Qualiport

Bruce Jackson (TMFGoogly) looks at the credentials of the largest chemist chain in the country.

Qualiport Update

A double figure spurt yesterday helped save the day (or week) for Rentokil Initial as the Footsie has raced to new, uncharted levels this week on the back of the proposed pharmaceutical mergers. On that note, those veteran Fools (like AceInvest) whose memory spans back as far as October last year will remember the very first Qualiport article was about a company called Glaxo Wellcome. If only we had bought it back then!

But, we're not that upset (really!). Dave wanted to have a closer look at Glaxo's numbers, but before he could do that I hijacked the Qualiport to go on and on and on about Rentokil Initial. Since the initial article, the only thing to change about Glaxo's business has been the potential merger with SmithKline Beecham. When I say "only," I have to admit it's a pretty big change. Whether it is worth a 67% jump from around 1200p to about 2000p is debatable.

A bumper week for the Footsie sees the Qualiport beaten for the second week running. However, we are still in front of the main index for the year, as well as the FTSE All Share.

The Boots Company

We've already looked at the biggest retailer in the UK, Marks & Spencer, and this week we're going to cast our Foolish eyes over number two, The Boots Company. If you missed the M&S trilogy, check out the Qualiport archives.

The Business

There's more to The Boots Company than just high street chemists. Although Boots The Chemist (BTC) accounts for 68% of turnover and a massive 87% of profits, there are other strings to Boots' bow. They may not all be hugely successful segments, but nevertheless they exist. Halfords, Boots The Opticians, A G Stanley and its FADS and Homestyle formats, Do It All, Boots Healthcare International, Boots Contract Manufacturing and Boots Properties are the other areas that contribute 13% to group profits.

Halfords, the motor spare part and bicycle store, is the second biggest division, although now that Boots has acquired the 50% of Do It All from WH Smith that it didn't already own, the DIY outfit will now be in second place by turnover. Boots continues to invest heavily in its chemist chain and is beginning carefully planned international expansion. They are concentrating more than ever on building up their Boots Healthcare International and Boots Contract Manufacturing divisions.

Margins

Operating margins give a measure of a company's profitability and the competitive environment in which it operates. They are calculated by dividing operating profits by sales. For The Boots Company in the full year to 31st March 1997, it was £491.8m / £4578.0m = 10.7%. This compares to Marks & Spencer's 13.2% and Rentokil Initial's 15.4%. For just the chemists alone, the operating margin improves to 12.9%. The retailing sector average is around 11%.

Net margins are calculated on the profit after interest, tax and minority interests have been deducted. The resultant net profit figure is ultimately the amount of money available to be distributed to shareholders. It is also the number upon which earnings per share is calculated. A sign of a quality company with a competitive advantage is one with net margins above 10%. The Boots Company has net margins of 7.9%, Marks & Spencer 9.6%.

Valuation & Growth

Price to sales (PSR) is a good way of comparing the valuation of different companies, as neither of the numbers in the equation are subject to the vagaries of accounting conventions. PSR is calculated by taking the market capitalisation (917m shares x 850p share price) of £7,795m and dividing it by the annual sales of £4,578m which equals 1.7. Marks & Spencer had a PSR of 2.2.

The PSR needs to be put into some context. Value investors usually look for companies with PSRs of less than one, but growth companies traditionally have PSRs well above this. Also, it is often true that the lower the PSR, the more competitive the environment in which a company operates. The average for the retailing sector is around 1.5.

Normalised EPS for the year ended 31st March 1997 are 39.5p. With a share price of 850p, that leaves Boots trading at a trailing P/E of 21.5. Current estimates for the year ending 31st March 1998, in 7 weeks time, are for EPS of 41.6p, leaving Boots on a forward P/E of 20.4. Full year growth is forecast at just over 5%. Estimates for 1999 EPS stand at 47p, giving growth of 13% and a one year and seven week forward P/E of 18.

Capital Allocation

This is arguably Boots' strength. They are a cash generating machine, and at 31st March 1997 had net funds of £230m. In 1995 they repurchased 9.2% of their own shares at a cost of £511m, in 1997 they bought back 5.4% or £300m worth, and also in 1997 returned £400m to shareholders via a 44.2p special dividend. And that was on top of increasing their "normal" dividend 10.6% to 20.5p.

Boots are very focused on creating shareholder value. Over the past 5 years to March 31st 1997, when their share price was 675p, total returns to shareholders had been 75%. Whilst this is not hugely earth shattering, this is a commendable return for a big company with large cash generating abilities. Boots compare themselves to a basket of similar companies, creating a competitive benchmark. They did lie 4th in the table, only just behind M&S, but well in front of WH Smith and J Sainsbury.

Whilst the company keeps growing and generating cash, the prospect of more share buy backs and special dividends seems likely. Having had their fingers burnt by previous injudicious acquisitions, it seems that Boots are now much more focused on building up their core businesses.

The Boots Company Snapshot

Recent Share Price: 850p

Fiscal 1997 sales: £4,578.0m
Fiscal 1997 net profits: £361.7m
Fiscal 1997 EPS: 39.5p

1997 EPS estimates: 41.6p
1998 EPS estimates: 47.0p

Valuation-
Market capitalisation to sales: 1.7
Current P/E: 21.5
Forward P/E: 20.4 on 1998 estimates, 18.1 on 1999.
Long-term expected growth rate: 10%
Yield: 2.4%

Conclusion

Is this a quality company? If you stripped out A G Stanley, Do It All and possibly even Halfords, it would look more like a quality company with good margins and competitive strength. I suspect much management time and effort is going into turning around these underperforming businesses. Although there is plenty of scope to improve margins and returns in those segments, they have and still will operate in highly competitive environments.

For my mind, there is little doubt that Boots The Chemist is a quality business. Their shops are generally clean and well laid out, their staff are well trained and their prices are competitive. Boots' own brand products are themselves increasingly becoming recognised brand names. The No7 cosmetics range is a good example.

I have estimated Boots' long term growth rate at 10%. Their ability to expand BTC abroad may will be restricted because of regulatory problems. Whilst they will keep on stretching their UK and Ireland business, the pure growth potential is somewhat restricted.

Running the Fool Qualiport 10-year model on Boots, I get an annualised return of 8.2%. That is based on a long term growth rate of 10% and a P/E 13.3, being a 33% premium to Boots' growth rate. That annualised return doesn't give us enough of a premium over the risk free rate of about 6.5%.

Given also that I have doubts over whether this is in fact a quality business, I'm giving them a big Qualiport thumbs down. Having looked at the two biggest retailers, good old M&S is the pick. They have higher margins, more of a competitive advantage and don't have the excess baggage that Boots have. However, as we have said previously, we would only consider buying Marks & Spencer if their share price dropped to 513p or below. They finished today at 575p.

Next week we are moving away from retailers. I am hoping to have a look at a number of different companies in one particular sector, looking for one that will satisfy our strict Qualiport selection criteria.

Until then…

Keep Fooling,
Bruce Jackson (TMFGoogly) Qualiport Numbers

Qualiport Numbers 

Rec'd     #    Stock    Bought      Now   Change   Change  
                           £         £       %        £

19/12/97 1565 Rentokil     2.55      2.94  +15.3%    +0.39
19/12/97 1565 Rentokil 4,040.63  4,601.10  +13.9%  +560.47


                 Week          Year        History

Qualiport        +1.4%        +11.4%        +13.9%
FTSE 100         +4.2%         +9.0%        +11.5%
FTSE All Share   +3.7%         +7.6%         +9.8%