QUALIPORT
Qualiport Sells Carpetright

By Maynard Paton (TMFMayn)
June 29, 2004

Following the announcement on Tuesday last week, the Qualiport disposed of its remaining holding in Carpetright (LSE: CPR) the next morning. This article rounds off the portfolio's involvement with the carpet retailer.

Portfolio profit

The table summarises the Qualiport's investment return on Carpetright:

	Date	Number of shares	Price (p)	Dealing costs (£)	Total cost/ proceeds (£)
Buy	03/08/2001	514	578	29.85	3,000.77
Buy	25/09/2001	161	483.75	18.89	797.73
Total					3,798.50
Sell	06/12/2002	250	598	15.00	1,480.00
Sell	07/11/2003	259	773	15.00	1,987.07
Sell	23/06/2004	166	950.5	15.00	1,562.83
Total					5,029.90
Accumulated dividends					490.46
Net profit					1,721.86

Including dividends, dealing costs and stamp duty, the portfolio produced a 45% return. Not bad, especially considering the FTSE 100 (with dividends reinvested but excluding all costs) lost 11% between the first purchase and the final disposal.

Goodbye

Of course, with the shares presently standing at 1,025p (buoyed by full-year results out today), the overall (paper) return could have been much better had the portfolio held on. Still, there are two good reasons why the Qualiport has waved goodbye.

1. Not a true franchise: Carpetright is a very good business and is run by top-notch management. But no matter how great the boardroom talent, it can't hide the fact selling carpets suffers from low barriers to entry and intense competitive rivalry. If boss Lord Harris decides to quit for instance, investors could be in real trouble.

The proceeds from the three Carpetright disposals have been used to buy shares in Associated British Ports (LSE: ABP) and London Stock Exchange (LSE: LSE). Unlike Carpetright, these two firms possess obvious and sustainable monopolies, have no great need for skilled people to survive and therefore make far better buy and hold investments.

2. Consumer spending: Given the numerous variables and the finger-in-the-air guesswork involved, long-term investors should generally ignore economic forecasts. However, it's becoming increasingly difficult to ignore Britain's property boom and the signs of impending house price misery.

A downturn in the property market will affect Carpetright in two ways. Firstly, the number of property transactions will decline, so reducing the number of carpets bought by moving homeowners. But more importantly, a slump would curtail the mortgage equity withdrawal phenomenon and hit consumer spending. 

You see, during Q4 2003, borrowed money secured on housing -- but not spent on housing -- represented 8.3% of post-tax income -- the highest proportion ever. A fair bit of the withdrawal proceeds undoubtedly finds its way into home furnishings, but if such proceeds dry up, that new carpet may well become even more of a discretionary purchase. The last recession ended eleven years ago and to a certain extent, today's UK consumers are probably overdue some cutbacks.

Results

Despite those reservations, Carpetright continues to perform well. The year to April 2004 saw sales increase 5% to £392m, pre-tax profits increase 20% to £68m, earnings per share increase 26% to 70.1p and the dividend increase 19% to 44p per share.

Though cost cutting and sizeable share buybacks helped to boost earnings, underlying sales improved just 1.2% during the year. One top-line concern perhaps is Carpetright's move towards laminate flooring. The company does not have the same reputation and competitive strength in this market as it does with carpet, yet this type of floor cover provided a 'significant contribution' to improved second-half sales.

Margins

Still, the accounts seemed impressive. Cash flow is as prodigious as ever and the returns on shareholders' equity are still in the stratosphere. Nonetheless, operating margins in the UK and Ireland, which improved to 16.3%, don't appear sustainable. In the retail sector, the only other groups with margins in excess of 16% are Ted Baker (LSE: TBK), Monsoon (LSE: MSN) and Burberry (LSE: BRBY). While the customers of these three fashion chains quite happily pay up for distinctive products, it's difficult to associate Carpetright's commodity goods and value pricing with such mark-ups.

Past portfolio member PizzaExpress perhaps is an instructive example here. The Qualiport (mistakenly) rolled out many arguments supporting the restaurant company's 20%-plus margins, but they all proved to be a mirage as diners eventually succumbed to the bevy of alternative menus elsewhere. It's fair to say further margin improvements at Carpetright will be limited; most likely they'll come under pressure. It's worth noting the economic wobble of 1998 caused Carpetright's operating margin to decline from 13% to 8% between 1997 and 1999.

Valuation

Going on today's figures, Carpetright's 1,025p shares trade on a price to earnings (P/E) ratio of 14.6 and offer a 4.3% dividend yield. If maintenance capital expenditure is 25% greater than the reported depreciation charge, free cash flow comes to 62.2p per share, making the free cash flow yield 6.1%. Be aware that during the company's difficulties of 1998, Carpetright shares collapsed to a P/E of about 7. Should history repeat itself, the current valuation implies a downside of 50%.

Maynard owns shares in Associated British Ports and London Stock Exchange.