Why I won't be buying DFS Furniture plc after 20% drop

Updated: 
Danger: Cliff Edge sign

Shares of sofa retailer DFS Furniture (LSE: DFS) plunged 20% this morning, after the group warned that 2017 profits would be significantly below expectations.

According to the firm, trading conditions have "recently weakened beyond our expectations" and there has been "a material reduction in customer orders". Full-year earnings before interest, tax, depreciation and amortisation (EBITDA) are now expected to be in the range of £82m to £87m.

Taking the mid-point of this range, this means 2017 EBITDA is expected to be 10% lower than in 2016 (£94.4m) and 5% lower than in 2015 (£89.2m). Management believes that this reduction in demand is "market-wide" and results from caution relating to the general election and "the uncertain macroeconomic environment".

I'm not totally convinced that the election and Brexit are to blame. I think a more likely explanation is that customers aren't sure they can afford to pay for new sofas, even if they take advantage of DFS's current four-year interest-free credit offer.

What does this mean for investors?

I estimate that based on today's profit warning, earnings forecasts for the current year may be reduced to about 21p per share. With the stock trading at 196p after this morning's 20% fall, that gives a forecast P/E of 9.4.

That may sound cheap, but if consumer spending really is slowing, sales could have much further to fall. Profits could slide. I don't agree with DFS's decision to pay a special dividend of about £20m this year, while still maintaining a gross debt balance of almost £200m. In my view, it would have made more sense to clear this debt while the going was good.

If I held DFS shares, I'd probably sell after today's warning. I don't think holding the shares is worth the risk until we see whether trading stabilises later this year.

How to make money from falling sales

Falling sales are bad news for cyclical businesses such as sofa retailers. But for large defensive stocks like British American Tobacco (LSE: BATS), they're not necessarily a big problem.

Tobacco sales are falling globally, but BAT has dealt with this by acquiring rivals and consolidating its brands into a smaller number of larger Global Drive Brands. On Wednesday, the group said that it expects to outperform the forecast 4% drop in global tobacco sales this year.

Analysts expect the firm's full-year adjusted earnings to rise by 14.9% to 284.3p per share in 2017, putting the stock on a forecast P/E of 19. The dividend is expected to rise by 10% to 186.8p, giving a prospective yield of 3.4%.

I think these shares are starting to look expensive, especially as exchange rate effects are expected to provide a 14% boost to earnings per share during the first half. These benefits may reverse at some point in the future, putting pressure on profits.

I'm also concerned about debt levels. In 2011, net debt was about £8bn and after-tax profit was about £3.1bn. Since then, net debt has risen by 115% to £17.3bn, but after-tax profit has only risen by 50% to £4.7bn. Acquiring additional market share seems to be increasingly expensive.

These two factors make me cautious about this stock at current levels. Although I'd continue to hold BAT for income, I wouldn't buy any more at current levels.

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Roland Head 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.