Description

*All number unless otherwise stated are in GBP and relevant to the 2016 annual report.  

Summary:  

Howden Joinery (HWDN LON) is the leading supplier of kitchens in the United Kingdom.   They sell more kitchens in the UK than anyone else.   Howden started in 1995 with 14 depots and now operates 642 depots across the UK with 1.3B in sales.   Over the past 22 years, the company has exhibited a consistent track record of strong sales and free cash flow growth combined with stable gross and operating margins.  They have shown the ability to compound ROE under the umbrella of prudent and efficient management and have done so with a capital structure completely funded by its own operations, with no debt.  While the company lacks any interesting new age business model, technology advantage or general sex appeal, they are an entrenched market leader with a durable business model.  Their operations have a high level of understandability, and they maintain a clear focus on executing within their defined market competencies.  The company is highly profitable and cash flow generative.  Over the past 5 years the company has compounded annual growth rates of 9% for sales, 15% for free cash flow and 16% for earnings.  They are reasonably valued at 14X earnings, and I believe the business has significant scope for further growth in line with their operating history since inception.  

Historical Overview:  

The Company was founded in 1995 as a business unit of MFI Furniture Group with a focus on kitchens.  In 2006, as MFI group faced a series of financial struggles, the loss leading furniture manufacturing division was sold to private equity firm Merchant Equity Partners.  The parent company retained the Howden kitchen business and changed its name to Galiform.  In 2008 after continued struggles the MFI retail business entered into bankruptcy and closed all stores.   Galiform retained liabilities for cost associated with many of the stores and took an exceptional charge of 99.7mm.  (The liability cost associated to the MFI closure is seen in discontinued operations from 2008-2012. The majority of this cost was related to remaining lease payments of closed MFI stores.)   In September 2010, the company was rebranded from Galiform to Howden Joinery.

Business Overview:

Focus is a key differentiator: Howden Joinery is very specific in what they do.  

• They only sell kitchens.  

• They only sell to builders/contractors. No direct-to-retail sales

• They only sell out of their own local depots.  You won’t find Howden branded appliances on Amazon.   

This creates moat like attributes for the business, enabling them to add the most value for all interested parties including end customers, builders, depot employees and most importantly shareholders.  The kitchen, the small builder, and the local depot are all connected in a business model that makes sense.   Kitchens require professional installation to be fitted correctly and the small builder depends on the local depot model to do their job right.    

Why focus on the kitchen: We use the kitchen every day and the complexity of the kitchen continues to grow.  The kitchen is one of the most common renovation projects and an important value driver for housing and rentals.  Professional installation is required to work well, be of high quality, and meet safety and regulatory requirements.  

Why focus on the small builder:  The Howden business was designed from the start to meet the needs of the small builder.  By focusing on the small builder, Howden avoids retail competition and its associated advertising cost.  This is very much a relationship business and each depot manager is empowered to grow their book of business by positioning themselves as a valued construction partner and working capital provider to small builders.   By making the builders life easy, they attract customers, secure work, and make a profit.  Once a builder is contacted for a job, Howden will provide a designer to visit the site and create an expert and accurate digital plan for the kitchen design.   This ensures everything will look good and fit properly and saves the builder time and effort in design while helping them secure the project.   The customer can come into the local depot and see inventory on hand as they make final decisions.  Once the job is secured, Howden will offer the builder full credit terms and a confidential discount which enables them to manage their own cash flow and margin and quote the job to the end customer in their own preferred structure.  As soon as the builder is ready to begin work, Howden will deliver immediately from its 100% in stock local inventory.  There is no waiting for items to be ordered and items can be swapped or returned as necessary from the local depot a short drive away.   Each product Howden sells is focused not only on looking good but being designed in a way that makes installation simple, quick, and high quality.  Builders don’t get paid until the job is done and the job is done right.   By focusing on the needs of the builders Howden empowers them to install high quality kitchen in an efficient timeframe saving them money and in turn allowing Howden to collect payments efficiently, build trust, and grow their customer base.  

