Good morning! There is a very strong trading update from Topps Tiles (LON:TPT) issued this morning, which explains why the share price has shot up in recent weeks to an apparently inflated valuation - the market cap has reached £248m (at 129p per share) which looks very high considering they still have considerable net debt, and most recent annual sales of £178m, with profit of only around £9-10m for the last two years.
So clearly the market is already pricing-in a big improvement in trading. Today's statement says that LFL sales in the first 13 weeks of the current financial year (ending 28 Sep 2014) are up 9.3%. That's a remarkably good performance. Remember that retailers are operationally geared - i.e. with a high level of fixed costs, their profits are disproportionately affected by changes in turnover. So a rise of 9.3% in sales will typically generate an increase in profit way above 9.3%.
For example, if a retailer makes a gross profit of 55% (which is fairly typical for non-food retailers), and 80% of their costs are fixed, 20% variable, and a starting point of a 5% operating profit margin, then plugging in a 9.3% increase in sales results in an 84% increase in profit! I will insert a table here later to show those calculations (Edit: done - see below). This is the reason why some retailers are now looking expensive on a PER basis - because the market is anticipating an operationally geared trading recovery. That's fine as long as trading continues to recover. If it stalls, then the shares will drop back a long way potentially, so it's a risky investing approach to assume that all is well in the early stages of a recovery.
The table below (with example figures) shows how a 9.3% rise in turnover could trigger an 84% increase in profit! These are perfectly realistic figures also, based on my experience as a retailing FD.
Operational gearing of retailers explained | Year 1 | Year 2 |
Turnover | 100.0 | 109.3 |
Gross profit (at 55%) | 55.0 | 60.1 |
Variable costs (at 10% of t/o) | 10.0 | 10.9 |
Fixed costs (rent, rates, H.O, etc) | 40.0 | 40.0 |
Profit | 5.0 | 9.2 |
+84% |
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