Has James Halstead become an expensive chugger?

The business

James Halstead has been in business since 1915. It started out dyeing, finishing, waterproofing and rubberising textiles that were used in rainwear and outdoor clothing. Today, it has established itself as a leading manufacturer and distributor of high-quality flooring for commercial, contract and domestic markets. 

Its main commercial brand is its Polyflor vinyl flooring product, which is used extensively in buildings such as schools, hospitals, airports, shops, leisure facilities, public buildings and factories. It is known for its hard wearing and safety properties. Among the company’s other brands is Karndean, an upmarket vinyl flooring tile used in homes. In overseas markets, the company sells other branded flooring under the names of Objectflor and Expona.

As well as the quality of its products, the company places a strong emphasis on aftersales and service quality as a way of giving it a competitive edge. James Halstead is operating in a business where a large chunk of its sales comes from refurbishment and repairs. By looking after its customers it is able to secure a significant amount of repeat business and therefore recurring revenues with the aim of generating significant customer goodwill that enhances the value of the company over time. Evidence suggests that it has been very good at doing this.

The business has UK manufacturing sites near Manchester and Teesside, as well as a large distribution facility near Oldham. Extensive warehousing facilities exist in Germany, Australia and New Zealand. The existence of local warehousing in overseas markets gives it a competitive edge and helps with its branding image that it is not just a seller of flooring but a manufacturer as well.

As well as making its own flooring products, it does source other products such as luxury vinyl tiles and rubber flooring that are sold under its name.

The company has a good track record of investing in its business so that its customers have access to products when they need them and that it stays efficient and cost competitive with its rivals. In recent years, there has been plenty of investment in its manufacturing facilities to bring down energy costs and enable it to produce more for lower costs.

The bulk of the company’s sales come from the UK and Europe. Australasia and Asia are a significant source of additional growth as are countries such as Canada. The presence of UK manufacturing and overseas sales means that the company is subject to significant currency risks both in terms of sales and the cost of imported raw materials. 

The weakness in the value of the pound in recent years has been something of a double-edged sword. Producing products in the UK and selling it overseas has been given a nice boost but this has been offset by the rising cost of imported raw materials.

James Halstead does hedge these risks where it can, but changes in exchange rates can still have a sizeable impact on the company’s reported financial results.

Most of the company’s products are sold to regional distributors in its target markets. These are complemented by having a local salesforce that sells the product to end users.

The company’s growth strategy has been focused on selling new and improved products and selling them in new markets. During the last couple of years it has launched products such as  Palettone, a premium sheet vinyl product and a wet slip version of Polyflor. It tends to take a little bit of time from when a new product is launched to when meaningful sales are produced.

Looking at the numbers

I have to say that James Halstead appears to have one of the cleanest set of accounts I have come across. While many companies today litter their income statements with costs they say are one-offs and won’t happen again – when they often do – and suggest that paying employees in shares in not a real cost – when it is – you will find none of that nonsense when looking at James Halstead.

This is a company that is not afraid to have lower profits today by spending money in the hope that it will bring higher profits tomorrow. A very good recent example of this was the company’s recent launch of its Palettone products. The £2m spent on development trials and marketing in 2018 was taken on the chin as a cost, which reduced profits and wasn’t shown as an exceptional item.

The first thing I look for in any company is evidence of its recession resilience. Will its revenues and profits hold up when the economy is shrinking? If they did not in the last recession then there’s a good chance they won’t in the next, which would probably put me off owning the shares as a long-term investment

This means that I will spend some time looking at a company’s revenues and profits between 2007 and 2010 and seeing if there were any big falls. This is especially relevant for a manufacturing business such as James Halstead, which has significant fixed overheads and operational gearing that makes its profits quite sensitive to changes in revenues.

If there are falls in profits in a recession, I won’t dismiss a business straight away. Instead, I will look to see if the company has changed in any way to reduce or stop the risk of profits falling again. If it has not then my interest in a company tends to end there and then.

James Halstead scores well on recession resilience as its revenues not only held up well in the last recession but actually increased.

The company’s recession resilience is due to a large chunk of revenues coming from repairs and refurbishments. These can be deferred for a while in order for customers to save money but cannot be put off indefinitely. Vinyl flooring also offers very good value for money and this can lead to customers switching to it when times are tougher.

It’s always a good idea to go back to the annual reports of the last recession and read what the company was saying about its business back then. This is taken from the chief executive’s statement from the 2008 annual report:

“In looking at the UK in general, which is our main market (although at 42.5 per cent of total sales it is not the majority), it is clear that economic conditions have been gloomy for a good proportion of the year. Having said this we have seen, to date, little evidence of a slowdown in our businesses for which we identify several factors. These follow in no particular order. Firstly, we have no UK-based manufacturing competitors of substance and increased transport costs and falling sterling have given us a degree of competitive advantage. In previous recessionary periods we have noted a “trade down” from more expensive commercial flooring (eg, carpets) and can surmise this may be a factor in the prevailing conditions in the latter part of last year (and into the current year). Additionally, we are of the belief that refurbishment demand is unaffected by the widely reported slowdown in the commercial sector in the UK. Finally, although market information in our sector is scarce and unreliable we have no doubt that volume in the resilient sheet flooring sector has grown and that we have taken market share.”

