Dunelm’s share price has fallen by more than 40% over the last two years.
Part of that decline is due to the market’s Brexit-related dislike of UK-focused cyclical stocks, as some fund managers have pointed out.
However, some of the decline is likely due to increased uncertainty about the company’s growth potential and its ability to compete in the new world of online and mobile shopping.
But before I get into that, let’s back up a bit and have a look at how Dunelm got to where it is today.
Curtains: A surprisingly profitable business
Dunelm started out in 1979 as a market stall in Leicester, manned by Bill and Jean Adderly. They sold curtains, slippers and other goods which they’d bought as factory seconds, and the business was very successful from day one.
They opened their first shop in 1984 and in 1991 they stepped up another gear, opening their first out-of-town superstore. Within a decade, Dunelm had 50 superstores and after another decade it hit the 100-mark.
Today the company generates revenues of almost £1 billion pounds, post-tax profits of around £100 million and is the UK’s leading homewares retailer (ahead of arch-rival, John Lewis).
Here’s what the company’s performance looks like over the last few years:
As the chart shows, the company’s progress has been exceptionally rapid and steady. Here are some numbers to give you a better idea of how impressive this company’s performance has been:
- 10-Year growth rate: 13.5% (FTSE 100 = 2.1%)
- 10-Year growth quality: 96% (FTSE 100 = 63%)
- 10-Year profitability: 38% (FTSE 100 = 10%)
And here are some other attractive features:
Strong balance sheet: Dunelm’s debt ratio (total borrowings / 5yr avg. post-tax profits) is just 1.5, well-below the 4.0 average for UK dividend-paying stocks.
Capital light: The company rents its store space and has relatively little need to invest in expensive capital assets such as machinery, vehicles or other physical infrastructure. This gives Dunelm a low 10-year capex ratio (capex / post-tax profit) of just 46% compared to an average of 66% for the 215 dividend-paying stocks on my stock screen.
One benefit of a low capex ratio is that expansion is easier and less costly. In other words, Dunelm doesn’t have to spend huge amounts on physical infrastructure today in order to generate revenues and profits tomorrow.
No defined benefit pension scheme: DB pension scheme’s are getting a lot of attention at the moment, and rightly so given their frequently huge deficits. For Dunelm investors, this is one less thing to worry about.
Good dividend cover: Other than in 2017 (which in some ways was a bogey year for Dunelm) the company’s dividend has been covered about twice over by both profits and free cash flows. That sort of cover is generally seen as very healthy, although of course a progressive dividend cannot be guaranteed.
With all this good news and its many attractive features, it is perhaps no surprise that Dunelm’s shares went above 1,000p in early 2013, giving the company an optimistic PE ratio of 28 and a paltry dividend yield of just 1.4%.
However, since those happy days the shares have fallen by more than 40% to 570p as I write. So if everything at Dunelm is so rosy, why has the share price performed so badly?
Overpriced Brexit-fodder facing a low-growth future?
To be honest, I don’t like to think too much about why a company’s shares have gone up or down. It could be down to any combination of a million different reasons, many of which have nothing to do with the business (an investor could, for example, sell their Dunelm shares because they want to buy a speed boat).
In this case though, it might be useful to look at what could be some of the main reasons for the decline.
An overpriced starting point: Perhaps the biggest driver of Dunelm’s share price decline was the excessively high starting point. At more than 1,000p the company’s dividend yield was barely above 1% and my favourite valuation metric (PE10, price to ten-year average earnings) was 43, well above my preferred maximum of 30.
The problem with high starting prices is that they’re fuelled by optimism. The slightest whiff of bad news can cause a collapse in optimism and a collapse in the share price, as Dunelm shareholders have found out.
Brexit: This is widely seen as a bad thing for UK-focused stocks. Increased uncertainty has led to a weaker pound and that in turn means higher costs for imported materials. If companies cannot pass higher input prices onto their customers then they’ll have to absorb them, which means lower profit margins and lower profits for shareholders.
