Investment Decision: Dusk Group

Suppressed by China Troubles & Higher Cost of Living

This article captures, for posterity, the principle factors involved in my decision to purchase Dusk Group (ASX) shares. I’ll refer to them as “Dusk” in this article.

This article won’t cover the company and what it does. Do head to the investor relations website for Dusk Group if you’re interested.

Source: Facebook

Great Business at an Astonishing Discount

Dusk Group is cyclically depressed, with Australian retail sales slowing amid the pain of a lacklustre Chinese economy and cost of living pressure due to higher interest rates. Dusk has seen marginally lower revenues since a peak in June 2021, despite store expansion, with like-for-like sales down 13% in 2023. As a discretionary consumer goods company, they are more susceptible to weakening demand.

This sounds bad, and the share price decline of 65% from the 2021 peak agrees. But when retail sales recover, and they will, Dusk should be capable of generating in excess of A$20 million in net income and free cash flow in excess of A$30 million. With a market cap of A$65 million and A$16 million in cash, they have an enterprise value of around A$50 million. That's a net income yield of around 40% and a FCF yield of 60%. For comparison, Apple has a FCF yield of around 3.2%.

Dusk typically pays out about 60% as a dividend. They paid out 11c in 2023, or 10.7% at today’s price (A$1.03); that’s with the drop in revenue. When retail sales recover, the dividend yield will be in excess of 20%, with further growth in dividend payments due to store expansion ahead. In 5 years, Dusk could be paying out 40% on your investment today.

I can see Dusk trading close to their historic peak of A$4 in the next 3 to 5 years. That’s a 400% gain plus double-digit dividend payouts at today’s price. By comparison, a 15% CAGR is a great return and yields a 200% gain over 5 years. While I’m not expecting great things from 2024, I’m struggling to see where this investment could go wrong over 5 to 7 years.

Free Cash Flows

Dusk listed on the ASX in 2020 without raising additional capital into the business. The funds raised were used to pay off existing shareholders, notably BBRC and Catalyst. So the earnings you see today that are used to pay a dividend and sustain growth while retaining a reasonable cash buffer are generated by the business. That’s very impressive.

Even if Dusk Group is unable to improve revenue with their current FCF yield and very low stock comp, they could take the business private in possibly less than 3 years. It would take Apple around 30 years.

Store Expansion & Online Sales

Dusk may appear to have saturated the Australian market, but they still believe they have opportunities in outer suburban and regional areas, with 6 new stores planned for H1 of FY24. They have also begun to operate in New Zealand with 3 stores. They still have other markets they can expand into, with Canada and the UK being close to their target consumer markets. Historic growth has been around 13% annually, but I expect, rather conservatively, this to slow to perhaps upper single digits as their capacity to open stores as a percentage of total stores tapers off. Even with growth slowing, we can expect to see upper single-digit growth in dividend payouts, well above inflation.

It’s worth noting that online sales are not performing as expected. At 5.4% of total sales in FY23, they are having a negligible impact on the bottom line. There are actions underway to redesign and re-platform, in addition to improvements from click to dispatch or collect. I think online is going to need some time to establish itself. There is much learning, which comes at a price, to be had here. It may be that this is a physical market, with customers needing to see and experience their products before making a decision to purchase.

“Peak China”, COVID-19 & Taiwan

China is Australia’s biggest trading partner in terms of imports and exports. As China shifts away from infrastructure, Australia will need to find alternative export markets for some of its mining sector, especially iron ore. I suspect Australia will also continue to develop their market to cater to the growing middle class in China, although exporters got hit by China’s reaction to Australia’s COVID comments. This fallout in relations didn’t have quite the impact people were expecting, with Australia finding other destinations for its exports, but it still hurt. Having said that, work is underway to repair diplomatic relations, which should be positive economically in the coming years.

Any invasion of Taiwan by China will have a devastating effect on the economies in the Asia-Pacific. Fear of invasion will continue to suppress markets unless Xi starts softening his tone. With China’s current woes and troubles with trading partners, I wouldn’t be surprised to see such a softening. China is also something of a technocracy (which I see as a technocratic oligarchy) and can be pragmatic. They know great harm will come from any invasion of Taiwan, so I just can’t see this happening. I’m sure they’ll continue to invest in their military’s ability to challenge the US.

Fear of Recession

Sales do not drop to zero in recessions, as most people I know seem to imagine. And any downward pressure is not permanent, again, as many people imagine. Recessions are a temporary reduction in sales growth, sometimes declines, for a few quarters. In the Great Recession of 2008–09, Woolies, one of Australia’s biggest retailers, managed to grow sales by single digits in most categories. UK-based Tesco managed to grow sales throughout 2009 and 2010. If you hold well capitalised great businesses, you need not fear recessions.

In the last 25 years, Australia has only seen two dips in retail sales growth, both due to COVID-19 lockdowns. Worst-case revenue could drop by another A$20 million, or a further 14.5%, before they’d have to dip into any cash reserves. Even then, they could lean on A$6 million in financing facilities if required. It would take a very severe recession in Australia to put Dusk Group at risk.

Catalyst Investment Managers Pty

Catalyst was an early investor in Dusk Group. After selling ~40% of their holding in the business through the IPO, Catalyst has been selling out their remaining stake, putting further downward pressure on price. They owned 25.4% post-IPO and have since disposed of their entire holding. This was in line with their investment philosophy and not a reflection of Dusk’s prospects. Regardless of how they offloaded the stock, it will have had a suppressing effect on the price. This downward pressure has now been released.

CEO Change

Peter King, who has helmed the business for almost 10 years, stepped down in 2023. Peter has been a big influence on the success of the business, but I’m with Warren Buffett, as I believe a mediocre CEO can have success with a great business, whereas a great CEO struggles with a mediocre or poor business. In any case, Vlad Yakubson, the newly appointed CEO, has a great pedigree. Any near-term underperformance is unlikely to be noticeable. The ship is well established and steady, and Vlad has plenty of time to find his feet.

Australian Dollar (AUD)

I haven’t hedged any currency risk, nor will I. I haven’t found anyone that can reliably forecast currency exchange rates 5 to 7 years into the future, so I’ll shrug my shoulders. I may have to take a hit, as my personal suspicion is that GBP may continue to marginally outperform AUD, which will erode some of my gains. I think Dusk is priced at a level where it will still significantly outperform the market despite any exchange rate losses I may incur.

Summary

This is a rare opportunity to acquire a very disciplined business for a fantastic discount. With downward price pressure abating, relations with China improving, and rates peaking, over the next 5 to 7 years this business should yield returns, including dividends, well above the market average.