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Financial Analysis of Carpetright plc and Topps Tiles plc

Summary
This analysis of Carpetright plc and Topps Tiles plc has been undertaken in order to choose which one to invest in for the medium or long term, taking on a medium amount of risk. Ratio and financial statements analysis demonstrate that the major problem of Topps Tiles is the great amount of debt and negative equity. It makes investing in it more risky and not very promising. Carpetright shows overall stronger financial performance and more enthusiasm in the management team. The financial analysis correlates with the projections made by a number of brokers recommending to sell the shares of Topps Tiles and withhold from buying.

Introduction
Carpetright plc and Topps Tiles plc are two competing companies that specialise in retail sales of different types of flooring. They are listed on London Stock Exchange (LSE) and constitute FTSE 250 share index. While Carpetright plc specialises in carpets and Topps Tiles in floor and wall tiles, there are similar products sold by both companies. Laminate flooring is an example. It makes them compete for new customers through price wars and the quality of the products offered.

The retail sector in which the companies operate is greatly affected by macroeconomic factors, such as consumer spending level, the rate of employment, inflation, house price trends, interest rates and others. The economic recession that hit the UK in the second half of 2008 caused the retail industry to experience certain difficulties (McConnell, 2009; Kollewe, 2009). The credit crunch and growing unemployment reduced consumer spending levels and left future revenues of the companies uncertain. In such conditions, a potential investor should look at the cost cutting strategy of the company, burden of debt, efficiency of use of assets and profit margins that would show what portion of the total sales the company can retain and distribute to shareholders.

The geography of operations of both companies stretches from the UK to European countries. Carpetright plc (2009) currently operates in the UK, Republic of Ireland, Netherlands and Belgium. The main business of Topps Tiles plc (2009) is in the UK and Holland. Consequently both companies are exposed to the risk of foreign exchange transactions. Further analysis will consider strengths and weaknesses of each company and help make the right investment decision.

Management and Accounting Policies
The risk of investing in a company can be reduced if the management team has much experience in the field where the company operates. For this reason, it is vital to explore the information on the directors of the company.

The Chairman and Chief Executive of Carpetright plc (2009) is Lord Harris of Peckham. He has had almost fifty years of experience in the carpet retailing business, earning him a reputation as one of the best businessmen in the sector. Previously he was associated with companies such as Harris Queensway plc, Great Universal Stores plc and others. Christian Sollesse is the Managing Director UK and Republic of Ireland. He has had many years of experience in sales management working in Harris Queensway plc. Martin Harris is the Group Commercial Director. He has been working for Carpetright plc (2009) for about seventeen years and is responsible for logistics and supply chain. Neil Page is a new director of the company who joined Carpetright plc in 2008. He is the Group Finance Director. Unlike the previously mentioned key managers, he does not have much experience in the carpet and flooring business but he has worked for other retail companies such as Marks and Spencer. Non-executive directors of Carpetright plc (2009) are represented by Baroness Noakes, Simon Metcalf, Guy Weston and Geoff Brady.

The overall experience of directors in Topps Tiles plc (2009) is not as extensive as the management team of Carpetright plc. Matthew Williams is the young CEO of Topps Tiles (33 years old). He has been working for the company for about ten years, holding different positions. It has been his first major experience since graduation. Rob Parker is another young manager of the company, holding the position of Finance Director. He has been working for Topps Tiles (2009) for only two years. However, he has about ten years of experience in other retail sectors. Nicholas Ounstead is the Business Development Director. He has worked for the company for almost twelve years and was previously Marketing Director of a large ceramics supplying company. Barry Bester is one of the founders of Topps Tiles plc (2009) and currently holds the position of Non-executive Chairman, being responsible for the strategic decisions of the Group. Other non-executive directors are represented by Victor Watson and Rt. Hon Michael Jack.

The financial statements of both companies were prepared in compliance with International Financial Reporting Standards (IFRS). It would make financial performance analysis more objective because the companies apply similar rules to depreciation of fixed assets, amortisation of intangible assets and consolidation of entities. Financial derivatives are used by both companies solely for the purpose of managing risk in foreign exchange transactions. All derivatives are stated at their fair value which means the current market value. Based on the fact that accounting policies and practices used by the companies are similar, the investor should switch to their actual financial performance in order to assess the investment potential.

