Interactive Investor

Stockwatch: these shares discount a recession but which one to buy?

UK consumers are already tightening their belts as stubbornly high inflation eats into disposable incomes. But analyst Edmond Jackson thinks a lot is already baked into share prices at this corner of the retail sector.

20th October 2023 11:06

by Edmond Jackson from interactive investor

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UK consumer resilience – at least for those in work on inflation-linked pay – is affirmed by strong sales at homeware group Dunelm Group (LSE:DNLM) , which cites a 9% increase on the same 13-week period ended 30 September. 

Significantly, the advance was driven by volume rather than pricing, as if discretionary spending on homes continues. Despite a weaker housing market, I find a similarity with the aftermath of the 2008 crisis when home sales stalled and headlines portended recession, yet kitchen/bathroom installations rose through 2010 and 2011. 

It appears to reflect people re-focusing on their existing homes, as if they are not going to move, and that enough people are employed in sufficiently well-paid jobs that are pegged to inflation. 

Dunelm management contends that its increasingly wide product range, outstanding value plus an expanding store estate, means “a significant opportunity to take further market share,” adding: “we remain very confident about our prospects for continuing to drive sustainable growth.” 

That would be hard to row back from should spending actually ease, but is presumably what they think. 

Showing how the market is significantly in “all news is bad news” mood, Dunelm remarkably traded 2% lower in response to the results before settling only 0.3% easier at around 1,030p. The stock is at the bottom end of a 1,000p to 1,200p range this year, but in a 20-year context is effectively down only to a steadily upwards trend line (notwithstanding considerable volatility during the Covid period).

Dunelm Group - financial summary
Year-end 1 Jul

Turnover (£ million)1,0501,1001,0581,3361,5811,639
Operating margin (%)9.111.511.012.513.812.1
Operating profit (£m)95.8127116166218199
Net profit (£m)73.310187.7129171152
EPS - reported (p)36.249.942.962.983.675.0
EPS - normalised (p)
Operating cashflow/share (p)48.685.712089.9123119
Capital expenditure/share (p)22.812.312.27.711.710.8
Free cashflow/share (p)25.873.410782.2111108
Ord dividends per share (p)26.528.
Covered by earnings (x)
Return on total capital (%)30.447.523.831.347.146.5
Cash (£m)
Net debt (£m)12425.3269165301288
Net assets (£m)135186173281178138
Net assets per share (p)66.792.085.713988.468.2

Source: company accounts.

Resilient margins (so far) and a culture of special dividends 

Despite consensus estimates already expecting a 5% annual revenue rise to July 2024, flat net profit of £152 million is targeted – as if implying margins must fall. Yet in respect of the first fiscal quarter, the update cites gross margin benefiting from “a net tailwind from freight and foreign exchange rates whilst continuing to offer outstanding value to our customers.” So gross margin improved by 1.2% versus guidance of a 1% rise for the year as a whole.    

This implies a 2024 price/earnings (PE) multiple near 14 times, reducing to below 13 if hopes for a recovery towards July 2022 earning power is achieved. But while the stock currently lacks growth appeal after some solid years recently (see table above), the yield could be 6% or better if the company maintains any extent of special dividends.

In respect of 2022, for example, the interim and final dividends totalled 40p a share, yet there was also a 37p special dividend, and this year a 40p special dividend has been paid. Take a draconian view – that the special element is halved and the ordinary held – and a total 60p a share would still get near 6%. If Dunelm’s current financial trajectory is held, that could be 7% or more. 

Given a fair chance, this area of discretionary spending could hold up, and if Dunelm’s marketing remains adept, I rate the stock a ‘strong hold’ despite some risk that management may have a rose-tinted view. 

Marks & Spencer was more cautious in outlook 

A mid-August update from Marks & Spencer Group (LSE:MKS) in respect of the first 19 weeks of its financial year from 1 April, included a 6% rise in Clothing and Home sales, although that seems rather historic now, and was helped by the turnaround on Marks’ clothing side.  

Contrasting with Dunelm and despite its “defensive” food sales, management warned of “considerable uncertainties about the economic outlook, a risk that the consumer market will tighten as the year progresses.” 

Norcros shares languish amid pension deficit repairs 

In home interior improvement, bathroom, kitchen and tiles supplier Norcros (LSE:NXR) updated on 12 October in respect of its first-half year to 1 October. Management cited “robust” performance albeit like-for-like UK revenues 1% easier while South Africa fell 11% at constant currency, hence a 4% revenue slip overall.  

Yet they are confident to achieve market share gains in the financial year to 31 March 2024, with operating profit (so far) in line with consensus. 