Why the local depot: Each local depot is run by the depot manager as an entrepreneurial profit share and given autonomy over their business including P&L accountability.  The depot manager is compensated at 5% of operating profit post SG&A expense.  It is the depot manager and their team’s responsibility to find and sell to builders in their local market.    With its focus on small builders, Howden depots are not found in high end retail spaces.  Typically they are in industrial warehousing.  Additionally there are no large or fancy showrooms.  Each depot has a simple counter and a warehouse with 100% in stock inventory.  Compared to a typical retail sales floor the company saves money with lower industrial rents, no cost associated with setting up, designing, and supplying a fancy showroom and no retail advertising cost.   All of these cost saving add to margin which is then shared between the depot manager, the builder, and shareholders.   

Operationally the company executes via a fully vertically integrated supply chain.  

30% of good sold are produced by Howden in their own manufacturing facilities.  Howden primarily manufactures cabinets and doors.   Howden makes the cabinets frames/boxes but the “fronting” or rather the part of the cabinet you see in different colors or materials that is highly subject to consumer taste trends is outsourced.  They manufacture those products, which they believe can be produced at the lowest cost and highest quality and importantly items that have low risk to technology obsolescence and changing consumer trends.  They operate two manufacturing facilities configured to meet their exact requirements that serve only one customer: Howden. Their working practices, scheduling and machinery are all done to their specification focused on providing builders an end product that is of high quality, is easy to install, and will look good.  The company also started their own white labeled appliance brand Lamona in 2009 which is built to their specification by outsourced producers.  They now sell more than 650,000 Lamona appliances each year and are the best-selling single oven, dishwasher and fridge-freezer appliances it their category in the UK and are only sold through Howden depots.    

Howden manages their own supply chain and distribution operations.  They have their own warehousing facilities and their own trucks deliver only their products to only their depots.  Howden supply chain is focused on meeting the needs of their depots and ensuring all aspects of the products are right for everyone involved.  Howden seeks to achieve 100% local in stock supply of all products to ensure each builder can be fully supplied as soon as they are ready without construction delays.  

Balance Sheet and Capital Structure:

As a reference here are some numbers from the 2016 annual report:

• 1.3b in sales

• 207mm in free cash flow

• 237mm profit before taxes.

Howden has a history of prudent capital management as well as returns to shareholders:  

• The company holds no debt and 226mm in cash on their balance sheet.   

• They pay a residual dividend policy that targets an earning payout of 30%-40%.  Currently yields 2.5%.  

• Company has authorized share repurchases of 55mm, 70mm and 80mm respectively over the last 3 years.  This represents approximately 7.5% of market cap

Risks and liabilities are as follows:   

• Inventory on hand: Holds a carry value of 183mm in inventory.  It is held at lower of cost or market value and incorporates a 10% allowance to fair value

• Customer credit extended:  100mm of credit balance extended to customers.   Includes 9mm of allowances for credit losses (9%).   Credit losses have averaged 1% annually and were only 2% in the 2008-2009 time period including debt recovery cost.   With over 400,000 open customer accounts spread across 642 depots they hold very low concentration risk to any single entity.

• Pension deficit liability: Company has 106mm pension deficit.  The defined benefit pension is frozen and no longer offered so no further benefits are being added.   The majority of the deficit on the balance sheet is related to discount rate reduction as interest rates have fallen.  The company is likely to pay 25-30mm a year towards this for the next 3-5 years.  That is consistent with how the company has operated for the last 3 years, so it’s not an expected shock to cash flow or earnings.   

• Operating leases:  Company currently holds all leases for depots, warehouses, trucks etc. as operating leases and they are not on the balance sheet.  Lease payments for 2016 were 443mm for depots and 58mm for all others.  Note that when IFRS 16 comes into effect these leases will be moved onto the balance sheet.  

Catalyst

Investment Thesis:

Howden Joinery will continue to compound investor capital via continued growth of depot unit economics.    As of end FY 16 the company had 642 stores.   The company has a 5 year depot roll out plan that will add 30 depots a year for the next 5 years bringing the total to approximately 800.   In addition the company has stated the following depot unit metrics:

• A depot cost approximately 350k to fit out.  

