Halfords Group PLC (HFD) is the largest auto parts retailer in the United Kingdom and it also offers car repair services through its network of auto centers.  UK auto parts retail is a very mature and highly consolidated industry, and HFD has lion’s share of sales in that market and no direct competitors.  The company possesses a number of important scale and brand advantages that create a wide moat around its business.  At the same time, HFD trades at an attractive price of approximately 9X NFY EPS and sports a 7.5% dividend yield, which indicate that the stock is significantly undervalued.

Here is a more detailed summary of what makes HFD an attractive investment at the current price:

BUSINESS

-          HFD’s significant size enables the company to source its products at a price that would be out of reach for most potential entrants, thus creating a substantial cost barrier to entry.  Further, HFD’s substantial volume enables the company to offer in-store fitting services, which further strengthens the company’s competitive advantage.  A new entrant would find it hard to offer full-blown fitting services from the get-go without incurring substantial losses.  Yet another HFD’s competitive strength is the company’s brand name.  In auto parts retail brand name is a lot more important vs. a traditional run-of-the-mill retail business, because of the needs-based nature of auto parts purchases, which means that for most customers immediate availability takes precedence over price.  As HFD’s name stands for the best SKU range and availability, it makes the company a default choice for consumers who do not mind paying a small premium in exchange for assurance that they will always be able to find what they need.  It would be tough for a potential new entrant to replicate HFD’s reputation for parts availability without incurring substantial cost over an extended period of time.

-          HFD generates significant free cash flow, has limited capx requirements, and enjoys a solid financial condition.  One of the main reasons behind the company’s cash-generative profile is that HFD operates in a highly consolidated and mature market, which means limited growth opportunities.  At the same time, the company’s ample free cash flow enables the company to devote significant amounts of funds to dividend payments and share repurchases. 

-          As a result of the advantages outlined above HFD is able to generate returns on equity in the range of 25-30% while employing a reasonable amount of debt.  As the said advantages are likely to prevent potential entrants from encroaching on HFD’s turf it is likely that the company will continue generating above-average returns over the long-term.

MANAGEMENT

-          Historically, management has done a good job on the operating side of the business by augmenting HFD’s scale advantages, making sure the company stays on top in terms of parts availability, and keeping a tight lid on costs.  With respect to capital allocation management probably deserves a B-, primarily because of the purchase of Nationwide Autocentres in 2010.  While Nationwide is a solid business and was purchased at a sensible price of approximately 12X after-tax earnings, it is only somewhat related to the core business of HFD, in my opinion.  On a positive note, it appears that post-acquisition shareholder feedback changed management’s approach to capital allocation.  Within a few months of the Nationwide purchase, management indicated that future acquisitions are unlikely, hiked the dividend, and started an aggressive buyback program.  Therefore, it appears that going forward management might be getting higher grades on the capital allocation front.

VALUATION

HFD is selling for approximately 9X NFY EPS, and the EPS figure is probably somewhat below normal given the poor state of the UK economy.  Further, the company sports a 7.5% dividend yield.  Given the quality of HFD’s business the stock represents an attractive investment at these levels.