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Why I’d buy this FTSE 100 6% yielder over this struggling retail peer

UK homewares retailer Dunelm (LSE: DNLM) saw its sales growing rapidly in the first half of its 2017 financial year, but this growth came at a cost for the company which, like most of its peers, is struggling to compete in the UK’s increasingly competitive retail environment. 

Contracting margins 

According to the company’s second half figures, which were released this morning, total group revenues increased by 18.4% in the final six months of last year. Like-for-like sales, which exclude sales figures from new stores opened during the period, increased by only 6%. However, this sales growth was offset by significantly weaker gross profit margins. The company’s gross margin declined by 1.8% to 48.6%. 

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Overall pre-tax profits rose marginally to £56.3m from £55.9m, although on an underlying basis, excluding items related to the acquisition of WS Group (acquired out of administration in late 2016), underlying profits dropped 8%. Still, despite this performance, management is upbeat. The group’s chairman Andy Harrison said alongside today’s numbers that Dunelm expects “a more stable margin performance in the second half which, together with reduced losses and increased integration benefits from the acquisition, should deliver good full-year profit growth”. 

Nevertheless, while management is optimistic about what the future holds for the group, it seems that investors are less willing to wait for a turnaround as shares in the company have dropped by more than 13% in early deals this morning. 

Not living up to expectations 

It seems that investors are concerned about Dunelm’s growth prospects. Over the past five years, the company’s revenues have grown at a steady rate of around 10% per annum as its low-cost offering and store expansion programme has attracted new customers. Thanks to this growth, the market awarded the shares a high valuation. Before today’s trading update the shares were trading at a forward P/E of 13.5, compared to the retail sector average of 11.6. 

It now looks as if Dunelm is struggling. The market has quickly turned its back on the company and this is why I would sell it in favour of FTSE 100 retail stalwart Next (LSE: NXT)

The best in the sector 

Next is not immune to the pressures impacting the rest of the UK retail industry, but it is coping better than most. The firm’s online business is still growing at a high double-digit rate, offsetting declines in its brick-and-mortar store portfolio. Indeed, for the year to 24 December, stores sales contracted by 7.2%, but online sales grew by 10.4%, resulting in overall sales growth of 0.2%. What’s more, unlike many of its peers, Next’s strong cash generation means that it is well prepared to weather any downturn. 

For the year to January 2018, management predicted excess cash generation of £300m after capital spending and dividends. The company is planning to return this unneeded capital to investors via a share buyback to complement its existing generous dividend policy. Current forecasts from the City suggest that the shares will support a yield of 3.2% for 2018, excluding any special distributions. 

Including special dividends, the shares yielded 7.2% for investors last year and I think it is highly likely management will follow a similar policy this year. Even if it doesn’t, the regular dividend yield coupled with the already promised £300m share buyback is equal to a total shareholder yield of 7.4%, a return few other companies can match.

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Rupert Hargreaves owns shares in Next. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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