Sometimes its more profitable to invest in already-successful companies than to hunt for turnaround bargains.
Todays half-year results from Dunelm Group (LSE: DNLM) show why. Like-for-like sales rose by 4.6% to 404.9m. Earnings per share rose by 11% to 29.3p, while fee cash flow rose by 66% to 76.7m.
The firms strong cash generation is particularly good news for shareholders. Dunelm announced this morning that most of its free cash flow from the first half will be returned to shareholders in a special distribution of 31.5p per share. Thats a total payout of 63.9m.
This one-off payout will be in addition to the groups ordinary interim dividend, which will rise by 9.1% to 6p per share.
Dunelm shares have risen by 7% following todays results announcement. Its tempting to say that theyre now fully-priced and that a turnaround story such as Tesco (LSE: TSCO) may offer better returns. But that may not be true.
Heres how the two companies compare based on forecasts for the 2016 and 2017 financial years:
Current broker forecasts |
Tesco |
Dunelm |
2016 P/E |
39.3 |
18.0 |
2017 P/E |
20.9 |
16.5 |
2016 dividend yield |
0% |
2.6% (plus special dividend) |
2017 dividend yield |
0.7% |
3.0% |
While Dunelm isnt cheap, its a profitable, cash-generative business with rising sales and profits. Dunelms 16% operating margin enables it to fund shareholder returns and highlights its strong brand and market share in the homewares sector.
As a contrast, Tesco is battling its way through a major restructuring and a supermarket price war. The outcome looks likely to be permanently lower profit margins for all UK supermarkets. An operating margin of 2% to 3% seems all that we can hope for.
Tescos very high P/E rating also implies that a significant recovery is already priced into the stock. I do expect the firms earnings to gradually recover to perhaps 15p per share, but at 180p Tesco shares look quite fully-priced to me.
A second concern is Tescos 8.6bn net debt. The group has already sold one of its best foreign assets, its Korean business, in order to reduce debt. Its not yet clear how Tesco will generate enough cash for further reductions.
Sell Tesco and buy Dunelm?
Should I sell my Tesco shares? In my view, fair value for Tesco isnt much more than 200p per share. Although this is close to the current share price, I probably wont sell at the moment: I believe trading conditions and sentiment are both improving. Further gains may be possible.
Despite this, I suspect that Dunelm will continue to provide superior returns. Earnings per share are expected to rise by 3.9% for the current year, and by 9% next year. I wouldnt be surprised if these forecasts are now upgraded following todays results.
Dunelms growth plans now focus on expanding its store network in the London area, and boosting online sales. Sales for home delivery rose by 24.4% during the six months, suggesting strong momentum in this area.
My only real concern is that Dunelms growth may be strongly linked to the UK housing market. When the next housing market downturn strikes, I suspect sales will take a hit.
Despite this risk, I believe Dunelm shares could continue to outperform those of Tesco for some time yet.
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Roland Head owns shares of Tesco. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.