Valuhunteruk

I first looked at Topps Tiles back in early December in this post. After writing a company up and concluding that nothing interesting is happening I usually put it out of my mind but I think Topps has some interesting attributes which should make it one to follow over the next twelve months although maybe not one to invest in at the moment.

Quickly summarizing what I thought about Topps the first time I looked: increasing S&D costs, significant declines in per store sales and profit, and debt. All of these factors are still important but I think Topps has quite a few strengths that make it more than the retail zombie I orginally thought it was.

The main problem that Topps is facing at the moment is that people aren’t buying tiles. Sales have dropped from a peak of just under £210m to £175m in the last fiscal year and, given the considerable fixed costs of the business, a lot of this drop has gone to the bottom line. The question for investors is whether this signals a permanent or temporary change in the demand for tiles?

I would argue that the demand for tiles has not changed fundamentally meaning Topps’  investment in the asset to retail tiles is still valuable. Tiles appear to be fairly unaffected by the move to the internet and there aren’t any technological changes seriously altering the demand for tiles. The purchase of tiles is fairly easy to defer which means demand drops off quickly when disposable income drops. We can draw two conclusions from this: first, an investment in Topps is going to be linked with recovery in the wider economy and two, investors will, and have, shunned Topps as economic recovery is an inherently uncertain matter involving a wait of unknown length. This latter point should be most interesting to us as it is a key attribute of any decent value investment.

However, we have still made no case for why we should invest. Certainly, this linkage with general economic conditions and the uncertain wait can be purchased elsewhere so how is Topps different?

One of the concerns I noted in the previous post was with falling margins however, this concern was both too general and needs refining in the light of latest results.

Dealing with the negatives first, the company continues to invest in stores which increases fixed costs and operating leverage. This is isn’t a great idea as the wait until recovery is unknown and the company’s financial position is weak. My view here is, therefore, unchanged. As we will see later, the company is increasing market share and its competition is fading away however, the company has boxed itself in with its financial position. In other words, it does make sense at an operating level to pursue modest growth in stores but I don’t believe the company should.

Turning to the positives, we have seen a significant improvement in gross margins which are actually near the peak level of 2008. This highlights the company’s strong competitive position which will be discussed later. Equally, the company has continued to increase marketing costs. I was somewhat sceptical of the value of this but this view was incorrect. The competition for customers is clearly fierce and the company’s marketing efforts have led to an increase in market share. The company also appears to have integrated its online offering well with the rest of the business as although the internet is not important for sales, it is often the first stage in the customers’ dealings with Topps. These investments aren’t too expensive and are far better way of exploiting the weakness of competitors.

The most compelling factor in favour of Topps and therefore the one I understated the most is its market share. Currently, Topps has 26% of the market with fragmented independents holding 36% and the “sheds” (i.e. B&Q/Homebase) holding the remaining 38%. It also offers a unique proposition to the consumer in being the only large tile-focused store. The question is whether the tile market is large enough to support a large independent like Topps (we can work out from these figures that it the total market is probably worth about £670m)?

We can work out from the figures that Topps gives on market share that the total market is probably worth about £670m. Since last year, the total value of the market probably fell by just over £50m while Topps’ sales only fell by £7m. The industry appears to be consolidating and so if, or when, the market recovers Topps will take a bigger share than before. In addition, Topps will likely have a far stronger market position which should allow it to push its distributors much harder which appears to be happening already with the growth in gross margins. Topps is clearly investing on the hope that it will be able to see this consolidated future with store numbers only down 20 from the previous peak. The question is: will Topps be around to see this future?

This brings us back full circle to the key factors of the investment case. Topps is an extremely good investment at this price as earnings will grow substantially due to greater margins, greater market share, and greater sales. We have to wait for the economy to recover on the last point but if Topps had a better financial position there would be no question it could achieve this outcome. However, Topps does not have a good financial position. The “going concern” section of the annual report changed again to state that if 2012 continued like it had begun then Topps would need further finance.

My view is that Topps is making investors ask questions and take decisions on factors they should never have been forced to bet on. Is the economy going to hold up in 2012? What is the housing market going to do? These questions are impossible to predict and given the exposure I have to them already I am going to continue to watch Topps through the year. I am reminded that this attention to short-term factors has led to many a missed opportunity but given the magnitude of Topps’ financial problems I have decided this is the only course to take. However, this does not take away the potential that Topps has especially for any investor looking for exposure to economic recovery (although given the companies in the “value zone” already I don’t think this applies to many of my readers).