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DFS Furniture IPO – Should you invest?

DFS Furniture have announced an IPO which will be available to retail investors – as long as you are happy to “take” the price the institutions are willing to pay. Anyone considering investing in the shares might like to note the comments below, but you are of course advised to read the full prospectus and/or take professional advice on the matter if necessary.

This writer is well qualified to write on this subject because I used to hold DFS shares the last time it was listed, before it was taken private much to my consternation by founder Lord Kirkham. Back in the mists of time, I also spent some years working for a furniture retailer.

Let’s first consider the profile of the furniture market in which DFS operates. In theory there are few barriers to entry to sell sofas. All you need is a large shed, and suppliers willing to sell you furniture when you get a customer order (although DFS is unusual in that it does manufacture a proportion of its products). You need some stock as “display” items to furnish the showroom, but you don’t actually need to hold a lot of stock because many customers will wait for delivery. Customers do often require finance of some kind for these big ticket items but that can also be arranged via a third party. In reality you can often collect the cash from customers before you have to pay the suppliers for the goods so like many retailers there is good cash flow (the “Current Ratio” from the last DFS accounts is 0.25 for those accountants among our readers).

Gross margins (i.e. the difference between supplier purchasing prices and selling prices) should be very high in comparison with other retailers, and although DFS don’t give the gross figures their net EBITDA margin is given as 12.2%. With stock that does not age, and few returns,  the business should be a simple and highly profitable one.

But it’s not quite as simple as you think. Many national retail chains have dabbled in the furniture market without much success. Selling furniture is to some extent a seasonal business (boxing day used to be our best for sales), but is also weather based – not many people want to shop for sofas when the sun is out. So lots of promotions are required to get folks into the stores including expensive TV advertising – yes there is always a “sale” on at furniture retailers.

In addition sales are dependent on the economic climate, particularly consumers disposable income and their confidence that they will still have a job to pay off the credit that they will obtain. So when the economy hits a bump like the UK did in 2008/9, then sales can fall off a cliff. That is what happened at ScS which caused them to go into administration as was noted in their own recent IPO. People can postpone buying a sofa for a very long time as they are not “essentials”. Sales are also partly dependent on the number of new house purchases or house moves which tend to crystalise purchases.  And interest rates also affect sales as high credit charges deter purchases. So furniture retailers tend to go through large cycles of boom and bust, and in essence it’s a pretty mature business sector with few innovations – selling furniture over the internet has not yet taken off.

You can see why now is a good time to float a furniture retailing company. Disposable income is rising, there is confidence in the economy, house sales are rising and interest rates are low.

Let’s pick out a few points of interest from the DFS prospectus. Firstly it’s worth noting that DFS have a large market share of upholstered furniture at 26% and hence are the biggest by a long way. But there are lots of other players of course from ScS already mentioned, other chains,  department stores and local specialist retailers. As the prospectus says “The retail upholstered furniture industry in the UK….is highly competitive….”.

Is DFS differentiated in any way from its competitors? One nice thing about retailers for the investor is you can go and walk around their stores and take a view on that and their operations. Do not be surprised though to find few customers in such stores – that was always the case on most days of the week, but I do not think you will notice much differentiation. Vertical integration at DFS from having some sofa manufacturing facilities might be one differentiation however.

DFS have 105 stores in the UK, Ireland and Holland. The latter is a recent venture which may be suspect as few retailers are successful outside their home countries, and particularly furniture and carpet retailers. In total they have 110 properties but these are mainly leased. What properties they formerly owned were hived off via a sale and leaseback arrangement to  a company now called Delphi Properties Ltd and there is a particular warning in the prospectus on the lease terms (see page 27) with that company which is worth reading. Should retailers own their properties? Probably not but it does make then sensitive to a temporary downturn in business, and effectively such leases are off balance sheet liabilities.

Some 65% of DFS customers use credit to finance their purchases which is arranged through third parties. Indeed the company offers “interest free” credit terms. There is a warning in the prospectus (page 19) about the possible impact of changes to LIBOR on this.

How much profit does DFS Furniture make flogging sofas? Surprisingly nothing at all in recent years. There was a loss of £5 million in the last full financial year and £17m in the previous year. The reason for this is simple – they paid £57m in “finance expenses” (i.e. interest on debt) from their gross profits of £112m last year.

DFS was geared up with debt by their private equity owner Advent, who as part of the IPO are selling some of their shares and the other part of the money raised is being used to repay some of the debt. The current debt of £307m will be reduced by £78m but that will still leave a heavily indebted company.

In addition Advent will still hold a very major interest in the company after the IPO (the free float will be in the range 38% to 57% depending on various factors) – similar to the level of interest Lord Kirkham had when DFS was last privatised so this should tell you there are some risks here. Will it be taken private again if the market for sofas declines?

The company expects to pay a dividend of 40% to 50% of post tax profits but given the current financial structure of the group profits might not be high even after repayment of some of the debt. I have not attempted to work it out because the key question when looking at IPOs is whether it is a quality business with future profit growth prospects. With the current and near term future financial and ownership structure there are some doubts in that respect. DFS has certainly historically been a quality business which has survived the ups and downs of their particular retail market sector and kept their market leadership position, but it is unclear whether it is likely to be a sound investment for minority retail investors.

But as with all IPOs, a feeding frenzy might take place to acquire a stake in this high profile and reputable company, so you ultimately need to make your own decision as to whether to invest in the IPO and I suggest you try and work out the likely future profits and dividends.

Roger Lawson

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