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Buying stocks for passive income is a proven strategy for making extra money without working for it. This is true not only of FTSE 100 heavyweights like Diageo and British American Tobacco (both have increased their dividends annually for decades). There are also some FTSE 250 stocks with income prospects that catch my attention.
It may not always work as planned: a company may suddenly cut its dividend and therefore cease to be a source of passive income. But when it works well, it can work very well.
A proven business that wastes large amounts of excess cash can sometimes pay handsome dividends year after year.
7.3% performance
By my calculations, one of those stocks will currently return 7.3% this year. This is based on increasing its final dividend at the same rate as the interim payment.
The FTSE 250 stock in question is a home goods retailer. Dunelmo (LSE: DNLM). The company announced its interim results this week. At least on the dividend front, they were mixed.
The interim dividend per share grew by 6.7%. The company also announced a special dividend of 35 pence per share. This is a sizeable special dividend, but down from the 40p a year seen last year.
A special dividend can be a good way for a company to smooth out the ups and downs in cash flows when setting a dividend level. It allows a company to increase the ordinary dividend seamlessly over the years, while returning additional excess capital to shareholders in the form of a special dividend that can go up or down.
Why I like the business
But what really matters to me when considering an investment is how I evaluate the business prospects. After all, what happens to the dividend in the future ultimately depends on the performance of the business.
Dunelm's revenue in the first half grew 4.5% year-on-year. In addition to its network of stores, digital channels continue to gain importance for the business and already represent 36% of revenue.
Pre-tax profit rose 4.8% to £123m. Free cash flow fell 11% to £91m. The ordinary and special dividends will cost the company £103m, so Dunelm is funding the dividend using all of its free cash flow for the period, as well as consuming its existing cash reserve.
The strong results underline some of the retailer's strengths. It seems to have a good understanding of what its customers want and has several unique ranges of products to attract them. It is combining online and offline sales channels with good results.
I would buy
As always, there are risks to consider.
A weak housing market could encourage existing homeowners to improve their living space, but on the other hand it could lead to an overall slowdown in home goods sales that hurt revenues.
But I think the business has good prospects and I think it could well generate significant free cash flows to fund future dividends.
If the full year dividend reaches the 80p per share I expect, buying 1,250 of this FTSE share today should net me £1,000 in annual dividends. If I had extra money to invest now, I'd be happy to do it.
