013. Given that annual profits have risen from £145m to £211m over this period, you might think the shares now seem cheap.

I’m not convinced. Although I believe the firm’s trading is likely to gradually improve, I don’t see much attraction for equity investors at the current valuation.

Earnings are expected to rise by just 7% to 21.6p per share this year. That leaves the stock on a forecast P/E of 16 with a prospective yield of 2.1%. That doesn’t seem all that enticing to me.

Although Merlin generated an impressive 21% operating margin last year, this high level of profitability isn’t reflected elsewhere. The capital-intensive nature of developing theme parks and hotels means that return on capital employed (ROCE) is relatively low, at just 10%. Net debt of £1.2bn is also quite high at nearly six times trailing profits. I’d prefer to see this ratio below four times.

In my opinion, Merlin shares just aren’t cheap enough to be attractive. As with Debenhams, I believe there are better options elsewhere.

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Roland Head has no position in any of the 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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