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QUALIPORT
By
Carburton Street, London -- DFS Furniture (LSE: DFS) has many attractive attributes for the long-term investor. The company is a market leader, run by experienced management and exhibits some eye-popping financials. DFS is certainly a Qualiport company. The business Worth some £460m, DFS is the UK's leading specialist retailer of upholstered furniture. Founded 33 years ago by company Chairman Graham Kirkham (who owns 8% of the company), the group has steadily garnered a 14% national share of its particular market. However, established stores generally achieve local market share of around double the national level. At the end of July 2001, the company operated from 58 outlets. DFS states that the country can support over 100 of its stores, with 15-20 new outlets planned to open over the next three years. The company itself manufacturers between 15-20% of all furniture sold through its stores, allowing for an "optimum balance between direct control over the supply chain and effective open market purchasing". DFS floated in 1993 and during its 30-odd year history, has only experienced two years of profit declines. Here's the five-year record of DFS: The two profit disappointments at DFS came during 1998 and 1999. A downturn in consumer spending and increased competition caused the shortfall. The deterioration prompted a full "top to bottom" review at the company, with subsequent improvements in systems, structure and supply chain management being made. Importantly, DFS stated at the time that its fundamental concept -- selling good quality, fashionable products from well-sited locations at affordable prices, and giving exceptional customer service -- had remained unchanged. Furthermore, the only exceptional item incurred since flotation was a £1.4m charge relating to the flotation itself. There has been no recourse to acquisitions and no change in executive directors over that time, too. Another other point to note is the frequency of special dividends. Totalling some £52m, a 10p special dividend was paid out during 1995, 1996 and 1999, with a special 20p payout in 2000. More than anything, these regular payouts indicate the cash generative nature of the business and a rational, shareholder-aligned management team. Cash flow and balance sheet Here's where things get tasty. Because of the store rollout programme, capital expenditure has substantially exceeded depreciation over the years. However, during 2000 when no new stores where opened, capital expenditure was some 80% higher than the year's depreciation charge. That gives a rough idea of DFS' maintenance capital expenditure, as opposed to the expansionary spend used to fund new outlets. DFS' return on equity is superb.Year to 31st July 1997 1998 1999 2000 2001
Turnover (£m) 254.3 280.5 295.5 357.3 401.9
Operating Profit (£m) 37.2 31.9 24.5 44.8 48.9
Pre-tax profit (£m) 38.7 34.1 25.7 46.1 50.1
Earnings per share (p) 24.8 22.0 16.6 30.2 32.3
Dividend per share (p) 12.7 14.5 14.7 18.6 20.8
Special dividend per share (p) - - 10.0 20.0 -
Number of stores 44 49 53 53 58
To 31st July 1997 1998 1999 2000 2001
Operating Profit (£m) 37.2 31.9 24.5 44.8 48.9
There's no problem with working capital at DFS. The only stock DFS keeps is the furniture in the showrooms. The furniture is made to order, with any financed-based sales dealt through third parties without any recourse to DFS.
Change in
working capital (£m) (0.5) 0.5 9.5 18.2 (4.4)
Depreciation (£m) 2.9 3.6 4.6 5.2 6.2
Capital expenditure (£m) (13.5) (12.1) (16.0) (9.4) (13.6)To 31st July 1997 1998 1999 2000 2001
Earnings (£m) 25.9 23.1 17.2 31.2 33.5
Shareholders' Equity (£m) 32.8 41.6 30.6 21.9 37.9
Return on average equity (%) 99.9 62.0 54.3 118.7 112.0
Incremental return on
average equity 97-01 (%) 149.0
Indeed, since July 1994, DFS' earnings have jumped from £13.9m to £33.5m, while the company's equity base has increased from £21.2m to £37.9m. The incremental return on equity over this seven-year period comes to a staggering 117% ((£33.5m - £13.9m)/(£37.9m - £21.2m)).
But the real eye-opener underpinning these stratospheric shareholder returns is this: DFS presently has some £97m of cash -- and no debt -- on its balance sheet! With shareholder funds presently standing at £37m, the large low-return cash pile is certainly no hindrance to DFS.
(On the cash pile, it's worth noting that £67m of the £97m relates to what's called the 'Primback Case'. The money reflects the difference in VAT payable on the eventual price paid by the consumer, as opposed to the initial discounted price effectively paid by the finance house for 'interest-free' type purchases. The case currently awaits the House of Lords for a final adjudication. If the decision goes against Primback, a small furniture firm unconnected to DFS, then HM Customs & Excise will be entitled to the £67m from DFS.)
Risks
DFS has many attractive characteristics. It's a simple, understandable business whose financial record is excellent. The boardroom is experienced and has been without change since the group's 1993 listing. Chairman and founder Graham Kirkham still owns a notable slice of the company. Furthermore, the four special dividends paid over recent years is a testament to the group's focus on shareholder value.
It's important to consider the DFS management because the company is certainly no business franchise. Retailing is an exceptionally tough industry. There's no doubt that the company's competitive advantage lies in the boardroom. The big shareholder risk with DFS is the staff going off the boil.
Of course, there are competitive risks too. IKEA, Marks & Spencer (LSE: MKS), ScS Upholstery (LSE: SUY) and Courts (LSE: CRTO) are amongst the company's rivals. Keeping ahead of the competition involved changing 60% of the group's range last year. While there is the danger of designing sofas nobody wants, the risk is mitigated as furniture is built to order. Poor selling sofas can be quickly detected and enhanced. Of course, DFS's rivals should also have that luxury.
Finally, there is the risk of recession. 'Big ticket' retailers like DFS are prone to sharp profit setbacks as and when consumer spending tightens. The latest results (published in October) were cautiously optimistic on the near-term, with like-for-like sales growth running at just 3% at the time.
Valuation
Assuming that maintenance capital expenditure is twice the depreciation charge, DFS generated 27.3p per share of free cash in fiscal 2001. At 447.5p, with the company essentially having 28.5p per share of excess cash (excluding Primback) in the bank, DFS shares offer a historic free cash flow yield of 6.5% ((447.5p - 28.5p) / 27.3p). But given that over two-thirds of the company's cash flow (20.6p) was paid out as a dependable dividend last year, the shares appear attractively valued.
Overall, the company's industry position, past management record, special dividends, great balance sheet, expansion potential and low valuation outweigh the general competitive risks any furniture retailer faces. So much so, that within the next five trading days, the Qualiport will spend its remaining cash balance (around £1,100) on DFS shares.