Flaw covering – Our analysis of Carpetright pulls the rug out from under an investment case
Carpetright – not least because its share price has all but halved since reaching a three-year high of 628.5p in early April – has been cropping up on a few of our value screens in recent months. So let’s take a closer look at what one of the UK’s largest floor-covering retailers might have to offer the discerning value investor.
On today’s estimates of profits, the company is trading on a price/earnings (P/E) ratio of 34x – a significant premium to the market’s 12x or thereabouts. First impressions therefore are not promising but, to be fair, Carpetright’s current margins of 2.6% are substantially down on a long-term average of almost 6% (over the last 10 years).
Adjusting for that, the business stands on a far less bloated P/E ratio of 14x and a similarly attractive free cashflow yield of around 9%. If you were to go even further and look at the business on what is known as the Hussman P/E, which uses a company’s peak profits number in the second part of the equation, Carpetright would trade on 5.6x, which is usually more than enough to pique our interest.
What no investor can afford to lose sight of, however, is that investment is every bit as much about risk as it is about reward and when we think about P/E ratios, we are only focusing on the latter. The first place to look if we want to understand the risks associated with Carpetright is its balance sheet and, this time, first impressions are actually quite favourable.
From a debt point of view, the company looks fine – its balance sheet is almost net cash – but businesses have other liabilities beyond debt and this is where we begin to grow uneasy. The issue is not with the providers of Carpetright’s debt financing but with the providers of the company’s other liabilities – its leases and working capital.
A good measure for assessing how big a drain on a business’s finances the leases it is signed up to are likely to prove is a ratio known as the ‘fixed-charge cover’. This combines a company’s leases and debt and compares the resulting number with its profitability in order to judge its ability to meet its fixed obligations.
On current profits, Carpetright’s fixed-charge cover stands at just 1.3x. To give you a point of reference, banks tend to grow nervous when a business’s fixed-charge cover dips below 2x and they become positively agitated when it drops below 1.5x so it is not unreasonable to suggest Carpetright may have an issue on this measure.
That said, as investors, we need to bear in mind that ratios do not offer answers about the state of a business so much as ways for us to ask the right sort of questions. And when we are faced with a fixed-charge cover of 1.3x, the right sort of question to ask is whether the issue lies with the ratio’s numerator or its denominator.
In other words, are Carpetright’s profits too low or is the cost of its leases too high? The simplest way to address this question is to ‘flex’ one of the variables so, say we go back to the business’s peak profits, how would its fixed-charge cover look then? If it looks suitably comfortable, then we know Carpetright’s current issue is profits while, if it is still not high enough, it is down to the leases.
Sure enough, if you flex the company’s profit number back up to peak profits, the fixed-charge cover still only comes to 1.8x, which is below a level with which we feel comfortable. An alternative way of assessing the state of a business’s leases is as a percentage of its sales and Carpetright’s current figure of 20% is one that, historically, has always been a red flag to us when we are assessing an investment.
Furthermore, the other working capital suppliers have been very generous and so, if they were to grow at all nervous about the business’s future value, Carpetright would in all likelihood struggle to replace that funding. All things considered, while the recent falls have made the reward side of the Carpetright equation superficially attractive, we see the risks as too great to justify a position in our portfolios.
Having been so down on a company, good manners dictates we caveat our thoughts by acknowledging that, for some investors, the potential reward may well be attractive enough to justify the associated risks. Certainly the company has a very concentrated shareholder register so, for example, it is possible to envisage some kind of M&A angle. However, our current thoughts on Carpetright mean, here on The Value Perspective, we are inclined to focus less on its covered floors than its uncovered flaws.
Fund Manager, Equity Value
I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials. In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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