I bought a 2.5% portfolio position in DFS Furniture at an average share price of 214 pence over the last trading days and will increase the position to 3.5% with a limit price of 220 pence.
DFS Furniture (DFS) is the leading UK retailer of upholstered furniture according to the company’s IPO prospectus (the IPO took place in March 2015 at 255 pence per share; current price 215 pence per share). In this industry, the company has a 26.4% share by value which is larger than the next four competitors combined. The retail upholstered market mostly includes sofas and armchairs and has a volume of roughly GBP 3.5 bn.
The company is vertically integrated meaning that from product design through to manufacturing, sales, installation and service the company is keeping most of the processes in house. With five factories in the UK, the company produces 30% of the products sold in house. The rest is sourced from European and Asian suppliers. The company has long lasting relationships with external suppliers and buys significant volumes leading to strong buying power.
In the current fx environment, the UK own-manufacturing provide DFS with an advantage compared to other retailers that have to source products from abroad. According to the prospectus, 24% of DFS’s purchases in Financial Year 2014 were denominated in USD, mainly because DFS’s China-based manufacturers are paid in USD. DFS generally hedges its USD exposure for a period of between nine and 18 months. It pays its external upholstered furniture suppliers in Europe in GBP. It also pays for some fabrics it acquires for its internal manufacturing in EUR.
As a result, the FX impact for the first 26 weeks of fiscal year 2017 increased the cost base by 200 bps. With exchange rates staying at the current level in the future, the cost base will further increase but less than compared to other retailers I suspect.
DFS’s manufacturing/procurement model allows the company to shorten lead times for new or highly sought-after products, provides management with cost insides for negotiations with suppliers and provides higher visibility to procurement costs. Management believes that DFS is the only major UK retailer that combines a sizeable design and manufacturing capability with an external supply chain.
The company’s costs structure includes a high variable and discretionary spend. About 15% of 2016 sales comprise of fixed costs including admin and rental payments. About 30% include discretionary spending (e.g. marketing) and semi-variable costs like delivery and store costs. About 42% of revenues are variable and include the direct sale of furniture (i.e. sales commissions and manufacturing wages). EBITDA as a percentage of revenue is roughly 13%. The company has been under the 10 largest advertisers in the UK for years and marketing spend makes up roughly 13% of revenue. As a result, and according to the company, DFS has a 75% brand awareness compared to 29% of its next competitor.
The company provides customer finance including interest free financing for a period of up to four years with the option to delay payments for twelve months from the purchase date to all products and invoice values without a minimum deposit required. The majority of customers or roughly 65% take this financing option. Credit risk and interest rate risk is outsourced to finance houses that in return for a fee bear the risk of customer default and a changing interest rate environment over the financing period. Fees are reviewed periodically depending on LIBOR, length of financing terms and customer defaults. Management estimates that a one percentage point increase of LIBOR rates would reduce DFS net revenue by only 0.4% in the future. According to the prospectus, DFS is currently partnering with five consumer credit providers including Hitachi Capital, V12, Barclays Partner Finance, IKANO and LaSer UK. It has long term contracts in place with two of these providers which alone more than cover the total requirement for customer finance.
DFS operates 169 stores as of March 2017. From the UK, the company entered Ireland in 2012, the Netherlands in 2014 and has recently opened a store in the South of Spain targeting the 800,000 British expatriate community in the country. In August, management announced the acquisition of Sofology. Sofology is also a specialist upholstered furniture retailer and has a network of 37 stores in the UK. In 2016, Sofology generated revenues of GBP 143 m comparable to 15% of DFS’s fiscal year 2016 revenue. DFS pays an initial enterprise value of GBP 25 m. An additional consideration can be paid twelve months after completion based on seven times EBITDA for the twelve months period less GBP 25 m. Given that Sofology generated EBITDA of GBP 2.9 m in 2015 and an EBITDA loss of GBP 2.7 m in 2016 an additional payment seems unlikely from today’s perspective. While Sofology will be integrated in the DFS infrastructure targeting GBP 4+ m of synergies annually, the Sofology fascias will continue to exist alongside DFS in multiple locations. The same approach was taken with former acquisitions of Dwell and Sofa Workshop. As a consequence, under the roof of DFS Furniture a number of brands offer products for different types of customers that are looking for differing price ranges.
DFS has already established a strong position in the online channel with their website attracting more than 40% of upholstery web traffic in the UK. Many customers will start their research online before they visit the physical store to test the product in reality. Nevertheless, management also sees web sales as being incremental to existing sales as 70% of internet buyers have not visited a DSF store over the last three months. From my perspective, selling sofas and armchairs is less affected by disruption for two reasons. First, most customers want to touch and sit on the product before they make a purchase decision. Returning the product to the seller after delivery is costly and time consuming. Therefore, a multichannel retail offering provides best value to customers. Second, DFS has always delivered the product to the customer’s home. As a consequence, the existing distribution channel needs less investment than in the case of other retailers whose point of sale was also their major distribution channel.
The following is an excerpt of the 2015 IPO prospectus:
“As a result of its leading market position, brand awareness and significant promotional spend, but relatively modest number of stores, DFS’s stores are a destination for potential customers generating high footfall compared to upholstery peers and sales densities that are amongst the highest in the UK general retail sector. Large volumes and a high sales density, together with DFS’s flexible product sourcing strategy leveraging both internal and external supply sources, enable it to achieve high profit margins and strong cash flows. The Group then reinvests a significant proportion of these proceeds in its customer proposition, product, finance and service offers and also its marketing activities, thus contributing to a high level of customer satisfaction and brand recognition, leading more people to the Group’s retail channels and generating customer loyalty, potential repeat purchases and recommendations to friends and family. The Directors believe this process results in a robust business model that has enabled DFS to increase its market share consistently.”
As you can see from the following table, DFS accomplished an impressive increase in market share from 9% in 1994 to more than 26% today. The largest increase in market share over the shortest period took place from 2008 to 2009. The company was also able to generate positive free cash flow during this recession period. Consequently, I expect the business to do well during the next recession and to gather more secular strength before the next upswing in consumer confidence.
The management team comprises former executives of Alliance Boots. The whole executive team is in their late fifties and was implemented under the former owner, private equity investor Advent, between 2010 and 2013. Advent sold its remaining shares in February 2017.
DFS has an equity value of GBP 450 m, net debt of roughly GBP 140 m and annual lease obligations of GBP 50 m to GBP 60 m. While debt and future obligations are at the higher end of my target range, I believe that DFS can handle a higher level of financial leverage than the average retailer due to the quality of the business.
For 2017, management announced a 13% y-o-y EBITDA decline to GBP 82 m. The company is a strong free cash flow producer. Free cash flow including growth capex ranged between GBP 60 m to GBP 70 m over the last years. This will be down in 2017 due to large investment spending. Also, during a downturn working capital will increase leading to lower cash flow. Nevertheless, I believe that DFS is currently trading at a normalized double digit free cash flow yield. While DFS is not the only conventional retailer that might fulfill this criteria, I have not found one that is able to profit more from current headwinds and turning them into long term growth prospects .
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