QUALIPORT
DFS: VAT Battle Pays Dividends

By Maynard Paton (TMFMayn)
April 18, 2002

Qualiport company DFS Furniture (LSE: DFS) announced its interim results this morning. The statement contained two notable features:

* A marked slowdown in like-for-like (LFL) trading, and;
* Favourable progress on the 'Primback Case', resulting in a 14.1p special dividend.

For those unfamiliar with the company, background to DFS can be found here. The latest performance of the furniture retailer is shown below:

                               Six months to
                            26/01/02  27/01/01     Change
                               (£m)      (£m)        (%)

 Turnover                    211.7    192.6         +9.9
 Operating Profit             25.7     23.6         +8.9
 Exceptional Items            17.4        -   
 Profit before tax            43.1     24.4        +76.6  
  




 Earnings per share*          16.4p    15.7p        +4.5
 Dividend per share            6.7p     6.1p        +9.8   
 Special dividend per share   14.1p       -         

 (* adjusted for exceptional items) 

Three additional stores, taking the DFS estate to 61, helped to push group turnover 10% higher to £212m. DFS stated that its programme to open 15-20 outlets over three years remained "on target". But registering LFL sales growth of 2% during the period was very disappointing. In DFS' defence, the latest performance was set against an 8.5% comparable LFL improvement, and also included the sudden downturn in consumer spending during September.

The continuing buoyancy of the housing market should, in theory at least, be doing DFS a real favour. However, current trading remains just 3% ahead on a LFL basis. That said, rivals of DFS haven't exactly been setting the world on fire either. ScS Upholstry (LSE: SUY) recently stated that LFL trading had been running at 4%, while Marks & Spencer (LSE: MKS) has revealed total sales at its 'Home' division had risen 6%.

At the operating level, increased store pre-opening costs caused margins to fall from 12.3% to 12.1%. But a lower cash balance (primarily due to a previous special dividend payment) and declining interest rates led to a notable reduction in interest payments, and left earnings per share to improve by just 5%.

Primback

Today's results also highlighted progress on the 'Primback Case'. To recap, the case is a legal dispute concerning VAT payable on purchases involving 'interest-free' credit. Primback, a small furniture firm unconnected to DFS, has argued that the "taxable amount" for VAT purposes should be based on the sum received by the vendor (i.e. the customer's payment less any commission paid to the finance house) and not the full price paid by the customer. The case currently awaits the House of Lords for a final adjudication.

While the Lords deliberate, there has been some Primback 'progress' made. Last month, DFS revealed that £17.4m worth of VAT that HM Customs & Excise had tried to claim back was no longer recoverable. After associated tax of £2.6m, the resultant £14.8m 'windfall' forms the basis of the 14.1p special dividend.

At the end of January, DFS held £56m that was subject to the Primback VAT dispute, of which £44m was subsequently given to HM Customs & Excise after the half-year to "protect ongoing appeals". DFS is still contesting all amounts claimed.

In addition, HM Customs & Excise has recently been ordered to repay DFS £6.2m, plus interest and costs, in relation to VAT payments made back in 1997. However, this action remains subject to appeal.

Valuation and summary

Overall, there was little in today's statement that contrasted with the conclusions made two months ago in the Qualiport's first review of DFS. The proven management, the industry-leading position, the healthy balance sheet, the great cash flow, the superior returns on equity; they all remain attractive features of DFS. Indeed, the announcement of yet another special dividend reinforces the notion of a shareholder-orientated management team.

The only disappointment comes from the current trading performance. LFL sales growth of 2-3% over the past eight months not a spectacular performance. Is DFS losing ground to its rivals? It's difficult to say at this stage. However, it generally pays to give long-standing and proven boardrooms, which have seen plenty of industry ups and downs before, the benefit of the doubt.

In terms of valuation, if we again assume that maintenance capital expenditure is twice the depreciation charge, then DFS generated 28.1p per share of free cash in the twelve months to January 2002. Strip out the Primback-related cash, and DFS' £32.8m cash pile equates to 31.5p per share.

If we expect free cash flow to grow at 5% in the coming year (to 29.6p per share), DFS shares, at 492.5p, offer a prospective free cash flow yield of 6.4% (29.6p / (492.5p - 31.5p)). Although DFS' present valuation doesn't indicate a bargain, it's worth noting over two-thirds of the company's cash flow is regularly paid out as a dependable dividend.

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