QUALIPORT
DFS: Dividend Fortune Share

By Maynard Paton (TMFMayn)
October 13, 2003

In terms of sustainable competitive advantages, DFS Furniture (LSE: DFS) is the weakest company within the Qualiport. Selling furniture is a tough old game and recent annual results were full of comments about the growing competition. But the retailer remains a market leader, its experienced boardroom has coped successfully with difficult times before and the accounts are still some of the best around. Assuming the sofa chain doesn't get routed by a full-on recession anytime soon, a 6%-plus dividend yield and a reputation for reliable payouts should serve investors well.

Five-year summary

The table below shows the progress made at DFS during the past five years:

Year to c31 July                 1999    2000    2001    2002    2003

Turnover (£m)                   295.5   357.3   401.9   462.2   499.1
Operating Profit (£m)            24.5    44.8    48.9    53.1    55.9
Exceptional Items (£m)              -       -       -    17.4       -
Pre-tax Profit (£m)              25.7    46.1    50.1    71.0    56.4

Earnings per share*(p)           16.6    30.2    32.3    34.0    35.7
Dividend per share (p)           14.9    18.6    20.6    22.7    24.0
Special dividend per share (p)   10.0    20.0       -    14.1       -

(* Before exceptional items)

Like-for-like sales of 2.5% and seven new stores helped DFS improve turnover by 8% to £499m in the year ending 2 August 2003. Operating margins during the twelve months declined once again, from 11.5% to 11.2%, as DFS noted a UK furniture market that had 'never been more active, aggressive and competitive'. However, margins in the second half improved on the first half (11.7% versus 10.7%). Annual operating profits increased 5.3% and earnings per share 5.6%.

Cash flow

DFS' attractive cash flow characteristics were again seen throughout 2003:

Year to c31 July                1999    2000    2001    2002    2003

Operating Profit (£m)           24.5    44.8    48.9    53.1    55.9
Change in working capital (£m)   9.5    18.2    (4.4)    7.2     1.4
Depreciation (£m)                4.6     5.3     6.2     7.5     9.1
Net capital expenditure (£m)   (16.0)   (9.4)  (13.6)  (28.5)  (21.5)

There were no problems with working capital, with DFS generating another inflow of cash. Judging 'maintenance' capital expenditure (capex), however, is complicated by DFS' store opening programme. In the past, the Qualiport has used a figure of twice the depreciation charge and, going on the 2003 results, the estimate still seems appropriate.

Good cash generation allowed DFS to raise the dividend by nearly 6% to 24.0p per share. What's more, the balance sheet continues to carry no debt and, excluding money associated with the Primback case, showed £32.3m (30.2p per share) sitting in the bank.

Return on equity remains superb. Over the five years starting August 1998, shareholders' funds at DFS have grown from £41.7m to £66.9m. During the same time, normalised earnings have improved from £23.1m to £38.1m. The resulting incremental return on equity comes to a wonderful 60% ((£38.1m - £23.1m)/(£66.9m - £41.7m)).

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 51%.

Summary and valuation

DFS' latest results contained many remarks about industry rivalry:

"With new entrants targeting our sector, and established players imitating aspects of our successful concept..."

"With competition in our market increasing to unprecedented levels..."

"Growing competition is making it an even greater challenge to recruit and retain staff of the calibre we need to drive growth."

"We believe that the slower sales performance [following the year-end] mainly reflects the growing intensity of competition in our sector..."

"Given the increasingly competitive nature of our market... we do not expect to make material profit progress in the current financial year."

DFS certainly isn't a business 'franchise'. A wide product range, an in-house manufacturing capability and an experienced management team can all be seen as competitive advantages of sorts, but with underlying sales down 4% in recent weeks, it appears the barriers are presently being breached. Indeed, rivals Marks & Spencer (LSE: MKS) and ScS Upholstery (LSE: SUY) have both admitted lacklustre furniture sales of late, suggesting perhaps that consumer spending in general has taken a knock.

Still, DFS does have a few things in its favour. No acquisitions, no goodwill, no restructuring charges, no diverse activities, no foreign operations, no pension and FRS17 issues; the company is as good as it gets in terms of clear-cut accounts. When judging DFS, the long record of increasing dividends (up 14% per annum on average since 1994), a handful of special payouts and the eye-popping returns on capital go some way to counterbalance the inherently tough industry.

Then there's valuation. At 388p, the latest figures put DFS on a lowly price to earnings ratio of 10.8 and offer a generous 6.2% dividend yield. Assuming maintenance capex is double the depreciation charge, DFS generated 29.6p per share of free cash during fiscal 2003. Consider the 30p per share of cash too, and the shares offer a historic free cash flow yield of 8.3%.

So the shares look a bit of giveaway, assuming recent trading in the sector is not the prelude to a full-on consumer recession. 'Big ticket' items (£1,500 is the average order value at DFS) will be the first to go in a downturn and it's worth remembering between 1997 and 1999, DFS' earnings fell by a third as consumers tightened their belts. How gloomy the market will view DFS should a similar shortfall occur is anyone's guess. But it's fair to say the current valuation already has a significant dose of pessimism factored in.

More: DFS Annual Results 2002 | DFS Furniture discussion board

The author owns shares in DFS Furniture.