Description

To scare off half the audience: Here’s a highly illiquid UK distributor serving big-ticket consumer discretionary products. 

Headlam is the UK’s largest distributor of flooring products. It is well-run, has a rock solid balance sheet, a defensible market position and a history of emerging from cycles as a share gainer. With the shares currently trading around liquidation value and a mid-teen levered FCF yield that is being actively returned to shareholders via dividends and buybacks, it offers a compelling upside/downside for a fairly straightforward business.

Overview

Headlam has a 20% share of the UK national flooring market (£3bn/yr of distributor and manufacturer sales). Flooring manufacturer Victoria PLC, which distributes its own product, is another 15% of this market, followed by a long tail of smaller players. Headlam offers the largest product selection in the UK and nationwide next-day delivery to its mostly trade and retailer clients. Sales are 66% residential and 88% UK, with smaller European operations in France and the Netherlands.

The business has 2k suppliers, 39k SKUs, 25k active customers and fulfills 5m orders annually. Average tickets skew tiny (~£150) thanks to its growing focus on trade counters but also reflect the high volume of small orders serving residential RMI. 

The business was built via a 30+ year roll-up strategy. It operates as 66 local and national distribution brands, backed by centralized procurement and logistics. It has 21 DC’s, 53 trade counters (notably growing to 90 by 2025), and a fleet of 360 vehicles. 

Flooring is a high-volume, low-margin product for which most retailers do not keep much inventory. Additionally flooring has a fragmented but consolidating global manufacturer base and highly fragmented selling outlets. As a result specialist distributors are especially important. 

Flooring distribution is more “specialty” than you might think. It is a bulky, high-weight / low-value, high SKU count product category where availability is critical. The scale distributor has clear advantages. It can offer exporting manufacturers the best domestic coverage while clients receive the largest SKU assortment, shortest delivery times and lowest prices. Flooring distribution is unlikely to be disrupted, as (a) retail outlets are likely to remain the status quo over ecommerce given consumers preference to physically interact with large-format samples and (b) most flooring is professionally installed, protecting established sales channels. In the US Floor & Decor presents a conceptual disruptive threat as a self-sourcing and self-distributing retailer, but remains just 8% of the market and has ambitious targets to grow to 20%. Worth being aware of but not an active threat.

Headlam owns most of its real estate freehold, with a recent independent valuation of £100m. Inventory turns are 3x-4x annually which is impressive given the high-SKU, bulky and low value nature of flooring. All this leads to mid-teen ROIC, a decent but not great return that would be difficult for generalist competitors to replicate from scratch.

Balance Sheet & Capital Allocation

At today's market cap of £228m, Headlam trades close to a reasonable estimate of its liquidation value:

The business typically maintains net cash throughout the calendar year, even with its 2H seasonality. This year saw a brief drop into net debt following a special £30m shareholder return program (50/50 dividend and ongoing buybacks):

Capex typically runs well below 1% of sales and <2% of gross profits. 2019-20 spending was elevated by the construction of a new Ipswich DC, which is now complete. 

By 2025 Headlam wants to upgrade and increase its number of trade counters from 53 to 90, at a cost of £18m. The goal is to add £120m of new revenue to the current £80m base, implying each counter will increase its annual revenue from £1.5m to £2.2m. Consensus estimates do not reflect this potential +17% tailwind to group revenue, despite early upgrades already showing traction (+12% yoy revenue growth). At an historically normal 4% NOPAT margin these growth investments would yield a 26% ROIC.

Additionally, Headlam is trying to increase its penetration within larger retailers and homebuilders. Currently it has just 6% of an estimated £1bn national accounts market. It recently won 2-year contracts with Homebase and a top-10 UK homebuilder. This will be a difficult segment to crack at accretive margins, but given Headlam’s current under-penetration any growth here will be incrementally positive.

Finally, roll-up opportunities remain. Covid interrupted Headlam’s longstanding practice of accretively acquiring mom-&-pop distributors. Headlam keeps the front-office sales teams and integrates everything else into centralized operations. These are typically £2m-£10m deals done at <5x post-synergy operating profits.

The pension is fully funded.

In the 5 years preceding Covid, Headlam generated an average 38p/share EPS and paid out cumulative dividends of 131p (i.e. half today’s market cap). Circa ~70% of net income gets paid out via ordinary + special dividends. In March 2022 the board approved a £30m “return of excess funds” to shareholders, split 50/50 between a special dividend and an ongoing buyback program that as of September has repurchased 1.9% of shares outstanding. At the time Headlam’s net funds position was £55m and it will likely end 2022 with >£30m net cash.

