Howden Joinery (HWDN)

Getting some credit

Howden have been one of the strongest performers in my portfolio and are one of its formative members, but I mustn’t let nostalgia and the fact I like the company get in the way of making an informed judgement. Eliminating our biases is easier said than done, particularly as Howden is a company that feels like it follows my journey as an investor. My buying reasoning back in mid-2011, as I was just getting to grips with investing and different techniques, was basic and a little quirky. I’d identified that I liked the company, but couldn’t particularly articulate why, beyond it being stable and reasonably cheap. Unlike some of my early choices, though, Howden never struck me as an amateur mistake – an oversight of something, or a fundamental misunderstanding. The opposite, in fact – the more companies I looked at and had to compare them to, the more I liked Howden’s way of doing things. For a far better explanation of Howden’s business model than I’ve ever been able to put on paper, look here.

The price is up about 110% in the time I’ve held it, though, and that should give anyone pause for thought about the continuing value. It is essentially the same business, too, with everything basically identical except for a few more depots (and the improved revenue and profits that come with that). Such a large price appreciation with a relatively small change in profits and (though this is a subjective metric) prospective profitability means the market has dramatically changed its opinion on Howden. What was a definitively ‘value’ company, selling at a small multiple of profits even with obvious growth prospects, is now priced more like the maturing, yet still growing established business that it is.

Prospects

I don’t hold many companies like Howden Joinery. My lot, in my experience so far, has mostly been with cheap companies. They might be cheap for a reason, of course, perhaps having a price that overdoes the pessimissm, but you’re unlikely to find diamonds by looking only in the bottom x%. In short, there’s a quality spectrum, and I’ve tended to focus on the lower end of it. That’s a consequence of the way I’ve screened for shares – using loose proxies for value like P/E and P/TBV too stringently means you’ll be focusing on ‘cheap companies – good and bad’. A more holistic approach allows me to look for ‘good/great companies trading at average valuations’. That’s something I’m trying to figure how best to do with the tools currently available to me.

And that presents me with an unusual dilemma. What price is reasonable to pay for Howden’s quality? Quality, as I’ve mentioned before, is best represented numerically to me in two ways – consistency of expected cash flow, and high returns (supernormal, in excess of cost of capital). A quality company, like Coca-Cola, has a large enough competitive advantage that their cash flows are more or less secure, and they earn above-CoC returns. Aside from the quality issue, there’s also the question of growth. Management have been saying for years that they think the UK could manage more than 600 depots. They currently have 529. I’ll also rehash a graph from my first post on Howden, though note that my forecast depot figures are now off. I’d penciled in 30 opening; in actuality, only 20 did.

So there’s an extrinsic growth driver – management spending money on new depots they think will be profitable – and an intrinsic growth driver, too. There are potentially others, of course – overseas expansion(they have some depots in France) being the obvious one. There’s both a clear negative and clear positive to that idea. Positively, the business model is provably superb, and the company has proven expertise in executing it. Negatively, there are all sorts of differences – including ones I’m sure I can’t even comprehend – between countries. France’s population density, for instance, is an obvious factor that probably dampens the profitability of a ‘local hub’ model like the one Howdens have. Management say the ‘inherent costs of doing business in France’ mean it’s unlikely to ever be as profitable as the UK.

Valuation

If you’re into DCFs, I reckon Howden Joinery is one you can fairly easily model with one. A quick back-of-the-envelope valuation I just jotted down came up with a value almost identical to the current market cap – and that’s without tinkering or pre-manipulating the inputs to come up with the output.

They key drivers, I think, are twofold. Firstly; do you think Howden Joinery has a sustainable competitive advantage? It will need this to justify it’s current valuation, at a level many times its current tangible operating assets. It needs to earn high returns to justify that. Personally – I think their advantage is sustainable. I think they have an entrenched, well-differentiated, customer-focused product, a supply chain which is neither cheap nor fast to build (deterring entrants) and, I suspect, enough saturation to put off prospective competitors, too.

Secondly, though, just how much growth do you think there is? If we take management’s 600+ depots at face value, there might be perhaps another hundred from here – about 9-10% more depots. The developing depots question is more difficult to quantify. Looking at it now, I actually suspect you could probably tease out a relationship from the data, but the figures might be a little noisy for it. How much more growth can we expect from new depots maturing? Totting it all up, I guess the underlying company maybe has 30% to go from here. It’s a guess, but it’s a guess with a tiny bit of guidance from what we know.

I think we’re probably about fair value here. The question for me now is whether to sell, which entirely depends on if I find somewhere else to put the money.

11 Replies to “Howden Joinery (HWDN)”

  1. red.

    One other factor: each depot becomes more profitable (via increased sales and increased gross profit) as it ages. So the current revenue and operating profits understate the earning capacity of the business at the current store count.

    And, as the legacy pension obligations are paid off at a rate of 34 million per year, another 40p of value is being added to the value of each share. That 40p is, by itself a 20% annual return..

    • red.

      HWDN is trading at the same enterprise multiple as KGF. HWDN returns ~25% on capital compared to KGF’s ~8%.

      And HWDN’s enterprise multiple (9.8x) is substantially below TPK’s (12.8x) even though HWDN is a betters and faster growing business.

