QUALIPORT
Kirkham's 415p DFS Bid: Derisory For Shareholders

By Maynard Paton (TMFMayn)
March 4, 2004

It wasn't just the Qualiport that noticed the shares of DFS Furniture (LSE: DFS) were 'very cheap' last month. The furniture chain's chunky dividend yield and substantial cash hoard have proved too tempting for Graham Kirkham, the company's executive chairman. A statement this morning confirmed Kirkham was 'contemplating making a possible offer' for DFS, though the planned bid price of 415p per share is derisory. The Qualiport is holding on.

Talking down to investors

Doing his best to talk down the prospects of DFS, Kirkham made the following remarks:

"Over the last two years the market place in which DFS operates has become much more competitive, as major retailers from other sectors have entered the home furnishings market. I do not believe this is temporary, but represents a structural change in the market place. As the UK's number one upholstery retailer, DFS is more affected than others. This increase in competition combined with the prospects of higher interest rates means that conditions in our market will become even more demanding.

I believe that DFS would be better able to deal with these conditions as a private company, free from the need to continue to deliver consistent growth in sales, earnings and dividends.

Since flotation in November 1993, DFS has grown annual operating profits from £18.6 million to £55.9 million. DFS' market capitalisation has increased by approximately £166 million from £271 million at the time of flotation. In addition, DFS has returned approximately £228 million to shareholders. I do not believe this level of profit growth and value creation for shareholders is sustainable. An offer price of 415 pence per share would represent a full and fair price to shareholders."

Naturally, the comments contradict Kirkham's thoughts from October's preliminary update:

"I remain totally confident, however, of our ability to meet all the challenges in our market place and that the fundamental strengths of our brand and concept will enable us to continue delivering profitable growth for the benefit of our shareholders in the future."

Points to consider

What should DFS investors consider now? There are four main issues:

1) Proven industry expert: Kirkham knows more about DFS than anyone else. Over thirty years, he's transformed a single store into a national chain worth £450m (his 8% stake is worth around £36m). Kirkham's obviously made plenty of lucrative business decisions in the past, and buying the company outright (at 415p a share) could well reward him further.

2) Non-execs: The non-executive DFS directors will have a large say in whether any bid is successful. But the corporate governance signs aren't good.

Firstly, one of the non-execs is Malcolm Walker, ex-boss of Iceland, whose shareholder pedigree is debatable. At the end of 2000, he sold Iceland shares worth £13m the day after 'remaining positive' about his then company's future prospects. One month later, the frozen-food firm issued a profit warning.

Secondly, Walker and fellow non-exec Kevin Morley have been at DFS for over ten years, which perhaps questions their independence. Appointed in 1999, former Halifax chief Mike Blackburn is the third, and thankfully senior, non-exec.

3) Competition: Competition in the furniture market is increasing: DFS warned in February that first-half profits would not match those of last year. The Qualiport has previously admitted DFS is the weakest watch-list company when it comes to all-round competitive 'moats'.

Consumer spending appears shaky, too. A profit warning from Ultraframe (LSE: UTF) this morning -- a maker of conservatory roofs and another 'big ticket' consumer-item business -- doesn't bode well.

4) Value: For such a proven performer, the proposed bid price undervalues the shares by a wide margin. At 415p, the price to earnings (P/E) ratio comes to 11.2, the dividend yield is 5.8%, and the free cash flow yield is 7.7%. At the last count, DFS had 30p of net cash in the bank.

(At the present 430p price, the P/E comes to 11.7, the dividend yield is 5.6% and the free cash flow yield is 7.4%).

JJB or PizzaExpress?

There are now three possible outcomes for shareholders:

1. Kirkham (or somebody else) comes up with a better offer;
2. Kirkham buys for 415p a share;
3. Kirkham doesn't bid.

Outcome 1. is obviously preferable. Should it not happen though, the Qualiport is well prepared for Outcome 2.

The portfolio experienced an 'undervalued' bid situation with PizzaExpress in 2002. But the harsh lessons learned from that encounter were that other investors (or company directors) do not owe fellow shareholders a return and that they're free to buy any company at below its 'intrinsic value'.

If the 415p offer for DFS is made and accepted, the Qualiport will not be spending time wanting 'fair value' to be upheld, and will instead just get on looking for a replacement share. Read more.

Outcome 3. could provide the most downside. Having failed with his bid, would Kirkham then lose his motivation to generate superior returns for shareholders? Kirkham may in fact be proved correct with his claim of DFS being better able to deal with its rivals as a private company.

On the other hand, something similar to the events at JJB Sports (LSE: JJB) may occur. With his family controlling nearly 40% of the group, chairman Dave Whelan announced he was considering a 220p per share offer for the sports retail chain in March last year. JJB's non-execs commendably didn't recommend the bid (it equated to a P/E of just eight) and, following a disposal and change in strategy, the shares now trade at 305p.

All things considered, the Qualiport will hold onto its DFS shares. Simply, a 415p share price undervalues the company, and the fact that such a successful businessman as Kirkham wants to buy at that level indicates there's upside to be had.

More: The Market's Best Mid-Cap Yield | PizzaExpress: The Harsh Reality | Fool's Guide To Corporate Governance.