• It takes 2 years for a depot to breakeven.

• It takes 7 years for a depot to reach sales maturity of approximately 2.2mm in revenue.   

• The growth from year 1 to year 7 is generally linear.

Given that 25% of depots are less than 7 years old, they will see continued revenue growth from those stores as they mature to full potential in addition to the 30 new depots a year they are adding.  

My unit economics model can be found below.  It incorporates:

• Number of depots added per year going forward at 30 which is the company’s stated target.

• Average age per depot (7 is the max age used as it assumes full maturity, so a depot that has been opened 9 years in still counted at 7).

• “Revenue Per Depot Year” (RPDY):  Revenue per depot, per year in in existence.  This incorporates the linear revenue growth as the depot grows to maturity at 7 years.   For example if the RDPY number is 0.314mm (which is the 2016 calculated number and the number I use going forward in the model) a depot opened 2 years is projected to have 0.628mm in sales.   A depot open 5 years would be expected to have 1.57mm in sales.  And any depot 7 years or older would have reached maturity at 2.2mm per store.  

My model below assumes the company adds 30 depots a year for the next 5 years and the “Revenue Per Depot Year” (RPDY) remains constant at the current 2016 level of .314mm of revenue per depot year.  This projects the company to have 25% sales growth over the next 5 years.  

While the main investment thesis is focused on UK depot growth and continuing to execute via the depot unit metric plan explained above, there are other value add growth opportunities available.

Everything above is specific to UK depots only.  I have yet to even mention that the company currently has 24 depots in continental Europe.  One of the things I like about this management team is they are prudent and conservative.  You can see that in the in the language they use to define the international growth where they define it as “a learning process” with no commitment to move forward beyond the current 24 depots.  25% sales growth as stated in the unit economic model above assumes 0% expansion anywhere other than their ground and pound depot roll out plan in the UK.  I could stop there on the investment thesis.  However, I believe the company is cautiously setting up for more growth internationally.   Howden opened 11 depots in France in 2012 as part of a pilot program.  Over the next two years they learned about the nuances of the French market and how it differs from the UK (Builders quote jobs differently, the French cook at different temperatures, they have different door sizes, etc.).   Over the last 3 years as part of a phase two plan they opened 9 additional depots in France applying everything they learned in the pilot program.  They have 3 depots in the Netherlands and Belgium, which they claim have very similar nuances to the French market and have opened 1 depot in Germany which has its own set of market conventions.   While management has reiterated their non-committal language to expansion in continental Europe, what I see is France same store sales growing 5.3% in constant currency through July 2017 and a new CEO starting mid next year that is coming from another trade/builder only retail store (Screwfix) in which he led a sales expansion across many countries in Europe (more on the management change below).  If Howden never sells another thing in France or Europe I still like the investment based on UK unit economics, but the possibility for them to expand across Europe brings additional opportunity for revenue and profit expansion.  They are scheduled to review the European expansion data from phase 2 in the spring of 2018 as a joint process between the current and incoming CEO.   

Howden is also starting to offer more integrated value add service to the builder.   As of July 2017 they now install 25% of all solid surface countertop sold.  That is up from only 10% in 2016. Generally when a builder installs a granite countertop they have a professional granite cutter come install it.  It takes a special skill set and can be very expensive to replace if done incorrectly ruining the granite slab.   Howden now offers this service themselves.  I see room for them to continue to increase these value add services where it makes sense for the builder, the end customer, and the company.   

Valuation:

The company has a 3 year average ROE of 51%.  I conservatively use a 30% ROE and fade to 15% over 25 years.   Using a terminal multiple of 14x earnings, a payout ratio of 37% in line with their policy, and a discount rate of 9% to account for the company’s cyclicality, I value the company at 511 GBP intrinsic value and a price-to0intrinsic-value of .80.   While I don’t consider 20% to be a deep value company, for a company with its steady growth potential it is an acceptable margin of safety.  I triangulated that against a discounted free cash flow model assuming 4% free cash flow growth and the valuation was similarly in the .80 range to intrinsic value (The company has a 5 years free cash flow CAGR of 15%).

