I recommend buying DFS Furniture’s (bberg ticker: DFSLN) 9.75% Sr Secured Notes due 2017 at $97.50 for a 10.3% yield to maturity. DFS Furniture is the leading UK upholstered furniture retailer. While DFS is not actually distressed, it does have a yield greater than 10% and can provide investors with a mid teens total return over the next year. Since coming to market last year, DFS has delevered, with net lease adjusted leverage decreasing from 4.9x to 4.4x and the company is buying back the bonds with excess cash. While UK retail is not terribly attractive right now, DFS is. The company has a flexible cost structure, low capex requirements, made to order model, customer financing offerings, and a dominant market position that allows the company to generate strong free cash flow and positions the company to continue to delever.

DFS has an extremely simple capital structure and an extremely simple and easily understood business model. The only debt at DFS is an undrawn £30 million super senior revolver and £230.7 million of 9.75% Sr Secured Notes due July 15, 2017. As a result of this simple capital structure, there are no debt maturities until 2017. Understanding DFS’s business model is pretty simple too. The company generates approximately 70-80 million in EBITDA, interest expense runs around 24 million per year, maintenance capex is 6-8 million and the company will spend an additional 7-10 million/yr on growth capex (so 13-18 million of total annual capex) over the next 3 years to open 20 new stores. Taxes are about 10 million per year and then working capital is negative as DFS gets paid immediately and then has normal payment terms with suppliers.

As the leading UK upholstered furniture retailer, DFS has approximately 22% market share, which is 3x its nearest competitor. The upholstered furniture business has been relatively stable over the past 10 years as seen in the chart below from DFS’s offering memorandum.

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DFS designs, manufacturers, sells and delivers to its customers an extensive range of upholstered furniture products. DFS operates a national retail network of 74 upholstered furniture stores and five dining stores, totalling approximately 1.2 million square feet. DFS’s sales density is among the highest in UK retail. All of the company’s products are made to order and hence the company has minimal inventory risk. Because DFS is paid immediately and then pays its suppliers on normal payment terms, working capital is negative.

According to the bond’s offering memorandum, “the retail upholstered market is the market for upholstered (in leather or fabric) two and three seater sofas, sofa beds, arm chairs and reclining chairs, footstools, combinations of module sofa units (e.g. corner units) and action furniture (which refers to furniture with moving parts such as recliners and unfolding footrests).” The majority of activity is in the sofas and units subsegment with action furniture making up the 2nd largest category and the balance evenly split between sofa beds and arm chairs. The upholstered furniture market mainly grows with GDP and is primarily dependent on consumer spending, the availability of credit and the level of housing activity.

DFS offers more than 100 exclusive upholstered furniture product ranges. A competitive advantage of the company is its breadth of product offering across all price ranges. The company manufactures or sources each of its products to order from a selection of up to 50 different color and 8 cover options (leather or fabric) and with different types of accents and trims. DFS is the only leading national retailer of upholstered furniture in the UK that combines internal production with an efficient external supply chain. Approximately 20% of its production is manufactured in house at 3 facilities in the UK, 20% is outsourcd to a UK partner, 20% is outsourced to Western Europe and the remainder of the company’s requirements are manufactured by Asian suppliers. This gives DFS a very flexible and efficient supply chain.

One of DFS’s greatest competitive advantages is its ability to offer its customers interest free financing. Approximately 70% of the company’s customers choose this option. DFS offers its customers up to 4 years of interest free credit with no requirement for upfront deposit and the option to defer payments for

up to 12 months from the order date. DFS is the only upholstered furniture retailer that offers this so it gives the company a tremendous advantage over many mom and pop retailers that do not offer this financing option. The company offers its financing packages in conjunction with 3 credit providers, Hitachi Capital, Santander Customer Finance, and La Ser UK. DFS is also in trials with a four credit provider which the company says is going well. DFS does not have a contract with its credit providers so they can walk away at anytime. However, all 3 providers have been with DFS for a long time (none left during the credit crisis) as the business has been profitable for the providers even during the latest credit cycle. The provider with the shortest history, La Ser, started providing credit to DFS in 2005. Hitachi and Santander have longer relationships. Of utmost importance to bondholders is the understanding that DFS maintains absolutely NO CREDIT RISK with these sales. DFS pays the credit providers a fee, which is calculated based on a periodically agreed pricing matrices, generally determined with reference to 12 month LIBOR and the length of the financing term and in return its credit providers bare all the credit risk. DFS believes it is the only national upholstered furniture retailer that provides interest free credit on similar terms on all products and across all price ranges.

