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Qualiport

[ December 11, 2000 ]

Carpet -- Right for the Qualiport?

By Maynard Paton (TMFMayn)

Carburton Street, London -- Continuing the occasional review of companies that could merit Qualiport status, today's feature will look at Carpetright (LSE: CPR), the carpet retailer.

Of course, long-standing Qualiport readers will know that this portfolio has already been badly burnt by investing in retailers. Overall, the sector is renowned for its intense competition, low growth and susceptibility to fickle consumer tastes, all of which combine to make the industry a poor hunting ground for predictable, long-term investments. However, just like the insurance sector and Independent Insurance Group (LSE: IIG), or the restaurant industry and PizzaExpress (LSE: PIZ), company gems can still exist within an industry heap of coal.

Rolling out the business

Carpetright opened its first store in 1988 and, taking advantage of cheap out-of-town retail space during the early nineties recession, quickly expanded to 116 outlets by 1993. That year saw Carpetright float at 148p per share and the company has subsequently expanded to over 300 stores, taking its shares to today's 535p. Carpetright operates at the "value for money" end of the sector and as the company became larger and economies of scale were created, so growth has been generated by taking market share away from the independents.

The financials

Here's the financial record of Carpetright.

To April 30th       1996   1997   1998   1999   2000

Turnover (m)      185.3  233.9  269.3  277.7  304.8

Gross profit (m)   84.5  114.6  137.6  140.5  164.2

Operating
 profit (m)        23.4   31.0   28.8.  23.2   36.6

Earnings per
 share (p)          23.3   28.5   26.0   22.8   33.3

Gross margin (%)    45.6   49.0   51.1   50.6   53.9

Operating
 margin (%)         12.6   13.3   10.7    8.3   12.1

Sales
 growth (%)         31.1   26.2   15.2    3.1    9.8

Earnings
 growth (%)         38.7   22.3   (8.8) (12.3)  46.1

Carpetright's growth, whilst purely organic, hasn't been a smooth upward path. Although sales have risen each year and, very impressively, gross margins have improved from 45.6% to 53.9% since 1996, profits over the last five years have been somewhat erratic. The reasons are two-fold. Firstly, those cheap property leases bought in the early 1990s have come back to haunt the company in the form of rent reviews. And secondly, there were "difficult" trading conditions during 1998 and early 1999, caused by a deterioration of the housing market.

Carpet and furniture retailers are all inextricably linked to the property market. Simply, when people move house, they often take the opportunity to replace their old sofas and refurbish their new home with new carpet. Thus, when the housing market took a knock during 1998, so Carpetright was hit hard. However, moving into 1999, confidence was quickly restored in the property market and Carpetright gained on two fronts -- the obvious renewed enthusiasm for carpets and the undoubted reduction of smaller independent competitors during the period of tough trading.

Whilst the company has expanded rapidly through the 1990s (the number of stores having increased by three-quarters over past five years) the rollout process has begun to reverse slightly. At April 2000, 321 Carpetright outlets operated, covering 3,092,000 square feet of selling space. Twelve months earlier, the company had 333 stores and 3,209,000 square feet of space. However, the small reduction in stores still led to an improvement in profits during the year and it's this performance that highlights the real investment attraction of Carpetright.

Essentially, the company has little scope for rolling out its retail format any further. Instead, profits growth is now largely attained by generating additional volume from its existing estate, coupled with margin enhancements. As we'll see, this is all good news for Carpetright shareholders, as they no longer have to stump up any money to grow the business.

Return on equity

To April 30th          1996   1997   1998   1999   2000

Earnings (m)          17.1   22.5   20.7   17.8   25.6

Shareholders
Funds (m)             27.2   37.7   41.1   35.6   35.6

Return on average
Equity (%)             70.8   69.4   52.6   46.3   71.2

Incremental return
on equity (96-00) (%)                             101.2

In anybody's book, these are stunning returns. Carpetright has improved its post-tax profits by 8.5m since 1996, while the company's equity base has increased by the same amount. Carpetright's steady equity base of late can mainly be attributed to share buybacks. During the company's sharp share price fall during 1998, and its upward rise during 1999, excess profits were used for some canny share purchases. Carpetright has spent 14m over the past two years, buying its own shares at anything between 262p and 440p.

Even if we were to ignore the buybacks and use retained profits as a proxy for the increase in equity since 1996, the incremental return on equity calculation would still return a 34% figure. A wonderful performance.

