Howden Joinery is the sort of business that makes me feel good. It’s a kitchen/cabinet/door etc. supplier that services local builders – not a retail business, but serving hundreds of thousands of small builders across the country from its 500 depots. It’s easy to understand, clear and forthcoming with how it makes its money, and relentlessly customer focused. The 2009 annual report has a fantastic diagram (7th page, if you’re interested) which effectively outlines the length and breadth of their operations. They design the kitchens, source wood from UK forests, assemble the cabinets in factories in the UK to keep costs down – though using some imported parts – and deliver to local depots where they sell to trade.
They’ve certainly come far from the uncertain days of their 2005 split off from MFI. This left them with long-term debt, leases, and a shaky pension plan. Much of their first few years were spent sorting out these backroom issues but, since then, they’ve become a solid business in their own right with few of the scars remaining. Last year they earned £66.9m which, against their market cap of roughly £670m, leaves them on a P/E of around 10. Debt is practically non-existent, though the firm does obviously have facilities in place. Operating lease commitments sit at a total of £325.9m, which gives no cause for concern, as they paid only £48m last year. The cheap rates are primarily down to Howden’s refusal to target the mass market – they have no need for flashy prime location showrooms. The only concerning factor is the pension deficit, which is never a pretty sight on a balance sheet. Still, while I’m no expert on this particular field, the deficit looks reasonable and the assumptions used when calculating it tally with my own opinion. Salary increases of 4.5% pa, expected return on assets of 6.3%, and a CPI of 2.8% all seem fine for the long term. Attempting to analyse a pension scheme in any detail is a first for me, so I may well have missed some of the more intricate workings.
Operations-wise, the company earned revenues of £807.9m last year, on an operating margin of 13.3%. The feed-through from operational profit to investors is straightforward due to the lack of debt, though the effective tax rate is variable – last year their £100.9m profit before tax played off against an effective rate of 33.7%. A simple 5% revenue growth, taken from their performance in the first few months of this year, would leave them with revenues of £848.3m. Assuming the same margins as last year with finance costs remaining equal, if the tax rate were to revert to a hypothetical figure of 27%, Howden would have a net profit of £77.6m. I consider these undemanding figures (though by no means are they a given), and they put Howden on a forward P/E of less than 9.
The company is committed to growing steadily, too, and sees some residual growth even if they were to open no new depots. The chart left below shows the number of depots ‘maturing’ to maximum revenues over the next few years. This is an important indicator for Howden as they believe it takes 7 years for a depot to reach maturity and hit its full potential – a line which makes sense to me. Howden spend very little on marketing, so word of mouth and building up contacts is a slow and organic process. However, the company is planning to open more – they reckon the UK has potential for 650 depots with minimal cannibalisation. This is around a 30% upside from the current 490. They also operate 10 depots in France, though these should be seen as more of an experiment than anything else. The group tone stays conservative on expansion until they are ‘satisfied that all the necessary criteria for growth are in place’.
I’ve also included a table, using their statistics on depots through time, which shows how many of their depots are under 7 years old and thus expected to grow. These can be seen as growth prospects even if the group were to open no new depots, and I would venture this is what has enabled Howden to keep revenues roughly flat in the economic climate. It also alludes to potential for more powerful growth once the market recovers – it should be noted that Howden earned revenues of £976.5m pre-crisis, and it is their improving margin that has driven the profit figures. Should all depots earn the same average turnover in 2011 that they did in 2007, Howden would be looking at revenues of £1162m – nominally, not inflation adjusted. Of course, it’s not likely to happen that soon, but this is another potential upside to the firm – a recovery in demand for new kitchens.
As you can probably tell, I’m bullish on growth prospects. The company came through the difficult times by improving margin and making enduring changes to the business’s supply chain and structure. They’re now placed to be even stronger and maintain these margins when volume improves. And once again, the clincher for me is the fact that, even though I’m bullish on growth prospects, I needn’t be. Even if I forecast no improvement for the next few years, they are still selling at a single digit P/E.
Finally, the bit I’m sure you’ve all been on tenterhooks for – my macro view. Deja vu perhaps, but my macro view is mildly positive while accepting the chance of prolonged softness. Finding proxies for kitchen demand was a little difficult and stretched my imagination, but I managed to come up with a few. Firstly, we have a chart of real wages and unemployment. I think these are both important indicators for the demand for new kitchens, as they are essentially luxury and unessential purchases – of course, some demand will always be in the system as kitchens deteriorate over time, but it seems a little silly to suggest that the majority of kitchen replacements couldn’t be deffered. This potential for the deferral of spending makes unemployment and real wages important – if it’s not urgent, unemployed people are unlikely to be doing it. They have more important things to spend their money on. Real wages are a similar, though less extreme proposition – the chart shows the near 10% decline in real wages over the last 4 years. The implication here is that a larger amount of the household income will be going towards other more important purchases like food and fuel. Hence, they’re left with less for big-ticket items.
The retail sales (household goods) chart more or less confirms this hypothesis. Retail sales have been on a downward trajectory since the start of the crisis – and while the series isn’t perfect (it includes things like furniture, white goods, TVs etc.) I consider it to be a group of items that I’d think are along the same sort of lines. Still, unemployment is falling marginally and CPI will tail off sharply at the start of next year as the tax hike falls out of the equation. Essentially, this year is the economy’s adjustment period (yes, another one!), and given that Howden see underlying sales growth at 5%, they seem to be coping just fine. 2012 will, I think, be a more positive year in a general macro sense on a number of grounds, though in all honesty there is a lot of downside risk to my assessment – notably interest rates and slow wage growth.
Overall, the story that my readers have probably come to expect from me – a company that, yes, would love to see an economic recovery, but I think will do just fine if we totter along for a few more years, especially at the cheap price it’s selling at. I was slightly concerned about the relationship between Barratt, one of my bigger punts, and Howden – who I would have expected would be fairly related. Happily, Howden quantify their exposure to the big housebuilders – less than 0.2% in 2007. Admittedly out of date, but it tells the story, and I doubt things have changed that much!
That last lingering worry cleared up, I have no problem with Howden occupying a sizable slice of my opening portfolio.