Example of Profit Growth in a UK Retailer

Title: Corporate Finance – Topps Tiles 1. Topps Tiles is one of the leading UK retailer and distributor of ceramic tiles, wooden flooring and related products. It is a FTSE 250 index company. Topps Tiles is a highly cash generative company with rapidly increasing earnings per share. Over the last five years, its earnings per share have increased from 2.6 p to 11.3 p – annualised growth of 44% (See exhibit 1 for earning per share and dividend history). Its cash inflows have also increased substantially. In the year ended 2 Oct 2004, Topps Tiles had cash inflows of A£13.3m before financing, a significant growth in cash inflows over the corresponding figure of A£10.3m for 69 weeks ended 27 Sep 2003. The cash balance at 2 Oct 2004 was A£29.6m as compared to A£18.6m on 27 Sep 2003, a 50% increase in one year. The company has long term interest bearing debt of A£6.5m only, which means it has negative net debt of A£23.1m. The cash balances are so high that the interest received at A£0.93m is more than twice of interest paid at A£0.4m. While the company’s profits and cash are rising, it is finding tough to employ them at new projects. The increase in cash balance is even after A£8m on capital expenditure. Faced with a rising profits and lesser options to employ cash, the management of Topps Tiles has decided to distribute increasing amounts of cash to shareholders in terms of higher dividends. Exhibit 1 shows the growth in profit after tax, which is in line with growth in earning per share. This shows that earning per share and dividend per share growth is not because of reduction in number of shares. Exhibit 1 also shows dividend cover over the five year period. The dividend cover has decreased from 3.05 in 2000 to 1.41 in 2004. This shows not only that the management wants to return excess cash to investors in terms of higher dividends but also that it is confident of generating enough profits and cash in future to meet high dividends. The company mentioned in its 2004 Annual Report that the Board is committed to maintaining progressive dividend policy (Topps Tiles, pg. 3). One of the ways of measuring success of dividend policy would be to analyse abnormal share price movement in two days following dividend announcement. Increase in share price in line with increase in dividend is probably the indicator that the dividend policy is successful. Also higher current dividend may signal greater expected earnings (Dickens, Casey & Newman, 2003). Topps Tiles announced its last dividend on 30 Nov 2004. Exhibit 2 shows the percent change in Topps Tiles’share price, General Retailer Index and FTSE All Share Index over the two day period surrounding 30 Nov 2004. It is better to compare Topps performance with the General Retailer sector than overall market. The two day change in Topps Tiles’ share price was 16.3% as compared to 0.5% change in General Retailer index and -0.2% change in FTSE ALL Share Index. Hence the abnormal movement in Topps Tiles’ share price with respect to General Retailer Index was 15.8% in the period surrounding dividend announcement. This significantly high upward movement proves that Topps Tiles’ dividend policy is successful and investors have now more faith in management’s ability to maintain and increase high dividends. 2. One of the ways of measuring success of dividend policy would be to analyse the change in share price with respect to change in industry sector index. Managers should compare the percent change in Topps Tiles share price with index over the medium term. In established and mature companies, increase in dividend increases share price. If the percent change in Topps Tiles share price is statistically higher than the percent change in sector index price, then the management has done well to convey the message to shareholders and market in general through dividend policy. Also managers should compare Topps Tiles’ abnormal share price movement near dividend announcement date with abnormal share price movements near dividend announcement dates of some of its peer group companies. If abnormal percentage increase in price in two days following the dividend announcement is more than the corresponding movement in peer companies’ share price, then Topps Tiles dividend policy is successful. Managers could also look at change in profile of shareholders over time to analyse the impact of dividend policy. There are many institutional funds that invest in dividend yielding stocks only. If the ownership has changed in favour of income and dividend favouring financial institutions, then increase in dividend policy is successful. Another indicator of successful policy would be adoption of similar dividend policy by per group. Companies are many times forced to adopt better dividend policies of their peer companies because of market expectations. If after Topps Tiles adoption of higher dividend payout policy, other companies have also adopted similar dividend policy over time then Topps Tiles dividend policy is successful. 3. According to Dividend Growth Model, a firm’s share price is the present value of its future dividends. The mathematical representation of the above statement is Share price = D1 / (r-g) - (I) Where, D1 = expected dividend next period r = return on equity g = dividend growth rate (in perpetuity) D1 = Dividend in current period (D) * (1+g) In case of Topps Tiles, the company announced a dividend of 8.0 pence (D) for the year ended 27 Sep 2004. The one year growth rate of dividend was 130%. The expected return on equity, r = 10% Using equation I and assuming that current one-year growth in dividend is maintained till perpetuity, we get Expected share price = 8*(1+130%) / (10% - 130%) Since the growth in dividend is more than the return on equity, the denominator is a negative number and the above equation is not valid in this case. As the growth of earnings is more than the increase in discounting factor, the Dividend Growth Model would give an infinite share price. The annualised dividend growth over the five year period is 74.5%. Since this is also more than the expected rate of equity, the Dividend Growth Model would again fail to give a proper share price. The share price on 7th April 2005 is 184.5 p (Source: https://uk.finance.yahoo.com/q?s=TPT.L). Since this a finite number, if we use Dividend Growth Model then the market is assuming that over longer run Topps Tiles would not be able to sustain such high dividend growth rates and its growth rate would be lower than the expected return on equity. If we now reverse calculate the expected dividend growth rate for a share price of 184.5 p, we get 184.5 = 8*(1+g1)/(0.1- g1) g1 = market expected dividend growth rate = 5.4% Market expects Topps Tiles to grow slightly above average economy growth rate over perpetuity and this is logical as no company can ever grow more than average economy growth rate. Moreover in the longer term of 10-15 years, Topps Tiles growth is linked to growth in housing market. Housing market growth over longer term will match growth in economy and population. 4. UK has enjoyed one of the best economic conditions among OECD countries in the recent times. Its economy is strong with increase in companies’ earnings. Employment is at high levels and salaries have also started to increase. Inflation rate is also around 2 % only. Topps Tiles’ market is very much related to the housing market in UK. UK has also enjoyed lower interest rates in 2002 and 2003, allowing more people to take higher mortgages. Lower mortgage costs have created more demand for houses. House prices have witnessed double digit growth rate each year in the last few years and thus created a further demand to refurbish houses. Topps Tiles products  ceramic tiles and wooden floorings  are widely used in house construction and refurbishment. Many house owners have used cash release, due to remortgaging, for house refurbishment. So it can be safely assumed that stable and strong economy with rising house prices have helped Topps Tiles perform excellently. Its cash inflows have increased significantly over the years. The company is confident of maintaining strong demand for its products and its ability to generate high profits. Topps Tiles have decided to reward its shareholders with increasing dividends. In absence of suitable number of investments and ever increasing cash inflows, it has not only increased dividends in line with increase in growth but also at a rate higher than growth in earnings. 5. A listed firm’s ownership can be broadly categorised into the following categories:

