QUALIPORT
Target Prices For Retailers At Risk

By Maynard Paton (TMFMayn)
May 10, 2005

When I sold the Qualiport's final batch of Carpetright (LSE: CPR) shares last year, I gave two reasons for the disposal:

"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." Read more.

"2. Consumer spending: It's becoming increasingly difficult to ignore Britain's property boom and the signs of impending house price misery... The last recession ended eleven years ago and to a certain extent, today's UK consumers are probably overdue some cutbacks."

Sure enough, consumer spending and the housing market now appear on the wane. And the intense competitive rivalry that all retailers suffer is really beginning to show.

Property downturn

I accompanied the final disposal of Carpetright with these remarks:

"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."

Well, mortgage equity withdrawals have been drying up of late. Latest statistics from the Bank of England showed such withdrawals falling from £11.3b in Q3 2004 to £6.9b in Q4 2004. Read more.

It all seems to have had an effect on Carpetright. At the end of last month, the carpet retailer admitted underlying second-half sales had contracted by nearly 6%. Lord Harris, Carpetright boss, said: "Our UK and Republic of Ireland business has had a difficult half within a weakening consumer environment and set against strong comparatives last year."

Other retailers have also felt the pinch. Recent updates have revealed underlying sales down 2% at Jessops (LSE: JSP), down 2% at HMV (LSE: HMV), down 6% at Kingfisher (LSE: KGF), down 9% at Matalan (LSE: MTN) and down 17% at French Connection (LSE: FCCN). Indeed, the British Retail Consortium today confirmed high street sales declined by nearly 5% in April, the worst since the BRC's survey began in 1995.

Carpetright history

I reckon today's investors could get caught out by any prolonged downturn in retail spending. The profit disappointments are likely to be significant and extremely pessimistic valuations will almost certainly occur.

You see, the last time consumers tightened their belts was in 1998. Sadly, the setbacks that occurred back then no longer feature in annual report five-year reviews or investor databases such as Company REFS. And the last recession proper occurred way back in the early Nineties, the effect of which on high street chains can now only be discovered in the history books.

The table below summarises Carpetright's performance between 1995 and 1999. Following years of double-digit increases, like-for-like sales growth was just 2% in 1998 and was a negative 3.5% during 1999.

Year to April 30	1995	1996	1997	1998	1999
Turnover (£m)	141.3	185.3	233.9	269.3	277.7
Pre-tax profit (£m)	19.7	25.2	32.2	29.1	23.5
Earnings per share (p)	16.8	23.3	28.5	26.0	22.8
Dividend per share (p)	10.5	14.5	19.0	22.0	22.25

Remember, Carpetright was a textbook retailer throughout all this time. It possessed established and proven management, had a leading market share (at least 20% in 1998, with 300-plus stores) and exhibited some wonderful accounts. And yet it still came a cropper when underlying sales declined. Between 1997 and 1999, pre-tax profits fell 27% and earnings per share fell 20%.

During October 1998, Carpetright shares touched 171p. At that time, consensus estimates for Carpetright's near-term earnings and dividends looked like this:

Year to April 30	1997	1998	1999(e)	2000(e)
Earnings per share (p)	28.5	26.0	23.9	24.8
Dividend per share (p)	19.0	22.0	22.0	22.3

Such was Mr Market's depression, the low point saw Carpetright shares trade on a forward price to earnings (P/E) ratio of 7.2 and offer a prospective dividend yield of 12.9%. See what I mean about extremely pessimistic valuations?

Carpetright target

This is how City analysts currently see Carpetright's progress in 2005 and 2006:

Year to April 30	2003	2004	2005(e)	2006(e)
Earnings per share (p)	55.6	70.1	61.5	62.8
Dividend per share (p)	37.0	44.0	46.8	48.7

Earnings are set to drop by 13% for 2005. Going on the ratings experienced at the bottom in 1998 and the current forecasts, it's not hard to come up with a target price of below a fiver should the carpet trade get even tougher. The shares currently stand at 824p.

(Something that will almost certainly give over time is Carpetright's operating margin. The UK division is running at 16% -- a level that must surely be unsustainable for a company that fights primarily on price.)

Wine, perfume and tiles

Alongside Carpetright and the numerous other retailers that have admitted to tough sales, leading candidates for high-street distress this time around include Majestic Wine (LSE: MJW), Merchant Retail (LSE: MRT) and Topps Tiles (LSE: TPT).

Wine, perfume and tiles -- just like carpet -- are all inherently discretionary purchases and, should consumer spending deteriorate further, I believe these three retailers will experience earnings declines and watch their double-digit P/E multiples contract to single-digit status.

In addition, something I'm sure will encourage investors to drive down the price is that -- unlike Carpetright -- Majestic, Merchant and Topps have not yet suffered profit setbacks as listed companies and a subsequent revival, therefore, is not a sure-fire bet.

Indeed, the downside at Majestic, Merchant and Topps could be considerable. Apply a P/E of 7 to the latest estimates for the current year and my target price for Majestic comes to 100p (down from today's 227p), my target price for Merchant comes to 80p (down from today's 159p) and my target price for Topps comes to 90p (down from today's 162p).

Summary

Retailers rarely evolve into long-term 'franchise' businesses. Barriers to entry are low, copycat rivals are everywhere and, as Warren Buffett might say, they're often only as clever as their dumbest competitor.

Then again, retailers can produce wonderful stock market returns in a recovery-then-return-to-growth situation. Between the 171p 1998 low and the 1,183p 2004 high, Carpetright investors could have (with dividends included) earned about eight times their money in six years.

To enjoy those sort of returns, you have to buy during the point of maximum high street pessimism and pick only the retailers that, like Carpetright, enjoy clear leadership in their field, proven boardroom talent and a robust balance sheet -- giving them every chance of a strong earnings recovery when consumers restart their spending and the sector has been cleared of the also-rans.

More: The Small Investor's Graveyard | PizzaExpress Shares Could Fall To 300p

Portfolio value

Holding	Number of shares	Closing price 09/05/05 (p)	Value (£)
Associated British Ports	681	465	3,166.65
Emap	372	775	2,883.00
Halma	1,920	146	2,803.20
Johnston Press	1,608	500	8,040.00
London Stock Exchange	2,018	461.75	9,318.12
Cash			268.36
Total			26,479.33