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Dunelm (BUY)

Dunelm Q3 mean FY16 is on track to beat profit forecasts

Dunelm, a FTSE 250 constituent delivered strong Q3 results, helped by its “Simply Value for Money” range and a Winter Sale period that was six days shorter than 2015.

Total sales growth of 5.9% was helped considerably by the online home delivery growth (+27.6%) and new store openings (+10.5%).

Together, these comprised £42m or 18.3% of total sales of £229m over the period of 13 weeks to 2nd April. This period has been described as being very challenging by other major retailers (as discussed below).

Dunelm has reduced the carrying inventory and reported a lower cost for end of sales clearance boosting gross margins by 0.9%. The board has guided analysts to expect a 0.5% margin improvement over 2015.

Over Q3 net debt rose to £85m after Dunelm paid a special dividend of 31.5p per share costing £63.9m.

Going forward, the Dunelm board’s plan is to grow from 151 superstores to 200 locations with a focus on London. Dunelm is underweight in London with just 8 stores at present. The plan is the new 50 London/SE stores will complete the UK national coverage.

On the 7th April, the board provided further details on the roll-out which is six for the 2016 financial year (ending 2 July 2016) and a further five in 2017.

Depending on the speed of this roll-out and the bank lending constraints, Dunelm may consider tapping shareholders, though this is some way off in our view. The board is likely to prefer the use of internal cash.

Broadly this is a very positive Q3 report that leaves Dunelm well positioned to beat consensus EPS forecasts of 49.5p for 2016.

Dunelm financing capacity will get maybe half the rollout

In funding the London “rollout”, Dunelm starts in a strong position with relatively low gearing and the added plus of being strongly cash generative. At the interims, cash levels jumped due to lower working capital/ lower inventories.

Over H1 Dunelm invested around £12m of a total spend of £20m on new stores. The £12m investment added 5 stores hence £2.4m per store.

Whilst these are rough and ready amounts and a rollout in London/ South East would come at a higher individual budget, using a £4m estimate would require c. £192m to achieve the 48 additional stores for a London rollout. This could be obtained variously.

Sources of “rollout” funds:-

  1. There is a £150m revolving credit facility (RCF) which expires in February 2020 and a £20m syndicated overdraft. About £70m of the RCF has been drawn down by end January 2016 hence available banking facilities are c. £100m.
  2. Dunelm might tap the retail bond markets, capitalising on its strong consumer name and the ability to obtain fixed term funding at near record lows. A retail bond of £100m is possible.
  3. Placing/ rights; clearly the most expensive funding a £100m issue of new equity is certainly possible.
  4. Internally generated cash, possibly around £50m from retained earnings.

£11bn UK Homewares environment shows differentiation

After a strong 2015 the UK retailers have sold off on concerns over UK consumer spending ahead of the 23rd June EU referendum vote, and the ramifications for the UK economy in the event of a “leave” vote. Would UK retailers continue to enjoy access to the EU on the same terms?

Lord Wolfson, CEO of Next says 2016 will see a challenging retail environment. He cited 2008 as being similar in terms of the level of uncertainty. In terms of clothing, the immediate outlook appears to lack positive catalysts.

But the UK homewares sector should benefit from the ongoing weakness in the Chinese yuan / soft pricing factors for Chinese-sourced homewares products ie soft furnishings/ sofas etc. The outlook is for UK monetary policy to remain unchanged over 2016 with positive increases in tax allowances helping consumer disposable income. These factors are positive supports.

UK Peer EPS Growth 2011-15 (%) EPS Growth 2016 (%) P/E (x) Comment
Debenhams -22   14 11.0 Top line +/- 1%
DFS Furniture >300   64 22.2 One-off factors
Dunelm  57     6 19.3 Strong trading
Home Retail -36  -33 11.6 Acquisition due
M&S -20 -0.7 11.8 Inexpensive
Next  62     8 13.1 CEO warning
Tesco -61 -61 16.9 Profit decline

Source; Fidessa

*Debenhams main job since IPO in 2006 was reducing debt which was far too high ten years ago (>£1bn) has since been cut to £300m. However the board has struggled with revenue growth and EPS has declined in the last five years.

*DFS Furniture has booked a tax credit of £9.9m following a conclusion of an HMRC negotiation hence this will boost FY16 results.

*Home Retail / Sainsbury merger is agreed at 55p + 0.321 Sainsbury shares. The deal follows five years of declining profitability for both Sainsbury and Home Retail.

*Next CEO Lord Wolfson reported solid profit growth for 2015 but warned of competitive, challenging conditions over 2016.

*Tesco’s market share loss and profit decline in recent years is yet to show a significant reversal, the Tesco business is stable but with far weaker profitability.

Overall the UK retailers are divided between those growing profits (DFS, Dunelm, Next) and profit decliners (Debenhams, Home, M&S, Tesco). This selection excludes privately owned companies such as IKEA, a major UK competitor (recently reported static profits of €3.3bn).  A more competitive IKEA, which is growing market share, could squeeze Dunelm, though so far that is not being flagged as a problem.

Conclusion

The Q3 results today demonstrate Dunelm’s sales, margin, and market share growth trends remain in place.

Our expectation is Dunelm’s EPS growth to 2020 will be c. 40%-60%, similar to that achieved since 2011 at 57% with some sensitivity to the timing of the store rollout.

Dunelm equity should continue to outperform the UK retail sector due to its superior growth and margin trends. Its’ higher PE reflects some of this variation. We have set an £11 per share price target looking forward 12 months.

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