As mentioned earlier, DFS has an extremely flexible cost structure. In addition to its flexible supply chain, DFS spends almost £100 million a year on marketing. According to Nielsen, DFS is the 7th largest advertiser in the UK. Should the company need to offset weakness in the business, DFS could always cut its marketing spend. These outsized marketing expenditures help provide a buffer to a weak business environment. In addition, the company’s cost base is quite variable. Wages of DFS’s employees consist primarily of sales commissions, while the wages of its manufacturing staff are based entirely on the number of pieces produced by each worker.

DFS faces competition from many different players. Its main competition in the upholstered furniture segment is ScS and CSL. It also faces competition from furniture specialists such as Habitat (which just went into administration), Harvey’s and Furniture Village. DFS estimates furniture specialists dedicate about half their furniture offerings to upholstered furniture. DFS also faces competition from companies in the UK homeware segment. This segment includes companies such as Argos, Marks & Spencer, Next, and Laura Ashley. These companies typically offer a wide range of home products as well as furniture, of which only approximately 10% of offerings are typically upholstered furniture products. Finally, DFS experiences competition from general retailers (Asda, Tesco and Sainsbury) as well as online and catalog retailers (such as EBAY, Sofa.com, and Sofa Sofa). Despite this extremely competitve environment, DFS has grown its market share from 17.9% in 2006 to an estimated 21.8% in 2010.

DFS’s variable cost structure, financing offerings and dominant market share create a very cash flow generative business. DFS’s immediate receipt of payment and customary supplier payment terms create a negative working capital environment. Maintenance capital expenditures are 6-10 million per year or appproximately 10% of EBITDA. Over the next 3 years, the company plans to grow by opening 20 new stores and spending 20 million on growth capex. As a result of the company’s strong business model, DFS generated positive profits and positive free cash flow during the economic downturn and credit crisis, generating 74 million, 24 million, 20 million, and 74 million of free cash flow in 2007, 2008, 2009, and 2010

Latest quarterly resultsDFS reported better than expected 3rd quarter earnings this morning. Sales of £155.3 million decreased 5.5% (before VAT), while EBITDA grew 12% to 15 million, highlighting the flexible nature of the company’s cost structure. Gross margins increased 160 bps to 11.5% as the company was able to reduce marketing costs due to better pricing terms and not an actual reduction of marketing activity. Funds from operations increased to 12.3 million from 8.3 million a year ago due to lower interest expenses. Free cash flow was 6.8 million compared with 4.8 million last year. Free cash flow was strong due to higher profitability and lower capital expendituers. Year to date, DFS has generated 43 million of cash even after purchasing 5 million of bonds. In addition, cash balances will increase by 6.9 million in the next quarter as a result of a sales/leaseback transaction. Liquidity is solid with 49 million in cash and 30 million in undrawn revolver

availability. Net debt declined to 182 million from 233 million at the start of the year sending net lease adjusted leverage to down to 4.4x from 4.9x at the start of FY 2011. On the back of today’s strong results, the bonds rose $4.25 to $96.50/$97.50. However, I still recommend the bonds.

DFS’s results today and historically show the strength of its build to order model, dominant market position, unique credit offerings and flexible cost structure. Even after today’s strong move up, DFS bonds still offer investors the opportunity for a mid teens total return. Given its relatively stable top line, and cash generative business, DFS represents good relative value compared to other UK retailers. Therefore I recommend DFS’s 9.75% Sr Secured bonds at $97.50 for a 10.3% YTW and a 10% current yield.