QUALIPORT
DFS: Sofa, So Good

By Maynard Paton (TMFMayn)
October 17, 2002

Qualiport share DFS Furniture (LSE: DFS) published a solid set of annual results this morning. Following a lacklustre interim showing, today's statement highlighted an improved second half performance. However, margins declined and comments over increased competition were made. That said, the DFS accounts remain in great shape and the shares are far from overpriced.

Results

Here's the five-year record of DFS:

Year to 31 July                  1998    1999    2000    2001    2002

Turnover (£m)                   280.3   295.5   357.3   401.9   462.2
Operating Profit (£m)            32.0    24.5    44.8    48.9    53.1
Exceptional Items (£m)             -       -       -        -    17.4
Pre-tax Profit (£m)              34.1    25.7    46.1    50.1    71.0

Earnings per share*(p)           22.0    16.6    30.2    32.3    34.0
Dividend per share (p)           14.4    14.9    18.6    20.6    22.7
Special dividend per share (p)      -    10.0    20.0       -    14.1

(* Before exceptional items)

Five new stores combined with 4.7% like-for-like sales growth caused turnover to jump 15% to £462m. However, operating margins declined from 12.2% to 11.5%. DFS explained the decline was down to "flexing margins to drive volume" (i.e. price cutting), higher rents and additional customer service costs. It all left operating profits to improve 'only' 9% to £53m.

Excluding a £17m exceptional gain relating to the Primback Case (read more here), normalised earnings per share increased 5% to 34.0p. The full-year dividend was raised 10% to 22.7p per share, while a special 14.1p per share payout was distributed at the interim stage.

Overall, the second half brought mixed news. Turnover improved 7.2% on a like-for-like basis, a very reassuring performance considering the pedestrian 2% improvement seen in the first. However, it was during the second period that operating margins suffered -- down to 10.95% versus 12.15% in the first. So it appears additional growth had a lot to do with discounting, which coincides with management comments concerning "the growing competition in the market place". That said, the strong like-for-like trend reported in the second half has been sustained into the current year.

Cash flow

DFS also maintained its attractive cash flow characteristics during 2002:

Year to 31 July                 1998    1999    2000    2001    2002

Operating Profit (£m)           32.0    24.5    44.8    48.9    53.1
Change in working capital (£m)   0.5     9.5    18.2    (4.4)    7.2
Depreciation (£m)                3.6     4.6     5.3     6.2     7.5
Net capital expenditure (£m)   (12.1)  (16.0)   (9.4)  (13.6)  (28.5)

There were no problems with working capital, as last year's somewhat unusual cash outflow was reversed this time around. Indeed, stock turn commendably fell for the sixth consecutive year, down from 13.8 days to 12.3 days.

Judging 'maintenance' capital expenditure (capex), however, is complicated slightly by DFS' store opening programme. During 2002, the company spent £14.5m on purchasing new freehold and long leasehold property. So the remaining capex, some £14m, can be taken as a rough proxy for maintenance spend. This figure is about twice the 2002 depreciation charge and correlates nicely with the 2000 performance, a year when no new stores were opened and total capex (i.e. in effect, all maintenance capex) was also double that year's depreciation figure.

(On the subject of ongoing expenditure (i.e. store refurbishments), PizzaExpress (LSE: PIZ) investors should note this comment from DFS: "The development of new stores has not distracted us from ensuring that our established outlets retain their consumer appeal by incorporating our continually evolving standards in design and decor.")

The DFS balance sheet continues to carry no debt and (excluding money associated with Primback) showed £25.4m (24p per share) cash in the bank. In addition, return on equity measures remain superb. Over the five years starting August 1997, shareholders' funds at DFS have grown from £32.8m to £51.2m. During the same time, normalised earnings have improved from £25.9m to £35.7m. The resulting incremental return on equity comes to 53.4% ((£36.7m - £25.6m)/(£51.2m - £32.8m)). Start at August 1994 (the beginning of DFS' first full financial year as a listed company) instead, and the incremental return on equity figure comes to 69%.

Summary and valuation

Today's statement from DFS contained the following remarks:

"Our strong sales growth in a crowded and competitive market place is based above all on having the products people want to buy, when they want them and at the right price. The DFS offer today is stronger than ever, with the most comprehensive range of designs and options, providing choices that are unmatched in breadth or depth."

"Our unique integrated approach to manufacturing and retailing remains a key point of difference for DFS... There is no doubt that our in-house UK production capability [producing 15% of group sales] gives us a flexibility and competitive edge not available to competitors who may be increasingly reliant upon sourcing from Far Eastern suppliers."

So, hardly the stuff of a business 'franchise'. However, product range, manufacturing capabilities -- plus a very experienced boardroom -- does provide DFS with certain competitive advantages. That said, there's no denying retailing is a very tough industry and plenty of management running must be done just to stay still.

Although its market share improved from 14% to 15% during the year, DFS stated today that it "cannot disregard the growing competition in its market place." Rivals such as ScS Upholstery (LSE: SUY), Marks & Spencer (LSE: MKS), IKEA, MFI (LSE: MFI), Courts (LSE: CRTO) and Argos are all threats of one sort or another, albeit each fights mainly on one on two of the key DFS strongpoints (e.g. price, range, quality and brand).

Partly offsetting the lack of obvious franchise features is the company's financial performance. No acquisitions, no goodwill, no restructuring charges, no diverse activities, no foreign operations; DFS is as good as they come in terms of clear-cut accounts. When judging DFS, the long record of special dividends and great returns on capital do a lot to counterbalance the inherently tough industry the firm operates within.

DFS shares rose 22.5p (6%) to 391p on today's results. At the current price, the latest figures value the firm on a price to earnings ratio of 11.5 and a 5.8% dividend yield. Assuming maintenance capex is double the depreciation charge, DFS generated 28.7p per share of free cash during 2002. Add on the 24p per share of cash too, and the shares offer a historic free cash flow yield of 7.3%. Backed up by the solid dividend and cash pile, DFS shares are bordering on the attractive.

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The author owns shares in DFS Furniture and PizzaExpress