1. High inside ownership. High inside ownership of directors and management should reduce agency problem (Jensen & Meckling, 1976). Management uses dividends to reduce agency costs. So when insiders have large stakes, there is very less or no agency costs and hence less need for dividends. Also inside owners can take compensation in other ways which will not result in similar compensation to other shareholders. Dickens, Casey and Newman (2003) found out that inside ownership has negative relationship to dividend yield.
2. Low inside ownership but concentrated outside ownership. Managers in this case may be pressured to act in line with large shareholders so as to safeguard their own jobs. Stagecoach plc is a listed company. Though it is managed by a management with not substantial shareholding, its Chairman has a large stake in the company. Last year the company paid a large special dividend. This allowed Chairman to earn a significant income without having to reduce his stake holding through share selling.
3. Low inside ownership with diverse outside ownership. In the above two scenarios, management is more in contact with major owners and there are less agency costs. Due to diverse ownership in this case, it is very difficult for managers to communicate properly with majority of shareholders. So they use dividends as a device to signal’s firm value. Intrinsic model hold that a share price is the present value of its future dividends and so increase or decrease in dividend should result in increase or decrease in market value respectively. So in this case, the managers have more incentives to increase dividends.

6. Investors look at signals to reduce information gap between management and themselves. They look for indicators about business performance and management uses dividend declaration to reduce information gap between them and investors. One of the best ways to remove agency problem is through the dividend policy. Stated dividend policy and dividend declarations help management to communicate its assessment of future business potential. Dividend payments allow investors to judge the thoughts of the management. The investors know that a firm which reports good earnings and pays a regular dividend is confirming in action what it has reported in accounting profits. Due to recent corporate scandals, investors value the information content of dividends more than the reported earnings. Also a consistent dividend policy is better than looking at one dividend alone. Managers can manipulate earnings and pay high dividend in short term. But if the company is facing serious troubles, they can’t continue doing so as the firm will face serious cash flow problems. A company which has regularly increased dividends commands more investor faith. Also by increasing dividends, managements send the signal that they feel comfortable about future earnings. If a management is not sure about potential earnings, it would not increase dividend because it may not be able to meet its dividend commitment going forward. Exhibit 1: Topps Tiles’ profit after tax, earning per share and dividend growth over the last five years.

	53 weeks ended 3 June 2000	52 weeks ended 2 June 2001	52 weeks ended 1 June 2002	Profroma 52 weeks ended 27 Sep 2003	53 weeks ended 2 Oct 2004	Five Year - Compounded Annual growth
Psot tax profit, A£m	5.53	6.55	8.04	13.12	25.65
Change, %		18.4%	22.7%	63.2%	95.5%	46.8%
Basic earning per share, p	2.62	2.96	3.58	5.82	11.30
Change, %		13.0%	20.9%	62.6%	94.2%	44.1%
Dividend per share, p	0.86	1.00	1.43	3.48	8.00
Change, %		16.3%	43.0%	143.4%	129.9%	74.6%
Dividend cover	3.05	2.96	2.50	1.67	1.41

Source: Topps Tiles’ Annual Reports for 2004, 2002 & 2001 (https://www.toppstiles.co.uk/3/frame-0financial.html) Exhibit 2: Topps Tiles’ share price, General Retailer Index and FTSE All Share Index

Date	Topps Tiles share price, p	Two day % change	General Retailer index	Two day % change	FTSE All Share Index	Two day % change
29-Nov-04	209.82		2121.0		2365.33
30-Nov-04	214.11		2108.6		2345.21
01-Dec-04	244.10	16.3%	2131.8	0.5%	2359.47	-0.2%

Source: www.uk.finance.yahoo.com Bibliography and references Dickens, R.N., Casey, K.M. and Newman, J.A.; ‘Bank dividend policy: Explanatory factors’, Quarterly Journal of Business and Economics, Lincoln: Winter 2003, Vol. 41, Iss 1/2 Jensen, M.C., and Meckling, W.H., ‘Theory of the firm: managerial behaviour, agency costs and ownership structure’, Journal of Financial Economics, October 1976. Topps Tiles, 2004 Annual Report (https://www.toppstiles.co.uk/3/frame-0financial.html)

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