      The reason, I think, is that investors fear pension liabilities a lot more than they fear bank debt. So, paying down the pension liability will reduce the cost of capital.

      HWDN, given its quality and organic growth profile, should be trading at an enterprise multiple above that of TPK, say 12.5x. At a 10.5x enterprise multiple and with 35 million less in pension liability, the value of the equity becomes ~250p. At 11.5x and another 35 mill reduction in pension deficit, the equity is worth 300p etc.

      Add in the effect from paying down legacy leases, the gross margin improvement as depots mature, and the reversion to normalized sales per square foot as the economy stabilizes, and the current market cap seems to me very safe.

      If Britain is really to turn its greenbelts into suburbs, the upside might be substantial.

      • Lewis

        Thanks, food for thought.

        How did you get a 25% RoC? I came out at somewhere in the range of 15 – 18%. I am probably underestimating by a decent amount given that I left cash in working capital, but even if I back that out it only adds a couple percentage points on.

        re: your first comment; I was sort of trying to thrust at the improving profitability of individual depots over time with my old graph. I hadn’t thought so much about the sales/ sq. foot issue, and it’s a good one. If we take ’06 as the base year and just increment 2% a year for inflation we end up with sales per depot about 30% higher than where it currently sits. Using ’07 with the same exercise gives us even more upside. The trouble is that both are (completely subjectively speaking) frothy bubble years. I’m not sure what a reasonable level of reversion to expect would be.

        I’m guilty of fearing pension liabilities more than bank debt. Like everyone else, it’s probably the open-endedness that does it; though I wonder if now might be exactly the right time to flip that, since perhaps now is a turning point after market conditions colluded to make otherwise quite well-funded schemes look shaky.

        • red.

          The legacy leases are hiding the real ROC. So, current year OPERATING rent (i.r. rent for the depots) = ~39m rather than ~50m. Adjusting for that and for the charges paid for terminating the legacy leases will get you to 25%.

          Legacy rent was 24.5m, 18m, 12m, 11m, and 4.9m in the years 2008 to 2012. Lease termination expenses were 6.5m, 28.3m, 25.5m, 17.9m, 11.7m in those years. And since the legacy leases were put to the company virtually immediately after it split from its weak sister, the underlying strength of the business has always been obscured from view.

          Adjusting for the above, I have 2012 pretax operating income at 134.5m.

          I was in England for a few days a little while back and caught a show (on Beeb2?) called The Planners. It left me with the impression that the government is determined to encourage construction as a way out of the current doldrums. Planning restrictions being relaxed beyond all precedent, etc. If that’s so, the boom may be yet to come and HWDNS is in the sweet spot.

          I don’t know that I would start a position in HWDNS at the current price (probably not; I’m a perennial optimist, hoping for the fall in price of my favourite stocks!), but I think I’d be inclined to stay in if I had.

          https://docs.google.com/spreadsheet/ccc?key=0AnH19qeUPSwgdHNKcnRSdmdGYldhZ21JMGhSZ0YwalE#gid=2

          The other thing I was thinking about was the clustering of depots in northern France. It seems to me that there’s a chance that the idea was/(is?) to spread to Benelux and Germany in concentric circles, so the 600 stores in the UK may not be the end of the runway…

          • red.

            re: pension liabilities, I agree with you. (In Howdens’ case, though, it seems to me that they are legacy liabilities and therefore closed ended; it should see the liability more or less eliminated in 4 years).

  2. Striver

    My thoughts are that if I like the business and it has a strong advantage then I will hold on even if it is at fair value. While you wont be getting 100% returns again from a fairly valued business, you can still get reasonable 10%+ returns per annum. Beats sitting on the cash.

    I usually only sell businesses like this if they are overvalued, or I forsee risks in the future which the current price doesnt seem to have made allowances for.

  3. Lewis

    Thanks all.

    I will hold on to the shares – I’m unsure about those growth prospects, but with the appropriate revisions I don’t think they’re necessary to make it a good prospect anyway with the obfuscation of the underlying operating business.

    And it definitely does beat holding cash, particularly as there’s a dearth of interesting stuff on my radar at the moment!

  4. Laurence

    Hi Lewis,
    Firstly thank you for your’re posting of these various articles. They are concise and clear and I’ve been a keen follower for the recent past.

    May I ask you; you mention above that you’re screening proxies have moved from simply p/e & p/tb. How has your screening evolved and what has it evolved to.

    I use low p/5 year ave earnings, ROCE or ROIC & low gross gearing.

    Tks
    Laurence

    • Lewis

      Hi Laurence,

      The problem at the moment is that I haven’t really moved my screening on. I screen on RoC, but since Sharelockholmes doesn’t capitalise operating leases or make the adjustments I want to make to the financial statements, it’s a bit of a blunt instrument.

      Ideally I’d want to screen on Return on Invested Capital to come up with a shortlist of quality companies, and perhaps screen for poor RoIC in combination with low PTBV to identify potential opportunities for mean reversion.

      I think Stockopedia might do this. As usual I am being irrationally slow to adapt and overly attached to the status quo. Thanks for the shove in the right direction!

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