Why we're adding more Dick Smith

Post-results, we increase our exposure to the retailer while cutting our valuation.

DSH: The market is jumping at shadows

On Tuesday (August 18), electronics retailer Dick Smith Holdings (DSH) announced to the market its full year financial results for FY15. The result was slightly behind our forecasts, at the lower end of market provided guidance. That said, the result still showed the market that growth was apparent, in particular from the roll out of new stores.

While the result was slightly behind my expectations, as a result of slightly weaker than anticipated like for like sales and a lower gross margin, the company is still attractive in terms of its ability to pay a strong income stream to investors.

What’s more, the company’s growth through new store roll-outs has some way to go. This was the driver of a 7.3 per cent lift in earnings before interest, tax, depreciation and amortisation (EBITDA), whereas EBITDA from existing stores was in line with last year. I have revised forecasts for the business in the longer term. I continue to view the opportunity as attractive. Hence, I increase the Income First model portfolio exposure to DHS to 8 per cent, purchasing another 1685 shares (I’ll use tomorrow’s open price as the entry).

The 5 cent fully franked DSH dividend is attractive, and the company has the long-term prospect now to provide some capital upside. We retain a buy call on the stock, albeit with a lower valuation of $2.25 after adjusting forecasts, and increasing risk weights.

Why the selling?

Following the release of DSH’s financials to the market on Tuesday, the company was sold down by 15 per cent plus over the next two sessions. This sell off is unfounded. The FY15 numbers were within my expectations, ahead at the EBIT line, but slightly behind at both the revenue and net profit lines. Nothing in these numbers warrants a 16 per cent decline in stock value. Additionally, the company’s cash flow and FY16 guidance for net profit offered no surprises. Below is a comparison between our forecasts and the result, showing that the company’s numbers were only slightly soft driven by that weaker sales number.

Dick Smith Holdings

FY15e ($m)

Actual

Revenue

1341.9

1319.7

EBITDA

81.2

79.8

EBIT

64.3

65

Net profit

44.7

43.4

Operating Cash flow

-5.3

-3.9

Net Debt

36.9

41.0

Why then did DSH shares get so heavily sold down? This will remain a mystery a little longer, but for now some speculation is possible. One potential reason is the cash flow result. More on that in a moment, but suffice to say we are comfortable with DSH’s cash flow and believe that operating cash flow in the first half of FY16 will be enhanced by a working capital unwind.

Alternative theories are doing the rounds – such is the ASX rumour mill. However, no credible reasons exist except one: the company’s like-for-like sales disappointed to the point that the company was derated. In the short term (from now until end FY17), DSH has a very clear strategy for store ‘roll out’ driven growth. With flat like-for-likes some may be questioning the terminal value of DSH beyond FY17. We are of the view that this would be a very harsh judgment to make. DSH management are likely to implement additional strategies for growth or improvement beyond FY17, but may yet to have created detailed plans and communicated these with markets.

So, while there is some merit to this argument, the same could be said of competitor JB Hi-Fi (JBH) or a litany of other retail businesses.

DSH dividend and cash flow result

As flagged to the market by DSH management, the company invested heavily this year, and saw its operating cash flow marred by some timing impacts. As discussed in our piece when we first added DSH to the portfolio (Dick Smith’s decent dividend, July 27), this operating cash flow was expected to be heavily impacted by working capital timing, so comes as no surprise. That additional working capital was a result of early purchasing decisions made to limit currency risk in the short term. This is likely to unwind in FY16, resulting in a vastly improved cash flow result.

Despite the weak cash flow performance, DSH has provided the market with a 5 cent final dividend, fully franked. This is as expected, and takes the full year dividend to 12 cents, a yield of around 7 per cent (10 per cent including franking credits). Given our view is that this dividend is likely to grow in FY16 to a forecast 13 cents, we think that DSH’s income potential is quite attractive at present.

Operating result uninspiring, but the growth is there

Sure, the result from DSH was a little soft, and in fact was a bit behind our expectations. The like-for-like sales and operating margins were soft. However, the company opened a total of 25 new stores in FY15, and is expected to continue that trend with 15 to 20 further new sites planned for FY16. Clearly, if DSH can hold sales and profit flat in the existing store network, then growth will be apparent via the roll out strategy. I have revised forecasts to what I believe are now bear case scenario forecasts for FY16 and beyond, based on the potential for continued flat performance in the group’s ongoing operations.

Industry trends and strategy

The strategy at DSH remains unchanged and will focus on new store roll-outs aimed at growing the group’s earnings through until FY17. This strategy should deliver. However, some risks are apparent, and should be identified. The consumer electronics sector remains competitive, and requires the company to continue to generate online revenue, protect margins through the increasing of private label ranges and expand product ranges to assist sales growth.

As mentioned there may be concerns regarding DSH’s ability to maintain growth in the absence of new store roll-out benefits. This is a key consideration given that the industry is one that is subject to technological disruption and heavy competition. We will continue to monitor DSH’s progress in attracting online market share, introducing high margin private label products (the company announced 40 new products to be introduced in FY16), and the general indicators provided by consumer trends and data.

Outlook and trading update

DSH has provided a trading update showing that July sales were a mere 0.1 per cent higher on a like-for-like basis. However including new stores, sales were 6 per cent higher, again reiterating the idea that DSH’s growth is borne from investment at this stage. This performance is in my view unexciting, but not disastrous. The company will be able to continue to pay investors a healthy dividend with this level of growth.

In addition to the July trading update, DSH management have provided guidance for FY16 net profit of between $44 million and $48m. Again, this is in line with our previously provided expectations of $46.7m for FY16. We note that this also places DSH in a good position to lift the full year dividend, or at least maintain it at the bottom end of the guidance range. Given the recent share price movements, and the potential alarms that this may raise, I have increased some risk metrics in my valuation. Additionally, we have revised our forecasts for FY16 towards the lower end of the guided net profit range.

To see Dick Smith Holdings’ forecasts and financial summary, click here.