QUALIPORT
Fool Buys Carpetright

By Maynard Paton (TMFMayn)
August 6, 2001

Rochester, Kent – As forewarned on Thursday, today's feature will cover the latest addition to the Qualiport – Carpetright (LSE: CPR). For the record, on Friday morning, we (notionally) purchased 514 Carpetright shares at a share price of 578p. With stamp duty of £14.85 and dealing commission of £15.00, the total outlay came to £3000.77.

The business

A full Qualiport review on the carpet retailer was published in December. The key features from that review were:

* Carpetright opened its first store in 1988, and helped by cheap out-of-town retail space in the early nineties, had expanded to 325 stores by the end of April 2001. Alongside the unquoted Allied Carpets, the two industry leaders share 40% of the carpet retail market. The rest is divided among small independent operators.

* Carpetright operates at the "value for money" end of the retail market. Its attraction to customers is largely price-based. But the company is not at the mercy of branded suppliers, as 99% of its sales are of own-label carpets. 

* Although sales have risen steadily over the past five years, profits have been somewhat volatile. The carpet industry's fortunes are generally linked to the health of the housing market. When the housing market took a knock in 1998, so did Carpetright's profits.

* In recent years, there have been few additional store openings. Instead, growth has been driven by generating additional sales from existing stores (which was great for shareholders, as they were not required to stump up any additional capital for the resulting profit) while timely share buybacks have helped contribute to rising earnings per share (EPS) too.

* Adjusted for the latest set of annual results, the company's incremental return on equity performance between 1996 and 2001 was a staggering 71.6%. Carpetright's working capital numbers are also great.

The growth

In addition to taking market share away from its smaller brethren, the latest results from Carpetright highlighted three other avenues for further growth:

* The introduction of a mobile carpet sales service, whereby consumers can choose a carpet in the comfort of their own home. At present, this sub-market is currently the domain of the small carpet retailers and is said not to overlap with Carpetright's store-based operation. Carpetright management estimate mobile sales could generate additional annual revenues of £200m within the next few years;

* Store openings in Southern Ireland, a country where no sizeable carpet retail chain exists, and;

* Moves into the insurance carpet replacement market.

The valuation

Following Carpetright's full-year results and AGM, brokers are pencilling in 18% earnings growth for the current year. Underpinning the near-term profit improvements is the group's current 8.6% like-for-like sales growth performance. Given the significance of fixed operating costs (e.g. rents and rates) at Carpetright, greater year-on-year store sales have an amplified effect on the group's operating profitability.

At 578p per share, Carpetright shares offer a historic free cash flow yield of 6.7%. Acknowledging the short-term prospects, pencilling in 10% free cash flow growth for the current year places Carpetright shares on a prospective free cash flow yield of 7.4%. As Carpetright distributes two-thirds of its earnings as a dependable dividend, I'm quite happy with the total "cash flow premium" that Carpetright presently offers in comparison to the current risk-free rate of return (of around 5%).

Alongside those "obvious and immediate" valuation measures, it's also worth highlighting a conservative projection of future sales and profits.

Using these assumptions...

* Store carpet sales grow 10% this year, followed by 4% annual growth for the following five years;

* Mobile carpet sales reach £66m in 2007 (Carpetright expects £200m);

* Pre-tax margins improve from today's 13.8% to 15.5% in 2007  (Carpetright already anticipates 15% pre-tax margins for 2003);

* Corporation Tax remains at 30% through to 2007, and;

* No interest is either received or paid in 2007;

... Carpetright's sales, pre-tax profit and EPS for 2007 are £498m, £77.2m and 71.5p respectively.

Thus, in five years' time, and using an undemanding forward P/E ratio of 12.5, we could envisage a 2006 Carpetright share price of 894p (71.5p*12.5). Now, assuming Carpetright's dividends increase in line with the expected growth in earnings (9.4% per annum) between 2002 and 2006 too, dividends of 178p per share should be collected over those five years as well.

So, add together the anticipated share price (894p) and collectable dividends (178p), and a total investment value of 1072p is envisaged for 2006. At 578p per share today, all the assumptions lead to a five-year annual investment return of 13.2%. There's a definite margin of safety here, especially after using the somewhat prudent forecasts.

The risks

Of course, no share investment is without risk. The threats to the Carpetright investment are:

* Management: Selling commodity-ish goods with price as your main weapon requires solid management skills. While not putting a foot wrong since their 1993 flotation, should management suddenly go off the boil, shareholders will be in trouble.

That said, Carpetright's Chairman and Chief Executive, Lord Harris, is the UK's "Mr Carpet". He's been in the carpet game for 40 years and has built up two national retail chains from scratch (he sold his first, Harris Queensway, just before the late-1980s housing collapse). In short, what Lord Harris doesn't know about selling carpets isn't worth knowing.

* Competition: The retail sector is notoriously competitive and fickle. Barriers to entry are low and there's little customer loyalty for the price-conscious retailer. However, Carpetright's competitive advantage is in its economies of scale and purchasing power. Big is best if you, alongside Carpetright, are fighting on price. Just as long as the management keep costs under control, Carpetright has a sustainable competitive advantage.

* Recession: Sales of carpets are very sensitive to the general health of the economy and property market. A recession will destroy the earlier five-year projections. However, while a recession will affect most other companies too, it does allow the strong to get stronger over the long term. An economic downturn will see many smaller carpet retailers go to the wall, leaving Carpetright to gain market share as and when the recovery comes.

Your thoughts on the Carpetright purchase can be directed to the Qualiport discussion board.

More: Carpet: Right for the Qualiport? | Carpetright discussion board | website

The author owns shares in Carpetright.