Hidden gearing

It has to be borne in mind, though, that the above calculations are not aided in any major way by debt. However, Carpetright, like most other retailers, operates with "hidden gearing", their returns being enhanced by property leases.

When it comes to property, retailers have two options -- freeholds or leaseholds. Rapidly expanding retailers typically go for the latter. With the leasehold option, the retailer doesn't have to find a large lump sum before it can start trading as it would with a freehold. Instead, it will enter into a leasehold agreement, pay an ongoing rental (reviewed every five years) and will typically benefit from a rent-free period at the start of the agreement.

The leverage effect of leaseholds can be clearly seen when adjusting Carpetright's accounts to assume the company had taken the freehold option. Assuming an average landlord requires a 7.5% return from his property, Carpetright's 35.3m rent bill of 2000 would equate to owning freehold assets of 471m (35.3m / 7.5%). Strip out the lease payments for 2000, and Carpetright would have achieved "freehold" earnings of 50.3m. Adjusting the balance sheet, replacing leasehold assets for the 471m of freehold assets, Carpetright's asset base would then total 493.3m. A simple return on equity calculation would then reveal a 10.2% (50.2m/493.3m) return, notably lower than the leasehold return.

Still on the subject of leaseholds, it's interesting to see how property costs have steadily risen over the years. No doubt the increased rental expenditure has played its part in Carpetright's decision to cut back on store numbers.

To April 30th         1996   1997   1998   1999   2000

Lease payments (m)   16.7   21.4   28.8   32.5   35.3

Ave selling space
(square feet 000s)   1,849  2,310  2,772  3,075  3,151

Cost per square        9.0    9.3   10.4   10.6   11.2
Foot ()

Working capital

A quick look at Carpetright's cash flow performance shows working capital is not a problem. The company generates plenty of cash in this respect, customers paying upfront while carpet manufacturers have to wait three months for their payments. Also of note is that, for 2000, capital expenditure on fixed assets matched the depreciation charge. Assuming the company remains with a restricted rollout plan, accounting earnings can be taken as a rough measure of free cash. Great stuff.

To April 30th          1996   1997   1998   1999   2000

Operating
Profit (m)            23.4   31.0   28.8.  23.2   36.6

Change in
Working capital (m)   (1.4)   2.4    9.8    5.6    2.7

Valuation and summary

Carpetright possess a lot of attractive investment characteristics. Unquoted Allied Carpets aside, Carpetright dominates its sector, a very important point for a retailer that "buys keen, sells keen". And unlike many other retailers, the company isn't at the whim of branded suppliers. Commodity manufacturers make the carpet and Carpetright slaps on its own brand label before selling it to the public. Currently, 95% of the company's sales come from its own-brand labels. Another significant plus for shareholders is that the company's growth has not been aided by acquisitions, a good sign that the company has some sort of operating advantage in place that doesn't necessitate it buying somebody else's business.

Perhaps the best attribute of Carpetright is the mouth-watering financials, even though the company can't reinvest any sizeable proportion of its profits at an attractive level. Improvements in sales and margins at the existing estate don't require vast sums of additional capital, so although the historically high rates of return on equity will certainly continue, having now reached its optimum size, Carpetright effectively becomes a cash cow. Apart from store refurbishments and creating extra warehouse space, surplus cash will be used to benefit shareholders in the form of dividends or share buybacks. No bad thing, but for long-term shareholder growth, that cash needs to be reinvested in the business.

At 535p, Carpetright shares stand on a prospective price to earnings (P/E) ratio of 13.2 and a prospective dividend yield of 4.8%. By no means a demanding rating, especially when brokers expect 21% earnings growth this year and 15% the next. So, Carpetright for the Qualiport? In my view, they certainly wouldn't look out of place in any portfolio of "quality companies". My only real qualm with the company is that it doesn't operate in an organically growing market and is reliant to a heavy degree on the health of the housing market.

In terms of joining the Qualiport, I think not. Well, not at this stage. I'm loath to add another different company to the portfolio and overall, Carpetright doesn't look to be a significantly better investment opportunity (at the moment) than the Qualiport's weakest holding. For the Qualiport's cash pile, I feel there are better long-term opportunities already in the portfolio.

Where Next?

• Visit the Carpetright discussion board | website
Learn about Incremental return on equity
• Improve your investment education. The Motley Fool Research Industry Focus 2001 is now for sale! We give our take on 14 sectors, including general retailers, and identify 21 companies we hope will be the long-term winners of tomorrow. Buy it now from our FoolShop for 25.