Description

Headlam is the leading distributor of floorcovering products (carpets, vinyl, engineered wood, ceramic tiles etc.) in the UK. This is a structurally advantaged business trading at an attractive valuation.

Favorable industry characteristics

Headlam sits between fragmented manufacturers and customers. Headlam is the largest distributor in the UK and the next player is 1/6^th the size in terms of revenue. Headlam purchases 30,000 SKUs from nearly 200 suppliers in 22 countries. Due to its size, Headlam is typically manufacturers’ largest UK customer and enjoys significant discounts from manufacturers.

On the demand side, Headlam has 70,000 active customer accounts. UK’s floorcovering retail market is dominated by independent retailers. 90% of Headlam’s sales are to independent retailers and flooring installers.

Headlam’s business is characterized by high volume (5 million annual orders) and small order size (average order is 130 pounds). The end customers typically only renovate one room at a time. Demand for floorcovering products tends to be price inelastic due to the infrequency of purchases and the vast selection of products catering to each price point. Like a lot of home improvement jobs, materials are a smaller portion of total project costs than labor. Customers would go to a carpet retailer, select a product and agree on a price. The retailer would order the product from Headlam and have a subcontractor install it for the customer. Retailers enjoy high gross margins and are able to pass price increases to end customers. To them, reliability of service and product selection are at least as important as prices.

It’s hard to sell carpets online. 95% of Headlam’s orders are cut to length or broken down to satisfy the customers’ requirements. Customers would also like to touch and see the carpets before they buy them.

Stable end market demand

England has an aging housing stock with 76% built before 1980 and 20% before 1919. In 2015, 19% of all residential dwellings in England failed to meet the Decent Homes Standard. These older homes should create a continued demand for home renovations. Headlam’s business is predominantly associated with refurbishment one-room-at-a-time versus new construction.

In 2009, UK like-for-like revenue declined 6%, followed by 4% growth in 2010 and 8% growth in 2011.

Pristine balance sheet and real estate ownership

Headlam has 4 national distribution hubs, 19 regional distribution centers and other smaller warehouses, trade counters, showrooms and specification centers. This dense network of access points allows Headlam to provide customers with fast delivery cost effectively.

Headlam owns most of its real estate (freehold properties). Land and buildings gross and net book values were 121 million and 91 million pounds as of 2018 YE.

The company has a net cash position.

Margin improvement

While Headlam enjoys a favorable competitive position, the floorcovering industry offers little growth opportunities. Therefore the company has focused on margin improvements. Gross margins has expanded from 30% in 2014 to 32.3% in 2018. Steve Wilson who became CEO in 2016 has an even greater focus on cost control. The company is implementing a 10-point efficiency initiative, tackling areas from route planning to cloud migration of business servers.

Acquisition strategy

Headlam routinely does tuck-on acquisitions of small regional distributors in the UK and continental Europe and uses its buying power to improve margins. Acquisitions tend to be very small (less to a million to a few million pounds). In 2018, the company bought 5 small distributors for 13 million pounds and acquired 24 million pounds of run rate revenue (implying 0.54x price/sales). Historically the company typically paid less than 0.5x sales with the exception of the 2017 acquisition of Domus which is a specification consulting firm. Headlam has traded between 0.5x to 0.7x sales in the last 5 years. As long as the company pays less than 0.5x sales for regional distributors and brings margins to corporate standard, the acquisitions should be value accretive.

Business seems to have turned around

The stock has been weak amongst a very weak macro environment in the UK. In March 2018, the company announced that its UK business had negative 6.5% organic revenue decline in January largely due to reduced orders from one customer (Carpetright). UK organic revenue was -5.2% in H1 2018 and improved sequentially to -3.5% in H2 2018. About 40% of the H1 2018 revenue decline was caused by Carpetright. The company hasn’t disclosed how much revenue comes from Carpetright, but it’s definitely below 10% because 90% of the sales are to independent retailers and installers. The implied 3% decline on 90%+ of the business indicates that the UK business is fairly stable.

Carpetright has completed a restructuring. It shrunk its store portfolio and reduced debt using proceeds from an equity issuance. Carpetright recently announced that comparable sales in May and June were up 8.5%. Separately, Headlam announced in March that like-for-like YTD revenue was positive in both the UK and Continental Europe.

Headlam still guides flat 2019 revenue, but this might prove to be too conservative if consumer confidence picks up in the UK and Carpetright stabilizes its business.

Risks and concerns

Continental Europe

The Continental Europe (France, the Netherlands and Switzerland) segment generates 100 million pounds of revenue but only about 1 million pounds of operating profit. Historically this business has always been subscale and much less profitable than the UK business. There’s no indication from management that they will do anything about this segment other than to grow it.

Brexit

Headlam purchases 65% of products from outside the UK. A hard Brexit or potential tariffs on imports into the UK would put inflationary pressure on costs. This is unfortunately a risk that can't really be mitigated.

Manufacturers might attempt to go direct

Victoria, a UK carpet manufacturer, has built a new distribution center so they can directly deliver to retail customers. I think the risk of Headlam being disintermediated is low because it would take significant investments to replicate its real estate network and customer relationships.

Valuation

Headlam trades at 7.4x EBITDA and about 10x free cash flow (excluding net cash). I think this is too cheap for a decent business with a good balance sheet. In the last 5 years Headlam has traded between 7x and 11x EBITDA, and I expect the multiple to rerate higher when the company returns to growth. While we wait, we can collect a 5% dividend yield.

Catalyst

Return to growth