Financial Performance Analysis
There are two major ways to make a financial performance analysis: ratio method and financial statements analysis. Ratio method will be applied to calculate the key indicators of the companies’ profitability, solvency, liquidity, investment potential and efficiency of the use of assets (Appendix A and B). Financial statements will be reviewed using horizontal (Pinson, 2001, p.111; Agtarap-San Juan, 2007, p.332) and vertical (Lane, 2001, pp.32-33) analysis of the profit and loss account and balance sheet. Horizontal analysis will use 2007 as the base year and the accounts in 2008 will be estimated as a percentage of the base year results. It is expected to reveal the trends where the companies are headed. This analysis will show whether the business is shrinking or expanding (Appendix C and D). Vertical analysis will be used to analyse the structure of the companies’ profits, assets and liabilities. This type of analysis is often interconnected with ratios calculated (Appendix E and F).

Since the investor is interested in medium to long-term time horizon of the investment, the following areas should be paid attention. Profitability of a company is one of the main preconditions of high returns that can be obtained by an investor (Stoltz and Viljoen, 2007, p.40). High profit margins would allow the company to grow faster and increase the value of the business. Gross profit margins (Milling, 2003, pp.51-53) of Carpetright plc and Topps Tiles plc are nearly identical. Their costs of sales constitute, on average, 40% of the revenue. However, deviations are observed in operation and net profit margins. Net profit margin is the proportion of revenue left for distribution to shareholders and reinvesting after paying all taxes and expenses (Van Horne and Wachowicz, 2005, p.147). Economic slowdown caused both companies to suffer from decreasing net profits. Nonetheless, Carpetright managed its cost better than Topps Tiles and the result was the higher net profit margin. Topps Tiles, however, provided a better return on total assets and investments.

The efficiency ratios demonstrate whether Carpetright and Topps Tales can maximise the revenue from using fixed and current assets. Good efficiency would lead to higher profitability in the future, increasing the return on the investment. Turnover of fixed assets is much higher in Topps Tales. It means that the company manages to generate more revenue from few facilities. It is a good indicator because the company can spend less on acquiring property and other long-term assets while making more sales from the existing stores. If the ratio is maintained, additional facilities are expected to help generate revenue faster than, for example, in Carpetright. Inventory is an important part of the current assets. Too much stock may indicate that the products are poorly sold and lack demand (Cohen, 2005, p.94; Pratt and Niculita, 2007, pp.157-158). Inventory turnover calculated by dividing the cost of sales by the inventory value demonstrates whether there is a problem with overstocking (Bernstein and Wild, 1999, p.135). Carpetrigth has about twice as high inventory turnover, demonstrating that the products are sold faster than in Topps Tiles. Total asset turnover has a tendency to decrease in Carpetright while in Topps Tiles it is increasing, showing that there is a potential that revenue will be generated faster in the future.

Investing for the longer term in Topps Tiles may be very risky because the company has negative equity as a result of the overall debts exceeding total assets. It is reflected also in debt to equity ratio (Bragg, 2006, pp.114-115). In order to make the equity positive, the company will have to serve and repay a great amount of borrowings. During the period of decreased consumer confidence it will be problematic. Gearing of Carpetright is represented by the debt ratio (Harrison and Horngren, 2008, pp.169-170) of almost 0.8, which is becoming quite high. It can be argued that low debt ratios would also be a negative sign, because it would suggest that the company did not use all of its potential for growth through debt financing.

Carpetright has a more attractive dividend policy for risk-averse investors. Even as the profits went down, the company continued to offer increased dividends to shareholders. It is valid to argue that this policy reduces the ability of the company to reinvest the money to generate more revenue. However, it gives more confidence to investors who see that the company is concerned with their interests.

The share price of Topps Tiles plc plummeted more heavily than the shares of Carpetright. It was reflected in lower price to earnings ratio (p/e) (Gildersleeve, 1999, p.35; Lavin, 1992). Since the equity is negative, shareholders cannot expect returns until the company pays of some of its debts. Liquidity of Topps Tiles is estimated mainly by the current ratio (Dyson, 1997, p.181; Costales and Szurovy, 1994, p.53) which is obtained by dividing current assets by short-term liabilities, and quick ratio (Seidman, 2004, p.76; Livingstone and Grossman, 2001, p.18), which uses the most liquid current assets as a proportion of current liabilities. It is demonstrated that Topps Tiles can meet its short-term obligations and has a positive working capital. However, overcoming the problem of negative equity would take at least three and a half years for Topps Tiles if the amount of debt exceeding total assets is paid off with annual net profits. The assumption is that the profits will not decrease in the future, which is also very unlikely due to low consumer spending.

