Too successful for the index

By JENNY RUTH

Carpet manufacturer Cavalier is not in the Top 40 index and will just miss out on being included in the Stock Exchange's new Top 50 index.

But managing director Alan James bristles when one calls his company "small".

He has a point. With a market capitalisation of $245.6 million at Thursday morning's $3.90 share price, Cavalier is the 29th largest listed company in New Zealand.

The reason it misses out on being included in the indices is that its shares lack liquidity. That's because rather than trading the shares, its shareholders tend to buy them and then sit on them. For years. The heaviest daily volume over the last three months has been a mere 50,000 shares and most days volume is a fraction of that.

"We're too successful for the index," James says. After a quick comparison of the Cavalier share price with the Top 40 index you'd have to agree. While the index is almost a flat line, Cavalier shares have surged more than 500 per cent over the past five years (adjusted for the recent two-for-one share split).

It isn't only the indices that pass Cavalier by: institutions mostly don't own it. Only 2.1 per cent of its shares are in institutional hands. Institutions tend to be "index huggers", buying shares for their portfolios in proportion to their index weightings. Their negative returns in recent quarters might make them think again.

Cavalier's latest results, reported last week, were stunning by any measure.

It easily beat its own forecasts and analysts' expectations with a 60 per cent surge in first-half net profit to $9.2 million. (The company's own forecast was $9 million.) That's an annualised 32.3 per cent return on average shareholders' funds and compares with the 21.5 per cent return in the previous first half.

The company did get a strong boost from the buoyant housing sectors in its key markets, Australia and New Zealand, but Cavalier has proved it can perform even when its markets aren't strong.

It has been able to wring full advantage out of the present upswing. Its strategy over the last few years has been to diversify away from its premium Bremworth brand to reach wider segments in the market. When times were lean, that meant more production over which to spread its overheads, even though the profit margins on the budget brands - Knightsbridge in New Zealand and Kimberley in Australia - are considerably lower than they are on Bremworth.

In the present upturn, Cavalier ran into capacity constraints. That allowed it to switch out of producing so much of the lower margin brands in favour of producing more Bremworth carpet.

That's the reason why the carpet division's earnings before interest and tax (ebit) jumped 41 per cent to $13.8 million, more than double the 19 per cent increase in the division's sales.

Its profit margin jumped from 18.4 per cent of sales in the six months ended December 2001 to 21.8 per cent in the latest six months. An easy comparison of just how rich a margin that is can be seen in the results from recently purchased Sydney-based Ontera Modular carpet tiles. While it made a maiden ebit contribution of $1.1 million, that represented only 7.6 per cent of sales. Cavalier reckons it can increase that margin.

John Cairns, an analyst at Forsyth Barr, says Cavalier's is "a remarkable achievement". While the carpet industry globally is a low-margin commodity-type business, "They've been able to position themselves with their brands to extract a healthy margin", he says.

Still, James is conscious that Cavalier needs to keep the lower-margin business "healthy and alive" and its customers happy for when market conditions aren't so buoyant and that means it needs to increase capacity.

But rather than building new plants, James is aiming to drive the company's existing factories harder.

"I'm fairly reluctant to invest a large amount of money in additional capacity at this stage," he says.

One way of increasing production is to buy yarn from outside the company, but only for the budget brands. Because the yarn the company produces is unique, buying in yarn for the Bremworth brand would risk damaging its credibility, James says.

The other way, which the company is working on through negotiations with staff, is to run its plants for 12 hours seven days a week.

The plants now work eight hours for five days a week.

That would immediately achieve a 20 per cent to 25 per cent increase in capacity. "It's just a question of what premium you need to pay to achieve that," he says.

But the Knightsbridge customers so far are proving exceptionally loyal. When the brand was introduced, the profit margin Cavalier was extracting was a little less than half that of Bremworths. Now the margin has climbed to between two-thirds and three-quarters of Bremworths, James says.

"Knightsbridge products are recognised as extremely good products for what they are." And retailers and their customers are now prepared to wait for Knightsbridge carpet rather than buy an alternative.

About two-thirds of Cavalier's 89 Knightsbridge variants are out of stock, but sales haven't slowed. Instead of supplying from stock, every metre of Knightsbridge carpet Cavalier produces is sold before it comes off the loom.

"I don't know how long we can keep it that way - it's a fantastic success story for a brand that didn't exist five years ago," James says.

Some might worry about the impact the rising New Zealand dollar against the Australian dollar will have on Cavalier's business.

Indeed, at the annual meeting last November the company said its forward currency cover was almost exhausted.

Should the currency rise much further, its then forecast of $16 million for the full-year net result might come under pressure.

But now James isn't expecting any erosion of profit margins. That's partly because the company has been able to get price increases in Australia. As James explains, all the wool for Australian carpets comes from New Zealand so all manufacturers are in the same competitive position.

If anything, it has been Cavalier's competitors that have pushed prices higher faster, he says.

The other side of the coin is that because the New Zealand dollar has also been rising against the US dollar, the costs of Cavalier's raw materials other than wool have been falling.

So confident is James that he has raised the full-year forecast to $17 million, so long as market conditions don't change dramatically.