Stalled like-for-like growth: Over the past decade, Dunelm’s like-for-like sales growth has averaged 2% per year, i.e. broadly in line with inflation. However, in 2017 like-for-like sales declined by 0.5%, despite inflation being close to 3%.
In the 2017 annual results, management give multiple reasons for this decline, including unfavourable weather, a late Easter and disruption following the introduction of a new warehouse.
Regardless of the reasons, this will not please investors as like-for-like growth is a key component of the company’s growth strategy.
A slower store rollout program: In the last decade Dunelm stepped up its store opening program, opening more than ten stores every year to add to its hundred-plus total. Opening new stores is the main driver behind the company’s impressive growth and it hopes to reach at least 200 stores in the UK at some point in the future (it’s currently up to 160).
But over the last two years the pace of new store openings has dropped, with an average of just six stores being added in each of the last two years.
Going from ten new stores per year to six may not sound like a drastic change, but in percentage terms it is.
For example, back in 2012 when investors were optimistic about Dunelm’s future, the company started the year with 104 stores and opened another 14 during the year. That’s a 14% increase in the number of stores in a single year.
If those new stores can be as profitable as existing stores then the implication is that the company has increased its profit potential by 14% in one year, a healthy figure by most people’s standards.
In contrast, 2017 saw the company start with 152 stores and end with 160, an increase of just 5%. That’s still a reasonable rate of growth, but for the fickle Mr Market it certainly doesn’t justify the company’s previous growth stock rating and near-1% dividend yield.
Potentially lower growth prospects: This one combines the previous two points about like-for-like growth and new store openings. These are two of the company’s key growth goals, with the third being expansion into multi-channel retailing (i.e. increased online orders).
One simplistic way to estimate a retailer’s growth rate is to combine its like-for-like growth rate (i.e. growth from existing stores) with its store-count growth rate.
For example, in 2012 Dunelm’s like-for-like sales grew by 3% and its total store-count grew by 14%, giving a “combined” growth rate of 17%. Obviously that’s pretty good and you can see why investors might pay a premium for that sort of growth.
Following the financial crisis, Dunelm’s combined growth rate averaged 13% per year, but in 2016 and 2017 it fell to 5% due to lower like-for-like growth and fewer store openings.
Of course, if Dunelm’s future growth rate is going to be closer to 5% than 13% then investors will demand a much higher return from income to offset the reduction in growth, and that’s probably a big part of why the dividend yield has gone from 1.4% in 2013 to 4.6% today.
CEO and CFO step down for “personal reasons”: I don’t put a great deal of weight on this sort of thing, but when the CEO leaves after the latest annual results and the CFO leaves after the latest interim results, I think investors are right to be concerned (if only mildly).
So Dunelm is a mixed bag. On the one hand it’s a fantastically successful market leader which has grow at double digit rates almost every year like clockwork. On the other hand, it’s facing difficult economic conditions and a potential shift from growth to maturity.
Given all this uncertainty, negative news and massive share price declines, it would be reasonable to ask:
Why do I still hold Dunelm?
There are three main reasons:
1) Mr Market is frequently wrong
In 2013, Mr Market valued Dunelm at 1,000p per share, probably because he was sure the company would keep growing at double digit rates for many more years.
Today, Mr Market values Dunelm at less than 600p per share, probably because he’s afraid the company will become the next Marks & Spencer, with virtually no growth prospects at all.
Given that Mr Market was so wrong in 2013, why should we trust his judgement today?
The answer is that we shouldn’t. Mr Market does not know what the future holds for any particular stock and, unfortunately, neither do we.
So the fact that Dunelm’s share price has fallen by 40% over the last couple of years tells me nothing about what its share price will do next. It is entirely possible that it could increase by 100% over the next year, or crash by another 40%.
If that degree of uncertainty surprises you then all I can say is, welcome to the stock market.
Because of this price uncertainty I would never consider selling a “loser” just because its share price has fallen; even if the fall was as much as 40% or more.
