Top up on defensive Dunelm

Yet for investors in retail stocks, there are recession-friendly value retailers with solid balance sheets that generate decent profit margins and the high levels of cash flow that fuel special dividend programmes - one of these is homewares group Dunelm (DNLM).

As part of its latest trading update ahead of announcing results for the year to the end of June, Dunelm reported underlying fourth-quarter like-for-like sales growth of 2.9 per cent, adjusting for the timing of Easter and the prior year's additional 53rd week. Overall sales for 2015-16 have increased by 7.1 per cent (or 2.5 per cent on a like-for-like basis) to £881m. Gross profit margins for the final quarter were also up 0.8 of a percentage point, leaving full-year margins up by 0.6 of a point. As for the Brexit vote, management says there was a softening in activity before the referendum, but normal trading has since resumed.

That's a pretty strong end to the year, which has contained a couple of wobbles such as unfavourable weather at the start of the year. But it's important to remember that Dunelm delivered steady sales and profit growth straight through the most recent recession and the financial crisis, too. That was likely a result of the group's broad 'value' proposition across the homewares and general merchandise categories, which analysts think attracts a more value-conscious shopper in tougher times. So it's reasonable to believe Dunelm is better suited than many retailers to trade well through a tough consumer environment as it captures customers who are motivated to 'trade down'. A key example is the traditional John Lewis customer who, last time around, took the decision to shop in search of the best value for money.

Dunelm's trading update also showed the group has finished with year-end net debt of £80m. This reflected working capital inflows from more efficient stock handling and was a better outcome than broker Peel Hunt's £95m forecast. Management has already set out the target for special dividend payments, too, specifically when a year's free cash flow is more than a quarter of cash profit. That would be the equivalent of net debt around £40m, prompting analysts to believe that Dunelm can pay a special dividend totalling around £65m for the 2016-17 financial year - equivalent to 32p a share - as long as all goes to plan.

Meanwhile, many retailers are faced with the prospect of rising costs because of the introduction of the new living wage in Britain and the current weakness of sterling versus the US dollar. But direct sourcing at Dunelm is fairly low - below 20 per cent - and US dollar costs have already been hedged for next year. However, analysts point out that the cost of the majority of items sourced in the UK are still dollar-dependent and therefore cost inflation could build from the next spring/summer season onwards. That said, Dunelm's largely exclusive, regularly changing own-brand lines means it is well placed to limit such effects through flexible buying patterns.