Vertical analysis of the income statement repeats the profit margin ratios that have been calculated. Balance sheet analysis shows that Carpetright has a higher proportion of fixed assets, indicating that the strategy of the company is aimed primarily at expansion to new geographical areas. Topps Tiles, on the other hand, holds more current assets, and inventory is the most significant part of them (Appendix E).

Horizontal analysis has shown that long-term liabilities of Topps Tiles tend to reduce but the decrease in total assets increases the amount of negative equity over time. Carpetright has an increasing equity as the assets value grow faster than the accumulated liabilities. Revenue of Topps Tiles has not significantly changed and the net profit reduced by nearly 40%. Carpetright, on the other hand showed a 10% rise of sales and only 8% decline in net profit (Appendix C and D).

Post Financial Statements Period, Future Prospects and Plans
During the economic slowdown in the UK, the companies make plans to improve the shape of the business for the time when consumer confidence is back. In order to do it, the strategies for cost cuts and cash management have been adopted by the businesses.

In the post balance sheet period, Carpetright plc made a new acquisition of a competing retail company located in Netherlands for the initial amount of €4 million and €3.8 million paid in October (Carpetright Annual Report, 2008). Topps Tiles plc did not undertake any significant deals in the post financial statement period except small benefits from interest rate falls noted by the management team (Topps Tiles Annual Report, 2008).

Topps Tiles plc plans to focus on improvements of the current facilities and cost reduction strategies instead of attempting a rapid expansion through opening new stores in different locations. It is explained by the company’s management that these measures would be more reasonable in the times of the current financial crisis. “For the coming year we will focus the majority of our attention on improvements to our existing estate. In the current economic climate we believe that a more cautious approach to expansion is appropriate” (Topps Tiles Annual Report, 2008, p.6).

The prospects of the Topps Tiles plc are not promising for the period of 2009 and 2010. According to Hemscott (2009), the majority of brokers forecast more than 50 per cent decrease in the company’s earnings per share (Siciliano, 2003, p.63) in 2009 and the predominant advice is to sell the shares. However, there is one broker, Singer Capital Markets ltd, that advises to buy. The prospects for 2010 are not promising either. Again, the majority of the brokers listed on Hemscott (2009) propose a sell strategy for the investors in Topps Tiles plc.

The top management of Carpetright plc plans to “focus on margin growth and strong cash generation” (Carpetright Annual Report, 2008, p.3). The measures to achieve growth in the difficult period comprise the widening of the product range, reducing prices to attract more customers and improving the customer service. Unlike Topps Tiles plc, the management team of Carpetright is more aggressively aimed at expansion to national and foreign geographic locations even at the current time of economic slowdown (Carpetrigth Annual Report, 2008). Thus, a clear difference in attitude of managers is observed. Topps Tiles plans to play safe and avoid additional capital investments in new facilities while the situation in the market is not favourable. Carpetright directors, on the other hand, continue to be more optimistic and are ready to catch every opportunity even in difficult times. For this reason, it can be expected that Carpetright will be in a much better position when consumer confidence returns, and investors in the company would reap their reward for taking on the risk.

Conclusion
The overall performance of Carpetright plc demonstrates that the company is a more attractive proposition for investing in the medium and long term. First of all, the management team is more experienced in the retail business, and has a winning attitude demonstrated in the plans to expand in spite of the current recession, while Topps Tiles’ managers count on the coming of good economic times to make the business grow. Secondly, Carpetright plc products seem to be sold faster and in larger quantities, shown by the increase of revenue and higher inventory turnover. The profits of the company reduced to a lesser degree than the net profit of Topps Tiles. Thirdly, Carpetright maintains the policy of increasing dividends paid to shareholders, which is favourable for investors with medium risk strategy investing for the medium or long term. It can be argued that Topps Tiles’ higher efficiency of the use of assets places it ahead of competition because it can generate more revenue from fewer facilities. Taking into account the amount of debt exceeding total assets of the company it is not expected that large capital investments will be made in the future to realise the advantage. The company will wait until consumer confidence returns and the burden of borrowing will constrain its expansion policy.

Appendices – Please note appendices have been deleted.

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