So rather than worry excessively about Dunelm’s share price decline, I prefer to focus on the company’s long-term past and its long-term future. And that’s the second reason why I still hold Dunelm.
2) Dunelm’s long-term past is still impressive and its long-term future could still be bright
Mr Market seems to base his valuations on how a company is performing today.
From a valuation point of view this is a problem because good companies have bad years and bad companies have good years. Basing valuations on short-term results will therefore result in wildly volatile valuations, and that’s exactly what we get from the excitable Mr Market.
Dunelm, for example, has been a very steady company with very steady growth in revenues, profits and dividends. Despite that steadiness, its price has varied from 230p in 2006, to 110p in 2009, to 1,040p in 2013, to 570p today.
Rather than Mr Market’s short-term approach, I think a better way to value companies is to think about their long-term future prospects, as implied by their long-term financial past.
For example, despite Dunelm’s somewhat slower growth in the last couple of years, its ten-year growth rate is still 13%, measured across revenues, profits and dividends. It has also increased its revenues, profits and dividend 96% of the time during that period, and its ten-year average return on capital employed is a very healthy 38%.
On top of that, the company has low levels of debt, no pension scheme to fund, no track record of wild acquisitions and relatively low capital investment requirements.
A steady track record of growth and a strong balance sheet don’t guarantee a bright future, but I think they’re a much better indicator than a low-growth past filled with losses, cut dividends and massive piles of debt.
In short, and largely ignoring some of the short-term uncertainties caused by Brexit and the UK’s economic situation, Dunelm is still a company I’d be happy to invest in.
Yes, it’s going through a difficult period at the moment, but as a long-term investor I see difficult periods as inevitable, entirely normal and nothing to get excessively worried about.
Short-term difficulties are definitely not a good reason to sell, especially as Mr Market and the share price are likely to be depressed.
Mr Market is currently negative towards Dunelm, but what does he know? Not much, is my answer. Looking into my speculator’s crystal ball, here are just a few of the million-and-one positive things that could happen:
- Brexit turns out to be not so bad for retailers.
- The UK economy picks up over the next few years, as the global economy seems to be doing.
- Dunelm expands rapidly to 200 stores and then begins to replicate its UK success overseas.
- The expansion of its online business (aided by the recent acquisition of Worldstores) more than offsets slowing growth in its superstore business.
Any and all of those could happen (although that’s not to say they will happen) and I think they’re just as plausible as the more negative scenarios.
But the company is only one side of the investment puzzle. The other side is price, and on that front I’m also happy to hold.
3) Dunelm’s share price is still attractive (and getting more so)
Given that I think a) Mr Market is frequently wrong and b) Dunelm’s long-term prospects are largely unchanged, I also think today’s lower share price represents better value for money than the previously higher price.
For example, the dividend yield has increased from 1.4% in 2013 to 4.6% today. If Dunelm’s long-term dividend growth rate is more or less the same from both starting points (let’s say 7%), then buying its shares today with a 4.6% yield will give a higher expected return (11.6%) than the 1.4% yield did in 2013 (8.4%).
Or you could look at valuation ratios, such as PE10 and PD10 (price to ten-year average earnings and dividends).
In 2013, when Dunelm’s share price was above 1,000p, those ratios were 45 and 128 respectively, which is far above my preferred maximums of 30 and 60. Today, those valuation ratios have fallen to 15 and 34 respectively, a more than three-fold decline in just four years.
From my point of view this means we have basically the same company (actually it’s slightly bigger today with higher revenues, profits and dividends than in 2013), facing basically the same highly competitive and unknown future, but which is available for one-third the 2013 valuation, relative to average earnings and dividends.
That’s a massive difference and for me it makes the company a far more attractive prospect; even more attractive than it was in October 2016, when I invested in Dunelm at 827p.
So despite the share price decline I’m happy to keep holding. In fact, if I had some spare cash, I’m sure some of it would find its way into Dunelm.