Description

Summary

The share price of DNLM is down 42% from its highs in 2016 and we believe at its current price DNLM represents a good opportunity to acquire a quality business at an attractive price.

Background

DNLM is a UK brick and mortar retailer with 172 stores in the UK focused on homewares.

DNLM was founded in 1979 by Bill Adderley, with the first store opening in Leicester in 1984. While no longer having an active role, Bill still holds 24% of shares outstanding. In 1996, Will Adderley, Bill’s son, took over day to day operations and was instrumental in growing the group to its current size. Will is currently deputy chairman and holds 26% of shares outstanding.   

Over the last 40 years the Adderleys have built DNLM into the largest homewares retailer in the United Kingdom (39 consecutive years of increased sales), with a 8.1% market share of homewares. While Dunelm’s core business is in homewares, DNLM is also expanding its furniture offering (particularly online), which currently accounts for about 10% of sales and 1% market share. We think it is important to distinguish at this stage the homewares market from the furniture market. While Dunelm often gets grouped into the same market as furniture retailers, homewares is a fundamentally different business. Both have a similar TAM (total addressable market) of about $12bn in the UK but the furniture market is made up of significantly higher valued goods and is therefore more cyclical. This is reflected in the fact that the average DNLM customer has an average basket size of £30 and typically shops at DNLM every 4 to 6 month. This therefore makes selling homewares less risky than furniture. This is further illustrated by the fact that LFL (like for like) sales in 2009 dropped only 6% and profit margins remained stable at around 9%.  

Disciplined capital allocation

Over the last decade DNLM has built an excellent track record of shareholder value creation, doubling revenue by reinvesting capital at a ROIC  above 30%.

This has been possible because management has been disciplined in opening stores in locations where unit economics are very attractive, typically achieving a pay back of less than 3 years. While we don’t believe the unit economics of opening stores will be as attractive going forward, we do believe that a payback of 4 years will be achievable. By achieving such high return on capital and growing in a disciplined and steady way, management has been able to pay on average all of its FCF (free cash flow) to shareholders in the form of dividends or special dividends and thus considerably increase returns to shareholders. DNLM is a perfect example of how a high ROIC can create a significant amount of shareholder value.

Growth

Due to the fragmented nature of the homewares and furniture market (see below), we believe there is still room for DNLM to grow, particularly in London where it has a lower retail footprint.  Management has a target of doubling revenue in the medium term through a combination of store expansion and online growth.

Like for like growth has historically been around 2% over the past decade but as shown below it has been quite volatile.

While We believe the 2% LFL sales growth will continue going forward, the composition of this growth will change as more and more sales comes from DNLM’s online channel.

We think DNLM will be able to grow at a faster rate than the 2% LFL growth rate as it still has room to open more stores, particularly in London. DNLM has a medium term revenue target of £2bn with about 35% coming from online sales. Historically DNLM has opened around 8 stores per years and while we expect this to moderate, we think this will still be a driver of growth going forward. In the diagram below, note that DNLM opened 10 stores in the latest financial year.

Why are the shares down?

Over the past few years the company has put more emphasis on online sales and this culminated in the acquisition of Worldstores in November 2016. The last 2 years have not been easy for Dunelm, with weak consumer spending in the UK, uncertainty due to Brexit, sales shifting online and a slower than expected integration of Worldsores. The acquisition of Worldstores was important to acquire the IT infrastructure to allow DNLM to accelerate its online sales. Worldstores did however operate under a different business model (more furniture sales, no own brands, lower gross margins, loss making) and this diluted results for the group as a whole.  With the integration of Worldstores now mostly complete, margins should start to improve as management can focus on the core business.

Notwithstanding the difficult environment over the past 2 years, the underlying business has not done as badly as the share price suggests, although, as seen below  operating margins have deteriorated (to a large extent due to the Worldstores acquisition.)

In terms of revenue growth, total revenue in 2017 and 2018 was up 8.5% and 9.9% respectively. Like for like sales in 2018 was up 4.2% (up from -0.5% in 2017), with online sales up 38%. Online sales now account for 16% of total sales. Over this period the share price has fallen 51% and although the share price has recently recovered some ground we think the shares are still undervalued by at least 30%.

Catalyst

Improving operating margin