Should you grab a seat on this furniture retailer’s sofa?

Stock markets, like people, love interesting stories. That’s why a listed technology company that promises to revolutionise social networking, data encryption or even ordering a car ride will consistently make its way into the headlines.

But value investors who believe in the power of compounding interest and its ability to deliver stellar returns over the longer term are drawn to different types of companies, which don’t typically make the headlines. Boring companies.

Nick Scali Limited (ASX: NCK) may well be a boring company, but it has delivered returns of over 180% over the past four years, all the while paying shareholders a regular, growing, dividend. So what makes the company a great business?

Store footprint

For all the talk about traditional bricks and mortar retail being dead, there is undoubtedly a place for it, and certain retailers are more immune to the effects of online stores than others.

As a high-end furniture retailer, Nick Scali is better positioned to fend off online competition than an electronics or general goods seller. That’s because a new dining setting or lounge room ensemble at this price point represents an outlay of several thousand dollars. And it is unlikely that a buyer would be comfortable parting with that kind of cash before performing the most important test for new furniture: is it actually comfortable to sit on?

Nick Scali has over 40 stores, predominantly on the east coast, to help potential customers answer this question. The last full year results showed the benefits of this strategy, with the store network delivering revenue growth of around 10%, while net profit after tax rose an even better 20%. This sort of result implies that efficiencies are being gained as the company matures and that more revenue is dropping down to the profit line.

Cost control

Nick Scali is an enviable business in that it is able to earn margins of between 50% – 60% consistently on sales. However, there are two big headwinds to the company continuing to earn those kinds of excess profits on its products.

The first is an obvious one: the falling Australian dollar. As Nick Scali sources almost all of its products from overseas, its margins will be impacted by a falling dollar. The full effects of this will likely be shown this year, as hedging contracts begin to expire and become renewable on less favourable terms.

The second factor impacting margins will be the expansion of the budget brand Sofas2go business. While the Sofas2go brand allows Nick Scali to expand into another product area, the core competency of the business is in lower volume, higher margin retailing, as opposed to the opposite.

Growth levers

However, with only 46 stores currently, the Nick Scali brand is nowhere near its full potential in the Australian market. The company has shown a disciplined approach to expansion, having moved into Western Australia last year with three stores, and plans to significantly increase the presence there.

In addition, Nick Scali has flagged plans to ‘infill’ in other states, taking advantage of existing distribution networks and efficiencies to service new stores. This is a good option, as expansion in this manner is only likely to require minimal capital expenditure to cater for newer stores, as opposed to the heavy outlays involved in greenfield expansions.

Foolish takeaway

Management faces a challenge in preserving enviable gross margins in the face of several pressures, but with a credible store rollout strategy and few competitors with national scale in the high-end furniture retail market, Nick Scali is well placed to continue growing revenue and profits.

While it will never be the kind of business that doubles in size overnight, but is likely to continue delivering patient shareholders with returns that will beat most businesses on the ASX. At the current price of $4.12, shares are trading on a prospective P/E ratio of 15.9x, which may be an attractive price.

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Motley Fool contributor Ry Padarath has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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