Company Spotlight: 'This could hold rich pickings for investors in the long-term'

Undiscovered gems in the stock market have the potential to deliver double-whammy gains to investors who spot talent before the crowds. Such companies are the stock market equivalent of Ben Curtis, the 500-to-one golf champion who emerged from obscurity to clinch the Open last week.

SCS Upholstery, with an £86m stock market value, appears to be such a budding star. If it maintains present form, its shares are likely to benefit from the double boost of rising earnings as well as a upward revaluation in its shares. That could be richly rewarding for investors over the long term.

As its name implies, SCS is a retailer of sofas. From its base in Sunderland, Tyne and Wear, the group has grown rapidly by opening stores and winning market share in a highly fragmented industry. Most of its rivals are small, family-run businesses that are slowly being squeezed out by better-funded chains with economies of scale.

Although SCS faces competition from major rivals such as DFS Furniture, IKEA, MFI and Marks & Spencer, there is considerable room for growth. The group still claims only a 4 per cent share of the upholstery market from a network of 53 stores with an average selling space of about 13,000sq ft. The goal is to increase the chain to 70 stores by the end of next year, which should position it as a truly nationwide retailer.

Importantly, the group does not manufacture the sofas. It sources them from a range of sub-contractors around the country. But what catches the eye most is the quality of the group's earnings. These have grown at an annual 25 per cent over the past five years, and pre-tax profits have almost tripled from £3.3m in 1998 to £9.75m for the year ended September, 2002. The group records a sale only after the sofa is delivered to the customer's home. Half the money is paid up-front by the buyer or a loan provider and the balance on delivery.

Reported profits are backed by good cash generation, giving it the means to expand through internally generated funds, rather than loans or new equity. Not surprisingly, return on equity is an astonishing 49 per cent. This suggests SCS has established a virtuous circle of growth, the hallmark of a robust business. In the first half to March 31, its cash pile swelled to £8.1m, compared with £4.5m last September. The half-year outcome was after a higher tax bill and a 33 per cent increase in the interim dividend, partly offset by lower capital spending. One reason for the strong cashflow is that SCS gets paid by customers well ahead of paying its sofa-makers. And it orders merchandise from suppliers only after it has signed up a firm order, reducing risk of unsold stock.

Given its tried and tested business model, SCS faces a bright future. Vendors of big-ticket consumer items such as furniture need a reasonably vibrant economy and a stable job environment to flourish. But demand for sofas is not so much linked to a booming property market as consumer confidence. The average customer order is about £1,400, and a typical buyer is aged 37 and unlikely to be a first-time property owner. So low unemployment and interest rates have been good for business.

The group also remains unfazed by competition from big multiple stores, because this can stimulate overall customer demand. Many SCS stores are in retail parks close to rivals such as DFS.

Analysts forecast profits to rise by about 15 per cent this year to £11.5m and earnings per share of about 24.5p. Even if the summer temporarily curbs demand, the group looks capable of solid long-term growth, though prospects partly depend on economic conditions.

Even so, at 268p the shares look a bargain. They are valued at under 11 times expected earnings for this year, falling to under 10 for next year. Income-hungry investors will also be satisfied with an above-average yield of 4.5 per cent for the current year, rising to over 5 per cent for the next.

Such modest valuations for high and reliable growth won't go unnoticed by the stock market indefinitely if SCS continues to deliver. The shares therefore have considerable scope for revaluation. Book a seat on SCS before it becomes standing room only.

Neil Thapar is equity strategist at the stockbroker Durlacher