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











Unlock the rest of this Article in 15 seconds

or Unlock with your email