QUALIPORT
The Pros And Cons Of Carpetright

By Maynard Paton (TMFMayn)
January 5, 2004

The Qualiport bought its first batch of Carpetright (LSE: CPR) shares in August 2001. Defying the bear market, the shares have since rallied 44%, with a string of good results from the carpet retailer prompting the share price momentum.

December's interim figures revealed another solid performance, as good progress from Carpetright's European operation helped underlying earnings improve 40%. The table below summarises the half-year performance:

Carpetright Interim Results
	26 weeks to 01/11/03	27 weeks to 02/11/02
Turnover (£k)	216,550	218,938
Operating profit (£k)	29,690	24,064
Exceptional items (£k)	-	(2,064)
Pre-tax profit (£k)	32,349	22,115
Earnings per share (p)	33.0	23.7
Dividend per share (p)	17.0	15.0

In the UK, a 'difficult trading environment' caused six-month sales to fall from £198m to £189m. However, operating margins improving from 12.9% to 15.5% supported a 14% increase to domestic operating profits (to £29.2m). An overhaul of the group's fledgling Benelux business (bought in 2002) turned last year's £1.5m divisional loss into a £0.4m profit. A £3.6m profit from fixed-asset disposals helped group pre-tax profits move from £22.1m to £32.3m and underpinned a 13% dividend hike.

Though Carpetright's share price and results have so far pleased the Qualiport, the holding is not without risk. Here are the main pros and cons:

Pros

Good management: Carpetright's chairman and chief executive, Lord Harris, is the UK's 'Mr Carpet'. He's been in the carpet game for over 40 years, has built up two national retail chains from scratch (he sold his first, Harris Queensway, just before the late-1980s housing collapse) and knows everything about the industry.

Dominant market leader: Using a keen pricing strategy, Carpetright has garnered about 25% of its market. Nearest rival Allied Carpets has below 10% with the rest nowhere. Economies of scale should help sustain the company's size advantage.

Attractive accounts: Carpetright's accounts are great. For instance, the incremental return on shareholders' equity has been an eye-popping 107% over the past five years. Cash generation is superb, too. Indeed, during calendar 2003, the company spent £34.4m buying back its own shares.

Cons

Not a franchise: Carpetright is not a business surrounded by a crocodile-filled moat. With barriers to entry low and competition tough, plenty of management running has to be done to stand still.

No growth: The UK market for floor coverings -- in terms of volume and value -- has been stagnant for years. In fact, to the detriment of carpet, demand for vinyl, laminate and wood has increased over time, up from 10% of the floor coverings market five years ago to over 20% now. Growth at Carpetright comes from stealing market share from competitors.

Economically sensitive: Reduced consumer spending will undoubtedly hit earnings. For instance, the economic wobble of 1998 caused operating profits to slump 26% between 1997 and 1999.

Given today's toppy housing market, another worry is the high level of mortgage equity withdrawals (MEW). During Q3 2003, MEW represented 7% of post-tax income -- the second highest proportion ever. A fair bit of MEW proceeds undoubtedly go towards refurbishing property.

Unsustainable margins? Carpetright's latest results showed UK operating margins of 15.5%. For a retailer operating on a value proposition in a competitive sector, this is an amazing accomplishment. Only four listed retailers have higher margins, and all these are specialist, upmarket merchants. Though Carpetright is operationally very efficient, just how sustainable are the current mark-ups?

Summary

Though Carpetright remains a good long-term company, it won't be able to buck any economic downturn. The last recession ended eleven years ago and to a certain extent, today's UK consumers are probably overdue some economic pain. But how much trouble a deflating property market will cause, for instance, is anyone's guess. As every buy and hold investor knows, trying to predict the timing and extent of an economic event is a mug's game.

Of course, there are two other issues to consider. Firstly, valuation. Assuming no profit growth, Carpetright could generate free cash per share of 53.9p during the twelve months to October 2004. At an 832p share price, the forward free cash yield comes to a reasonable-but-not-cheap 6.5%. Secondly, the Carpetright holding represents just 6% of the Qualiport. So even if problems do occur at the company, the portfolio won't be affected excessively.

On balance then, the shares are a hold. There could well be trouble in the short term, especially as the latest results showed like-for-like UK sales contracting by 1.8%. But as the past couple of years have demonstrated, it does pay to keep the faith with Carpetright and its management.

More: Phew! Carpetright Defies The Doomsters | Carpetright Right Right

The author owns shares in Carpetright.