Profit from Dunelm's digital revolution

If the overused proverb about necessity being the mother of invention is really true, then it seems to be working its magic at Dunelm. For the 2020 financial year, digital made up 27 per cent of sales. By the end of its 2021 financial year it was 47 per cent. That's an impressively fast transformation.

Digital first

The company focused has a 175-physical-store estate, but Dunelm is now focusing on online growth. Bricks-and-mortar is still important. The company is continuing to target three to five openings a year while accelerating refits following a slowdown in store-improvement activity during lockdown. However, management believes bigger opportunities are available from harnessing insights from digital data.

Initiatives the company is working on to drive digital sales include improving click & collect options, which come with a three-hour promise, increasing the speed of order turnaround and raising the proportion of orders classed as "perfect". Improvements to after-sales communications and resolution of problem orders are other areas of focus. And the company is looking to improve its product ranges, which includes focusing on the sustainability of products and offering instore recycling.

A key aim is for these efforts to boost the number of high-value customers – the 12 per cent of shoppers that account for two-fifths of sales.

Importantly, there is plenty of evidence in full-year numbers released by the company earlier this month that things are moving in the right direction. Despite Dunelm's shops being fully open for only 65 per cent of last year, turnover jumped 26 per cent while profits before tax were ahead by 45 per cent. That was in large part due to a 115 per cent surge in online sales. And underlying just how impressive the group's performance was during its financial year to end June 2021, management estimates Dunelm's share of the fragmented £25bn homewares market jumped from 7.7 to 9.1 per cent.

Quality and growth

The strong performance last year was exceptional and certainly benefited from the the timing of Dunelm getting its online act together. However, it is not simply a flash in the pan. Since 2015, Dunelm's annual revenues have risen 60 per cent from £836m to £1.37bn. This included almost constant year-on-year growth, other than 2020, when there was a slight dip due to the closing of stores during lockdown. What's more, despite a slight knock caused by the ill-fated Worldstores acquisition, the company has historically been very profitable. Indeed, return on capital employed (ROCE) – a measure of profit compared with the investments made to generate it – stands at over 30 per cent.

Gross margins, a key measure of a company's pricing power, are also high. Dunelm produces affordable products but thanks to longstanding and robust supplier relationships, the cost of production is also low. Its gross margin in 2021 was 51.6 per cent, up from 50.3 per cent in 2020. It hasn’t dropped lower than 48.0 per cent since 2015. For comparison, IKEA which is an unlisted affordable homeware and furniture company, had a gross margin of just 20 per cent in 2020. It also compares very well to other listed consumer businesses (see graph).

Dunelm's pricing power was also evident last year in its decision to have a smaller winter sale and push back its summer sale. None of that did much harm to its impressive market share gains.

The strength of the group's pricing power and supplier relationships are also evident in the company's outlook. Chief executive Nick Wilkinson said the company is experiencing “ongoing supply chain disruption and inflationary pressures from raw materials, freight costs and driver shortages”. All of these issues, plus rising wages due to a shortage of labour caused by the pandemic and Brexit, is expected to squeeze its margins. But despite these headwinds, improved sourcing means gross margin is only expected to come down between 0.5 and 0.75 percentage points in the current year.

Dunelm is also very good at turning its profits into cash. The impressive gross margin improvement in 2021 helped it increase its operating profit by 43 per cent for the year from £116m to £167m. From that operating profit, £184.2m of it was turned into net (after tax) operating cash flow, a conversion rate of 111 per cent. After capital expenditure and lease liabilities payment, its free cash flow (FCF) was £108.5m. And cash flow in the year was actually depressed due to crazy working capital swings caused by Covid, which saw the group running very low on stock in 2020, which boosted FCF that year to £174m, with a reverse impact in 2021. 

Having finished the financial year with net cash up £45m at £129m, which excludes lease liabilities of £293m, the company decided to dole out cash to shareholders by paying a 65p special dividend on top of the 35p basic payout. While the company pulled its dividend during lockdown, it has past form for making large special-dividend payouts and broker Peel Hunt believes another special payout could take the total dividend this year to about 90p, equivalent to around a 6 per cent yield. 

A family affair 

The timing of the digital transition was fortuitous, but it is often businesses that are forward-thinking that are the ones that benefit from fortune. Some of Dunelm’s willingness to look at the long term and its ability to cope well with setbacks, such as Worldstores, could be to do with the fact that it is a majority family-owned business. Pictet Asset Management has found that family companies (30 per cent plus owned) outperformed non-family companies by 56 per cent between January 2007 and June 2020. Dunelm was founded as a market stall in Leicester in 1979 by husband and wife team Bill and Jean Adderley and the family still owns more than half of the £3bn company. 

Family businesses historically have performed better than the wider market because of their willingness to see beyond the next set of analysts' calls. Instead of worrying about the ups and downs of fickle markets, they are instead motivated by leaving behind a well-run business for future generations. Family businesses are also often good dividend payers. Dunelm seems to fit the bill.

But while the family focus may help Dunelm set its sights on the long game, the pandemic undeniably increased demand for homeware and furniture last year. Many white-collar workers needed to order desks and office chairs and the hot property market means there was an above-average amount of decorating. But the property market may already be slowing down with the 73,740 residential transactions in July 2021 down 62.8 per cent on June 2021. The sales comparators for next year could be tricky.

Also increasing digital sales doesn’t always mean that overall sales will go up. There is a risk that they could cannibalise in-store sales. The company needs to find a way to reach new customers with its digital product rather than just servicing the loyal customers that were previously shopping in person.

Despite these concerns, Dunelm we feel is far from the top of the market. Sales in the first 10 weeks of the new year have been “encouraging” and the board expects pre-tax profit to be modestly ahead of the top of the range of analyst expectations this year. After the annual results last week, the pre-tax profit consensus was revised up from £166m for the current financial year up to £177m. 

Dunelm's share price jumped 13 per cent on the day of its results. We see this as encouraging momentum rather than frothy speculation. The shares do not look expensive at 21 times forecast next-12-month earnings given the quality of this business, its potential for growth and the likelihood of Dunelm continuing to hand back large wads of cash.