Carpetright is a mystery. Pofitability since the credit crunch has gone through the floor, yet it trades on a titanic multiple. The Human Screen is beginning to understand why.

Highlights

• Adjusted operating profit down 25%
• Return on tangible assets: 3%
• Adjusted net profit of ''3m compared to net cash flow of ''21 (''31m after net capital expenditure)
• Net debt including approximate capitalised lease obligations of ''726m down 7% at ''746m, 79% of tangible assets (the company also has a pension deficit of ''4m)
• Per-share dividend cut to zero
• Shares in issue up fractionally.

The Human Screen comments:

The Human Screen has been looking forward to Carpetright’s annual report. The company sells beds and floor coverings, a market his portfolio, the Thrifty 30, is interested in through its holding in carpet manufacturer Victoria, and Carpetright is something of a mystery to value investors. Like its peers it’s struggling because of our reluctance to spend, and the massive fall in new houses built, yet it trades on a multiple of earnings that would look more at home pinned to the listing of a company with massive growth potential.

Twenty twelve was a poor year for Carpetright but it reduced costs by closing many more stores than it opened, and raised cash selling off freehold stores and leasing them back. Cash flow from the property sales, renegotiating leases, operating efficiently, and cutting the dividend to zero, allowed it to reduce debt considerably.

So why the investor enthusiasm? The Human Screen can only guess. One possiblity is investors see it as a high return business. According to Stockopedia its conventional profitability ratios have in the past been impressive. Factor the off-balance sheet leases it uses to finance its shops into the equation though, and the profitability ratios look more mundane, especially this year.

An earnings yield of 3% is very low, corresponding to a high PE, and though cyclical stocks can look overvalued at precisely the time investors should buy them because profits are low but investors are already anticipating recovery, the Human Screen is surprised Carpetright hasn’t been punished more in the recession.

Perhaps the European stores, where its profiting at the expense of weaker rivals, show some of its potential to turn around in the UK. They produced 65% of the company’s profit from just 19% of turnover and 27% of trading space.

Investors may be gambling on Carpetright’s strong position, it has about a quarter of the UK market. Unlike some of its rivals, cash flows may see it through the recession, allowing it to merge even more dominant. Earlier in the year United Carpets, a northern retail chain, announced a number of its franchisees are in trouble.

Net cash flow from operations in 2012 was seven times net profit, and over the last six years, four of them pretty miserable, cash flow has held up even after deducting capital expenditure. Averaging six years of free cash flow figures gives a free cash flow yield of 7%, which ought to give investors confidence.

But there are limits to how much cash Carpetright can squeeze from the business and its property portfolio, and the fact that the dividend has been cut completely suggests it might be reaching them. Meanwhile economic recovery, and particularly recovery in the housing market, doesn’t seem any nearer than it was last year.

While recognising investors may be justified in favouring Carpetright, the Human Screen doesn’t share their confidence.

More on Carpetright

Worksheet

HS+ (worth watching for improvement in fundamentals/price)