Leadership

Until last year Headlam was run by longtime employee Steve Wilson, who joined upon formation as FD in 1991 and was made CEO in 2016. He was integral to Headlam’s formation and its roll-up strategy, and his retirement in late 2021 left a void. Steve retired owning just under 1% of Headlam’s equity. His base salary was £500k. 

After conducting an external search, the board selected CFO Chris Payne to succeed Steve. Chris joined in 2017 from Biffa, where he was Group FD. It's hard to make a firm assessment of Chris so soon in the role. His incentive compensation mirrors that of his predecessor: Annual bonus of up to 125% base, measured 75% on PBT targets and 25% on strategic goals. LTIP of up to 100% base, measured 80% EPS growth and 20% relative TSR. The 2022 plan’s EPS growth target is a 6% CAGR with full payout at 10% CAGR.

With Chris shifting to the CEO role, a CFO search is currently underway. Patrick Butcher has been named interim CFO and has extensive experience at much larger and more complex businesses (most recently Capita Group, formerly Go-Ahead and Network Rail).

The board is ok for a PLC of this size. Five independent directors with prior leadership experience at Card Factory, B&M, Wickes, KPMG, and decent current board exposure elsewhere.

No notable shareholders and liquidity will be a prohibiting issue for most institutional investors.

Cyclical headwinds

Headlam’s equity is -46% from its 2021 as a result of obvious macro fears around consumer weakness and inflationary cost pressures. Flooring is a big-ticket consumer discretionary purchase. 1H22 group sales were -2% yoy as residential sales declined -6% while commercial sales grew +5%. Daily sales through July have trended slightly below 2019 levels, with the clear concern that 2023 will see severe declines. The 3 analysts who cover Headlam have reduced their FY23 revenue estimates 10% and their EPS estimates 14%, although they still expect yoy growth.

Cost inflation has so far not been an issue, with gross margins maintained at historically high 33%. Headlam has benefited as manufacturer-led price hikes passed through to end-customers. Energy (mostly fuel) hedges have helped YTD but run off in October. At current rates this could compress margins ~75bps if not passed through via surcharges. 

Headlam will survive whatever recession is coming. In 2008-09 the peak revenue decline was 10.7% during 1H09 in the UK, while the full year recovered to only decline 6.1% in the UK and 4% as a group. In 2020 management put out a “severe downside scenario” that assumed 18 months of persistent Covid lockdowns and forecast revenue -11% versus pre-Covid. I won’t rehash all the compelling reasons to think UK homeowners remain more willing and able to invest in their homes versus 2008-09. And although Headlam is underexposed to new-build construction, the UK remains structurally underbuilt with an aging housing (and flooring) stock.

Valuation

At its peak last year Headlam traded at 19x forward earnings, versus today’s 8x and a 10-yr average of 13x. On stable margins in 2024 the business will generate £44m of EBITDA, 35p EPS and a 2-yr cumulative £60m of levered free cash that will be entirely returnable to shareholders (i.e. 25% of the market cap). The business today trades at 3.6x EV/EBITDA against that 2024 figure and a 15% FCF yield. Using an historically average 6x EBITDA, 13x earnings and most attractively a 10% FCF yield the equity is worth 435p (390p + 45p cumulative dividends). That’s a 27% 2-yr IRR for a business that should continue to generate double digit excess cash for years.

Downsides are protected, most obviously from the high level of asset backing. Headlam has £100m of land and £150m of inventory to flex, giving it lots of leeway. If sales decline 15% operating margins should still remain around 4.5% (they were 4.6% in 2009 and 4.4% in 2021). Headlam would generate £25m operating profit, £30m EBITDA and £20m of free cash flow - before any inventory sell-down action. This would be enough to pay down all the gross debt and at 22p/share EPS implies today’s shares trade at 12x potential trough earnings.

Ultimately the attraction to Headlam is not just that it’s cheap, but that it is an incumbent distributor with a surprising moat that is unlikely to lose share over the next decade+. The UK flooring sector is extremely likely to remain one in which the manufacturers and retailers continue to rely on 3rd party distribution, with Headlam the clear scale provider. Mid-teen shareholder returns for a structurally stable business distributing an undisruptable product seems like an attractive entry point.

Catalyst

Nothing imminent, which is part of the problem.

Growth of Headlam's trade windows and national accounts business should drive revenue growth beyond consensus expectations over the next 2 years.

Double digit shareholder returns and a clean balance sheet deserve a re-rating, perhaps only once “bad” industry numbers start coming through and people realize earnings and cash generation will remain decent.