Description

Summary:  Howden Joinery Group plc (LON:  HWDN.UK) is British kitchen wholesaler and distributor.   We believe the company’s asset light model will allow it to continue to earn significant returns on capital while also growing its store base in the next several years.  The company has no debt, approximately 8% of its market cap in cash, and will continue to generate excess cash that should be distributed to shareholders in the coming years.   

Business Overview:  Howden Joinery is the UK’s largest manufacturer and supplier of fitted kitchens, appliances and joinery products.  The company sells over 400,000 kitchens per year.  It operates over 650 “trade only” depots in the UK that sell to small builders and contractors.  The company has some minimal exposure to Europe with 24 depots on the Continent.

Key Pillars of the Thesis:

1.       Localized Management.  We believe that Howden is extremely well-run, with a management team incented to maximize value for shareholders.

2.       Differentiated Product Offering.   With its focus on tradesmen, Howdens builds loyalty among its customers, while at the same time operating an asset-light that allows for significant ROIC.

3.       Insulated from Internet Competition.  We believe Howden is insulated from internet competition due to the complexity of the kitchen outfitting process.

4.       Growth and Flexibility Even in a Slower Market. While Howden’s topline is somewhat correlated to the level of housing activity in the UK, the company has flexibility to continue to grow while also managing its working capital to maximize cash flow.

5.       Solid Balance Sheet and Returns on Capital.  The company has net cash on the balance sheet and generates 25+% ROIC.

6.       Attractive Valuation.  

#1.  Localized Management.  We believe that Howden management has done an excellent job of growing and managing the company.  One of the key components to the story is that each local depot manager runs his own business, including merchandising, pricing and staffing.  Each month, the depot staffers are paid a bonus based upon the gross profit they can generate.  The company believes that this incents the managers to optimize for local tastes and demand in a way that more centralized planning and merchandizing would be unable to accomplish.

We do note that, in early 2018, the CEO and founder, Michael Ingle, will retire.  He will be replaced by Andrew Livingston, currently CEO of Screwfix, a division of Kingfisher.  Screwfix is the UK’s largest retailer of trade tools.   In many Screwfix is quite similar to Howdens, with sales only to tradesmen, 500 stores in the UK and over £1 billion in revenue. From the time Livingston was appointed to the job in March 2013 to the most recent, Screwfix’s revenue grew more than doubled.   We believe that Livingston will be a good fit for maintaining the unique Howdens culture.

#2. Differentiated Product Offering Builds Loyalty Among Customers.   Howdens sells only to tradesmen/contractors.  While they are cognizant of the tastes of the end consumer, Howdens views direct sales to customers as a conflict with contractors, and would prefer not to engage in the negotiation over final price to the customer.  Instead, they would rather assist, not be directly involved with, the relationship between the contractor and his customer.  They believe this allows the contractors more flexibility in selling to end customers and generates loyalty among contractors.  Howdens competes for the contractor’s business based on convenience and price.  They offer the largest form stocks in the UK, with over 6,000 kitchen SKUs.  The depot design reflects their focus on convenience and fast delivery.  Each depot is approximately 10,000 square feet, with only 10% of the space dedicated to selling.  The balance is reserved for storing inventory.  Thus, they can maintain a fairly broad range of SKUs on hand, allowing for extremely fast delivery.

In 2015, the company announced a capex plan to invest in IT systems and supply chain.  We believe a similar supply chain would neither cheap nor fast for a competitor to build.

#3.  Insulation from Internet Competition.  Talk of supply chain expertise raises the specter of online competition.  Yes, in theory, Amazon could decide to tackle this business.  We believe, though, that there are limits to the inroads that online competitors could make.  By its nature, kitchen design and installation is a service-intensive, technical business that would be tough for an online competitor to break into.   For instance, Howdens employs 1,500 kitchen planners.  Every depot has CAD planning and A3 printers.  Given the intricacies of the kitchen design business, the supplier needs to communicate with the contractor installing the kitchen.  If not, there’s a good likelihood the kitchen equipment won’t fit correctly.   

#4.  Continued Growth Even in a Slowing Market.  As many kitchen projects are tied to new home builds or to home sales, the company’s topline does have some correlation to UK housing activity.  Activity has recently slowed a bit, but at 100,000 sales transactions per month they are well below the 2007 peak of 150,000/month.  Home prices are still rising, up 4.9% y/y in June. The most recent RICS survey indicated that prices were basically flat in July.   Though housing activity has slowed, the company was still able to show same store sales in 1H17 of 2.4% and total sales growth in UK of 4.0%.

In the event of a continued slowdown in housing and an overall economic slowdown, we believe there are 3 factors at play that can help to limit downside:

Continued Growth of Store Base/TAM in the UK:

The company believes that the UK can support 800 depots, 23% growth versus their current base of 653.  For the next several years, we expect the company will growth the store base by approximately 4% per year, or 25-30 stores per year.  They will open another 19 in the second half of this year.  Each depot is relatively cheap to open costing about £300,000 to outfit and requiring about £650,000 in sales to reach breakeven.

Continued New Product Introductions:

Howdens continuously introduces new items into their inventory (e.g. 22 new ranges in 1H17).  As they do this, they try to broaden the price ranges, materials, and colors they sell.

Evidenced ability to perform in a downturn:

Though I haven’t seen it broken out, the company says they have more exposure to tenanted housing that makes their topline not entirely correlated to home sales.  Additionally, we continue to believe the kitchen renovations are one of the highest return renovation activities that a homeowner can take. For some context, we looked back to the recession to see how the Howdens stores performed.  in 2008, same store sales were down 3.1%.  In 2009, they were down 4.6%.

Flexible nature of the distribution model:

Despite the 2009 same store sales decline, the company actually increased gross margin by 3 percentage points.   They were also able to increase cash flow by managing inventory more leanly.  One of the attractions of a distributor model for us is this cyclical relationship:  during good times, EBITDA rises, but the company need to working capital.  In bad times, EBITDA might take a hit, but they tend to be able to manage working capital to generate more cash flow.  As an example, the company currently holds approximately 140 days in inventory, whereas they reduced that number to only

#5.  Solid Balance Sheet and Returns on Capital.  Management has an aversion to debt.  In fact, they have stated that they plan to be able to operate through an annual working capital cycle without incurring any bank debt.   At June 30, the company had £215mm in cash on the balance sheet and no debt.  They do have a pension plan liability of £124mm that they will have to pay £30mm into this year.    Because of the small capital deployment required for PP&E, the company generates 50% returns on equity and 25% returns on assets.  Given their excess cash flow generation, in 2015, they paid out £105mm to shareholders through buybacks and dividends.  In 2016, they paid out £145mm.  They currently have another £80mm buyback plan in place and have increased the dividend for this year.   

#6.  Attractive Valuation.  The stock currently trades for 15x 2017 estimated earnings of 0.29p.  Backing out the 35p per share in cash on the balance sheet, the multiple is only 13.5x.  The company currently has a 2.5% dividend yield.  If the company can continue to grow sales at 5% per year the next several years and maintain margins, they should be able to generate approximately 34-35p in EPS.  As well, we expect the company to generate approximately £350mm in excess cash flow from now through the end of 2019.  At 14x EPS plus the accrued cash (either kept on the balance sheet or through dividends), this yields a 575-600p stock, up 40% from here.  

Catalyst

Execution