On such basis, at 141p the forward PE is 4.5 easing to 4.3 if expectations for results in 2025 are accurate, backed by a 7.3% yield covered three times by earnings. I have noticed Norcros appearing cheap for years, if not decades, given investors distrust South African exposure (a third of group revenue). More recently, pension deficit contributions have absorbed cash flow - by £3.8 million in the last financial year. 

The stock has been in persistent decline from 330p in August 2021, when expectations started to shift towards higher interest rates, hence “risk-off” sentiment affecting small-caps especially. Despite a full listing, Norcros is capitalised at just £127 million. 

Norcros is back near its 2020 Covid lows and in a long-term sideways volatile chart, making it pretty disappointing as a long-term investment. With leading market positions such as Triton and Merlyn showers, and despite the pension matter, I would not be surprised if takeover interest materialises. Net debt of £50 million makes for gearing around 35%, not exactly high-risk.  

Despite no apparent support level on the chart, plus the risk of a recession in 2024, Norcros tantalises as a ‘buy’. The six-year table shows a fair mid-to-high single-digit operating margin and a strong free cash flow profile. Mind, £210 million net assets last March were constituted 79% by goodwill and intangibles. Net tangible assets per share are 48p. 

Norcros - financial summary
Year end 31 Mar

Turnover (£ million)222236271300331342324396441
Operating margin (%)
Operating profit (£m)10.216.716.819.625.117.824.936.227.5
Net profit (£m)
EPS - reported (p)13.020.713.314.223.913.518.631.218.8
EPS - normalised (p)18.823.517.718.628.021.822.438.237.4
Operating cashflow/share (p)23.226.435.625.135.632.166.017.727.4
Capital expenditure/share (p)11.310.512.511.
Free cashflow/share (p)11.915.923.114.028.726.262.511.120.7
Dividend/share (p)
Earnings cover (x)
Cash (£m)5.65.937.525.827.247.328.327.429.0
Net debt (£m)14.232.523.
Net assets (£m)52.747.656.6105126104148200210
Net assets per share (p)87.477.391.5130156130184247235

Source: historic company REFS and company accounts.

Sanderson Design is similarly priced for recession 

Also relevant for spending on interiors is luxury interior furnisher Sanderson Design Group (LSE:SDG), which posted interim results to 31 July on 11 October – showing a 2% slip in like-for-like revenue, while net profit rose 12% near £5 million, hence earnings per share (EPS) up similarly.  

This reflected strong US sales of wallpaper and fabrics, offset by a challenging UK market. Licensing revenue soared, hence profits were boosted by its higher margins. Otherwise, brand sales dipped nearly 6%. 

We are told “luxury” is defensive given the most affluent in society are barely affected by recession. I would bear in mind an aspect of aspirational buying by middle classes however, possibly tempered in recession as home improvers back off from the highest quality. 

Consensus anticipates a fairly flat EPS scenario to year-end 31 January 2025, with EPS around 14p, hence with the stock currently around 102p, the forward PE is just over seven times. The prospective yield is 3.5%, covered nearly four times if the 3.6p forecast is fair.  

The balance sheet is especially strong, with net cash excluding leases at around £16 million, relative to £76 million market value. 

Further licensing deals could continue to offset softer UK consumer spending but equally depends on the US averting recession. 

Similar to Norcros, key brands are being rated modestly by the stock market, so could attract takeover interest. It is hard not to think a “buy” stance already applies. 

Sanderson Design Group - financial summary
Year end 31 Jan

Turnover (£ million)87.892.411211311293.8112112
Operating margin (%)9.38.311.
Operating profit (£m)8.27.713.
Net profit (£m)5.95.411.
Reported earnings/share (p)
Normalised earnings/share (p)13.825.021.610.17.05.912.614.6
Operating cashflow/share (p)10.315.06.416.311.525.112.58.3
Capex/share (p)
Free cashflow/share (p)
Dividend per share (p)
Covered by earnings (x)
Return on Total Capital (%)20.611.918.
Return on Equity (%)12.421.
Cash (£m)
Net debt (£m)-
Net assets per share (p)58.673.787.285.891.394.1112114

Source: historic company REFS and company accounts

What chance of a 2024 recession is thus the chief concern 

Analysis by Citi, borrowed and promoted by the Institute for Fiscal Studies (IFS), targets a “moderate” UK recession over the first nine months of 2024, given interest rates are likely to remain high and there is no genuine scope for tax cuts. 

It is entirely possible that operating narratives turn more cautious like M&S portends, or even profit warnings to follow. In this scenario, those cautious investors may prefer to sit things out, albeit at the risk of missing a turn, or takeover.  

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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