Risks to Consider:

The company states 800 depots is the top end target because they work on a 5 year rolling plan which currently calls for 30 a year.  They may for example come out next year and say the new 5 year rolling plan involves 850 depots.  They have stated they will not add depots where it does not make sense.  They look at demographic models and pointed out that driving distance is a key factor (they compared it to a pizza delivery chain).   The local in stock depot model generally only works if it is in “delivery range”.  To date, unit metrics have not indicated any signs of saturation or store cannibalization, but as the company continues to expand it will bear watching.  The company has never had to close a depot for economic reasons.

Margin risk: The first half of 2017 has seen a decline in operating margins from 14.1% to 12.1% as operating cost increased 21mm compared the first half of 2016  (Note that gross margins were generally stable and revenue was up 4% compared to the prior half year).  Most of the operating cost increase can be traced to the cost of opening new depots, new product initiatives, and opening a brand new warehouse facility that will be run in parallel to the old warehouse for 3 years creating a dual cost structure.  I believe I understand the recent margin compression, that they are investing in the future, and as depots continue to grow operating leverage expansion will support margins.  This trend will need to be monitored closely going forward.  Revenue is typically skewed to the second half of the year where they do 60% of annuals sales and I hope to see the margin trend stabilize or improve.   

The largest risk to Howden Joinery is general UK macro cycle risk.   An important distinction to make is that the Howden business is not generally tied to new housing development.  They build on average 150k new homes in the UK a year, mostly by larger builders.  Howden estimates that there about 1mm kitchen renovations per year in the UK and 95% of their sales come from renovations not new builds.   Their economic cycle is generally going to be tied more closely to consumer spending metrics such as consumer confidence and disposable income.   I do not have a specific view on where the UK consumer cycle stands but I believe the company has the ability to survive and thrive through the cycle.  The company has stated the following actions/flexibility would be taken to maintain margins in order of priority:

• Depot manager and employee payments get smaller as they are compensated as a % of profit and depot staff may shrink.

• A significant part of COGS is variable as 3rd party purchased or raw material cost.

• Flexible manufacturing utilization and staffing

• Capex plans for the next 3-5 years can be rolled back

• The depot roll out could be slowed (note that Howden has never closed a depot for economic reasons)

The above combined with limited exposure to concentrated debtors and a strong balance sheet with no debt or liquidity risk gives me confidence that Howden can manage through a cyclical downturn.  

Another thing worth pointing out to any potential investor is the new management team that will be in place.  I have stated above how much I like management, but the company has a new board chairman as of 2016: Richard Pennycook.  Mr. Pennycook has been on the board since 2013 and is also the director of “The Hut” a British e-commerce company that operates 100 international websites that sell consumer goods predominantly outside the UK.   The have also announce that Matthew Ingle who is the founder and CEO will be stepping down in 2017 after 22 years to be replaced by Andrew Livingston most recently of Screwfix (the UK’s leading hardware store focused on professional builders and a sub division of a larger conglomerate private equity firm.)  Why is Mr. Ingle Stepping down?  He is 64; he has been running the company for 22 years, is staying on as “lifetime president” and looking to transition slowly and smoothly to a new management team.   Andrew Livingston oversaw Screwfix’s strong expansion of physical retail spaces across the UK, Germany, France, Spain and Poland as well as expansion into digital web driven sales.   All of these moves point to a smooth transition to the next generation of management and an eye towards European expansion.  However, the risk exists that management could in some way change the game plan and mess up what is an otherwise good thing.

Summary:

• Entrenched market leader in an essential service.

• Prudent management and history of execution.

• History of free cash flow and ROE growth.

• Strong balance sheet and financial stability.

• Low obsolescence risk. (difficult to Amazon, low risk self-manufactured production)

• Room to grow unit economics. (# of units and per unit sales growth via depot maturity cycle)

• Valued with 20% discount to intrinsic value.

• Additional upside potential via European depot expansion.