Edmond Jackson's Stockwatch: Home Retail overcomes experts' warnings

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How sentiment changes. From one of the market's most-shorted stocks two years ago, FTSE Mid 250-listed Home Retail Group has trebled in market value to about £1.7 billion with its shares currently at 215p.

It is a terrific rally but there are good reasons to stay tuned to progress from the owner of the UK's largest general merchandise retailer and the number two home improvement chain.

A latest trading statement cites good performance in the year to 1 March 2014 for the Argos and Homebase stores, putting pre-tax profit slightly ahead of recent market expectations for up to £111 million.

It appears the group is benefiting from people searching for best-value products; whereas two years ago I recall brokers' analysts warning its customers were people most exposed to Britain's austerity policies, also the extent of Argos stores was uneconomic.

But after the chief executive bought 166,000 shares at near 77p in June 2012, I suggested: "Home remains a crowded trade on the short side, so if and when momentum does tip positively there will be serious upside."

Impressive marketing

I was impressed by the group's "click and collect" marketing which blends the convenience and product range of internet shopping with a genuine relationship with a store.

Online retailers such as Amazon tend to apply a one-month returns policy; and while it ought to be possible to pursue them for faulty goods under the Sale of Goods Act, this is a lot easier where the contract involves a store you can return to.

People appear to have cottoned onto this as a sound deal, with internet sales up from 42% to 44% of total Argos sales and mobile commerce up 89% to 18% of same.

Admittedly click-and collect also appeals because some 80% of Argos sales cost less than £30 but are too big for letterboxes hence a £5 cost for home delivery applies.

The majority of sales are collected in store - 40% within four hours - with little more than 10% ordered for home delivery.

The stores are effectively collection-point warehouses and 95% of the UK population is less than 10 miles from one. This approach is also more efficient than those retailers with large display areas.

It helps explain the increase in like-for-like Argos sales in the year to 1 March by 3.3% to £4.05 billion and the 5.2% acceleration of like-for-like sales in recent months, comparing the eight weeks to 1 March, with a 4.1% rise in the 26 weeks to 1 March.

Similarly at Homebase there was a 5.9% rise to £1.49 billion for the year and a 5.9% increase for the 26 weeks to 1 March. More recently sales are up 9.3% for the eight weeks to 1 March.

Well positioned to exploit the recovery

With a forward price/earnings (P/E) multiple of around 20 times and a prospective yield sub-2%, there seems little incentive to buy.

Yet within a market value of £1.7 billion there is net cash of £330 million, a self-financed customer credit book of about £470 million and possibly £100 million operating profit from Argos for the latest financial year.

Homebase may only add a little more but is well positioned to exploit the strong recovery in house sales; and as I have previously pointed out, is highly operationally geared and could make over £50 million a year.

In the five years before the 2008 financial crisis it averaged £85 million. So it may be possible to target £200 million operating profit for the group against £93.3 million in the 2012/13 year; why a high P/E is currently justified.

The chief executive says: "We have made good progress with investment plans... and we have a clear agenda for growth. However, although there are signs that economic conditions may be beginning to improve, we will continue to plan for a subdued consumer environment."

All plain sailing?

What could go wrong? The investment case here could probably only be undermined now by a series of shocks upsetting the UK economic recovery, especially the housing market. Obviously there will be a general election by May 2015. But you quite have to strain for negatives when it is also possible that the next stage of recovery involves wage increases.

As we have seen with Sports Direct from early 2012, despite economic worries a well-executed retail strategy to provide consumers with value can win through difficult times.

The main area where Argos is exposed to online competition is consumer electronics which account for about one-third of sales and has been the worst-performing category.

Gross margins here are only 15% to 20% compared with about 35% on other items. However its success with selling tablet computers suggests customers like the ability to try products in-store; also Comet shutting all its outlets will have helped Argos; and supermarkets' non-food space may have peaked. Argos may conceivably be able to grow market share even if consumer spending remains subdued.

Another significant factor is the new chief executive from 14 March, who joined the group in 2012 and has been managing director at Argos. The stockmarket will be interested to see how he comes across in months ahead.

For more information see homeretailgroup.com.