Edmond Jackson's Stockwatch: Home Retail Group

Does a soaring price/earnings (P/E) multiple for the FTSE Mid 250 shares in Home Retail Group, suggest the market is justifiably confident it can beat brokers' forecasts? Or, along with hysteria over Royal Mail and directors taking profits at Sports Direct, might it signal that asset inflation resulting from quantitative easing is becoming unstable?

The consensus is not necessarily right, and markets can swing to extremes. In June 2012 I drew attention to the owner of Argos and Homebase because an inflection point was apparent in the way the chief executive had snapped up 160,000 shares at 76.87p, when 22% of the total issued was out on loan (i.e. traders shorting) and 15 out of 22 brokers researching HOME advised 'sell'.

I pointed out it only needed a modest tilt in this extreme for the shares to re-rate. I have also been a fan of Argos' click-and-collect marketing where you can scan the internet for the right product and best deal, then collect locally, hence have a genuine relationship with a store. With enough online retailers it can be hard to assert the Sale of Goods Act if the product fails to work or is not fit for purpose.

In 15 months the shares have more than doubled to 200p, the rise accelerating amid latest interim results to end-August.

Due to restructuring at Argos - hence £12.6 million exceptional items - there is a discrepancy between reported and underlying profitability; but if the consensus forecasts, as shown in Company REFS (see table), are fair then earnings per share is set for recovery after years of decline.

For the year to 2 March 2014, about 8.5% earnings growth is anticipated, rising to 13% in 2014/15, hence a P/E of about 23.5 reducing to 21 times. Net tangible assets per share have advanced from 116p last year to 130p and while this previously implied 'a margin of safety' it now puts more emphasis on earnings. Dividends are also expected to recover but the prospective yield is only about 1.7%.

So the crux is whether marketing initiatives can offset risks for consumer discretionary spending as UK living costs rise. First half-year total sales have risen by 2.6% to £2.59 billion, with Argos up 2.3% and Homebase 5.9% higher. Mind that fine summer weather helped stoke demand for seasonal items, e.g. in the second quarter, sales of paddling pools soared 70% and more desk fans were sold in a fortnight than during the whole of 2012. At Homebase, sales of barbecues surged 56%. Not to disregard the operational skills helping achieve this, e.g. internet penetration has reached 43% of Argos' total sales with mobile commerce growing 124% to account for 16% of total sales.

Utility-bill increases are in public focus, but even if this amounts to a £150 increase in the annual toll on households, is it going to have such a negative effect or favour those better retailers? We have quite been here before, two years ago with dire warnings for 2012, but recession did not prove as deep as feared; life carried on pretty much as normal for a majority of people; and a few retailers such as ASOS and Sports Direct achieved bumper results by adapting to consumer needs. Within brokers' 2012 'sell' stances on Home Retail there was a sense that people who shop at Argos and Homebase - socially "the Bs and Cs of the nation" - are vulnerable to cost of living increases. Perhaps the brokers failed to appreciate click and collect can be a powerful marketing tool for wider society.

Within the latest income statement profile, cost of sales rose by 3.0% and clipped the rise in gross profit to 1.7%; while net operating expenses were flat at £800 million; hence, excluding exceptional items, operating profit rose 76.9% to £29.9 million. The group generated positive cash of £16 million with closing net cash of £412 million. It may not be possible to take out significantly more costs, considering some are liable to rise with inflation, so the case for Home Retail shares appears to rest on future sales growth.

Initiatives include new smartphone and tablet apps reaching eight million customer registrations; "digital concept stores" where laminated catalogues, paper order forms and pens are replaced by tablet computers; and a deal struck with eBay enabling customers of selective eBay merchants to collect goods in 150 Argos stores. Homebase is progressing store re-fits. Management is optimistic about prospects for Christmas sales, soon to launch a digital Christmas gift guide, while their assumption is subdued consumer spending.

This is all good and Home Retail may evolve as a textbook turnaround. Yet the prospects as can be envisaged look reasonably priced in, hence a more cautious stance is justified at 200p. Certainly shares can trade on a high P/E when anticipating earnings recovery, but there is a fair chance here that a P/E well over 20 times with insignificant yield is reflecting the wider market exuberance.

For more information see homeretailgroup.com.