QUALIPORT
Magic Carpet Ride

By Maynard Paton (TMFMayn)
June 27, 2002

Qualiport member Carpetright (LSE: CPR) published its results earlier this week. The carpet retailer reported a very strong performance and highlighted plenty of scope for further expansion. In addition, the shares remain cheap. (For those unfamiliar with Carpetright, some background information on the company can be found here).

Without any goodwill, acquisitions or exceptional items seen over the past ten years, Carpetright's accounts are a pleasure to look at. Here's the performance since 1998:

Year to April              1998     1999     2000     2001     2002

Turnover (£m)             269.3    277.7    304.8    322.9    361.5
Operating Profit (£m)      28.8     23.2     36.9     44.7     52.0
Pre-tax Profit (£m)        29.2     23.5     36.6     45.6     52.5

Earnings per share (p)     26.0     22.8     33.3     42.0     48.4
Dividend per share (p)     22.0     22.3     23.5     27.0     33.0

Aided by like-for-like (LFL) sales growth of 6.7% and an additional 22 stores (taking the total estate to 347), overall sales rose 12% to £362m in fiscal 2002. Operating margins improved from 13.8% to 14.4% (Carpetright's highest level ever) to help push operating profits up 16% to £52m.

Current trading remains positive, with LFL sales growth up 4.2% since April. However, during an interview with Bloomberg News, Chairman Lord Harris suggested this figure was "misleading". Had the figures been compiled the week before and thus excluded a weekend dominated by England v Denmark and Father's Day, the LFL performance would have been 10%. Significantly, the current margin performance continued to be higher than that seen the same time last year.

Although a buoyant property market has certainly underpinned Carpetright's recent performance, there's still scope for Carpetright to expand. Lord Harris confirmed the company's aim was to garner 30-35% of the UK carpet market over the next few years. At the moment, Carpetright has a 22% UK market share, while Allied Carpets has 8%, other multiples have 6%, department stores have 4% and independent operators have 60%.

Rolling out abroad

The major highlight within Carpetright's statement concerned the 50% purchase of European carpet retailer Carpetland.

The major points concerning this purchase are:

* It's Carpetright's first acquisition and first venture into Europe;

* The 50% stake will cost approximately £33m, a price that includes the purchase of 12 freehold and 3 long leasehold properties;

* Carpetright have an option (but not an obligation) to purchase the remaining 50% between 2005-2008 on an after-tax multiple of 9;

* Carpetland is the market leader in Holland, Belgium and Luxembourg, with a market share of 5% and annual sales of £61m;

* Carpetright will take management control of Carpetland and expect to double its market share over the next 3 years, and;

* With operating margins of just 4%, there's plenty of opportunity for higher margins. Lord Harris admitted that Carpetland had been "badly run", yet the firm remains a profitable market leader.

Although overseas acquisitions should generally make investors nervous, the financial details of this deal should limit any heartache. For starters, excluding the property payments, Carpetright is paying under £10m (i.e. less than 30% of this year's post-tax profit) for the 'operational' part of the business.

Furthermore, Carpetright bought its Carpetland stake on a historic price to earnings (P/E) ratio of around 9-10. With plenty of sales and profit upside for the proven Carpetright boardroom to go for, the eventual return on capital from the transaction should prove rewarding. As foreign purchases go, the Carpetland deal looks as good as they come.

Cash flow and return on equity

Year to April              1998     1999     2000     2001     2002

Operating Profit (£m)      28.8     23.2     36.9     44.7     52.0

Net change in
  working capital           9.8      5.6      2.7      6.0     (5.4)

Depreciation                6.6      7.5      7.5      8.1      9.8 
Net capital expenditure   (12.7)    (9.5)    (4.1)   (22.5)   (22.1)

At the interim stage, Carpetright suffered a rare outflow of working capital cash. Six months on, and the situation remains the same. One possible explanation for an increase in debtors would be Carpetright's recent dealings with insurance companies, who are unlikely to pay upfront for their clients' carpets. It's also worth noting how Carpetright's stock turn ratio has deteriorated:

Year to April              1998     1999     2000     2001     2002 

Cost of sales (£m)        131.7    137.2    140.6    138.3    151.8 
Average stock (£m)         21.8     23.0     22.6     25.4     29.7

Stock turn
period (days)                60       61       59       67       71 

Overall, the jury remains out on the working capital front. But given the prodigious cash flow characteristics of the past, it should pay to give the company the benefit of the doubt.

One feature of the accounts that still remains impressive is Carpetright's incremental return on equity. During the five years to April 2002, Carpetright's equity base has increased from £37.7m to £54.4m. Over the same time, earnings have risen from £22.5m to £36.4m. The resulting incremental return on equity comes to a mouth-watering 83% ((£36.4m - £22.5m)/£54.4m - £37.7m)).

Valuation

Given the expense on new stores over the years, it's difficult to accurately judge Carpetright's 'maintenance' capital expenditure. Assuming it's 50% higher than the depreciation charge, Carpetright would have generated free cash per share of 43.1p during the year ending April 2002.

At 585p, the shares therefore offer a historic free cash flow yield of 7.4%. Bearing in mind Carpetright's full year dividend is 33p per share, current trading remains upbeat and the significant opportunities for long-term profit growth, the shares look cheap.

But as before, the risks of holding Carpetright shares remain the same:

* Management: Selling commodity-ish goods with price as your main weapon requires solid management skills. While not putting a foot wrong since he founded the firm, should Lord Harris lose his touch, shareholders will be in trouble.

* 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. But being the dominant industry player, Carpetright's competitive advantages are its economies of scale and purchasing power.

* Recession: Carpets sales are very sensitive to the general health of the economy and property market.

More: Carpetright Interim Results | Fool Buys Carpetright | Fool Considers Carpetright