That said, what you can also see from looking at this chart is that growth has levelled off a lot since 2012 – an issue I will return to later.

The real hallmarks of James Halstead as a very high-quality business are shown in its consistently high profit margins and return on capital employed (ROCE). The latter has been on a declining trend but remains at a very high level.

The analysis of a company and its business should never be reduced to a painting by numbers exercise. It is important to understand how certain numbers are produced. The European flooring industry has been plagued by overcapacity for some time, which you would think would put downwards pressure on selling prices and profit margins. 

The company has said recently that there have been new entrants into European markets selling products of varying quality, yet its profit margins have held up remarkably well, especially considering that it has had to deal with significant raw material cost inflation due to the weakening of the pound.

Efficiency improvements have offset cost pressures. Also the company has kept its manufacturing plants well loaded by not increasing prices last year and taking market share as a result. Most encouragingly of all, it has been able to upsell more premium flooring products to its customers at higher margins.

The performance on cash generation – does it turn its profits into cash? – is not as impressive. Operating cash flow has typically been less than operating profits due to working capital commitments.

This, combined with the fact that the company has been investing in its productive capacity, has meant that capital expenditure has been more than depreciation in recent years, which has led to free cash flow being less than profits.

This can be a sign of something amiss, but in this case I think it is just a reflection of how James Halstead conducts its business. It needs plenty of stock available to satisfy customer demand and offers its customers sales on credit like many businesses do.

This means that when the business is growing its revenues it needs to spend cash to finance its working capital position. In recent years, 2014 and 2018 have seen big cash outflows but the trend does not suggest that investors have anything to worry about from a financing point of view.

Source: Annual reports

I must admit that James Halstead’s stock position does intrigue me a little. It has become a much more stock intensive business over the past decade – as evidenced by a rising stock to sales ratio – and this trend could be a cause for concern. 

Rising stock levels of finished goods increase the risk of having to cut selling prices at a future date to get rid of them or writing down their values to reflect this. Both cause profits to fall. We can see from its accounts that the company does male profits and losses from changes in the values of its stocks. Last year there was £2.6m of losses with £1.3m of profits the year before.

The other thing that you need to be aware of with rising stock levels is that the cost of stocks can often include the cost of direct labour and direct overhead costs to get them into a finished state. Building up stocks can be a way of reducing costs – and therefore boosting profits – expensed through the income statement by sticking them on the balance sheet instead.

I’ve no idea whether James Halstead is doing this but its general prudent approach elsewhere suggests to me that there is nothing untoward going on here. 

Elsewhere in working capital, the company is collecting money from its debtors faster, with its trade debtors to sales ratio coming down nicely in recent years.

Elsewhere its balance sheet is debt free with the company running a reasonably healthy cash balance. There is a small final salary pension fund deficit but this very manageable.

How can this company grow its future profits?

Meaningful profits growth has been quite hard to achieve for James Halstead in recent years. Operating profits have only moved forward £2m between 2015 and 2018 while revenue growth has been quite sluggish.

The big refurbishment projects that used to come from UK government buildings have been thin on the ground in recent years as cost-cutting has delayed orders. Overseas markets such as Germany have also become more difficult.

The good news is that markets such as the UK, France and Holland are currently growing strongly and that raw material cost pressures have eased. After delaying putting prices up last year James Halstead has done so this year and customers seem to have accepted them.

The company is expected to report record annual profits in September, but revenue growth is expected to have been no more than 3 per cent with profit margin improvements giving some additional profit growth.

New products such as Palettone should help profit margins stay high, but the company really needs volumes of work to grow. It is eyeing up new markets in Eastern Europe and South America but weakening economies across the world are a concern, despite the company’s proven resilience in tough times.

Acquisitions cannot be ruled out but are unlikely in my view. The company did look at buying the carpet tiles business of Airea (LSE:AIEA) but decided not to proceed with an offer for it.

James Halstead forecasts

Source: SharePad

I think there’s a lot to like about this company and how it is run. I can see why investors have bought the shares. The trouble is that the valuation of them has been very high for some time now and making money from them from a long-term holder’s perspective has been difficult given that the share price is around the same level as it was four years ago (although the shares are up 17 per cent this year).

At 491p, the shares trade on a one-year forecast rolling price/earnings (PE) ratio of 25.4 times, which looks expensive given the amount of growth the company is producing. James Halstead pays out a large chunk of its profits as a dividend, which gives the shares a yield of 3 per cent. Cover is quite thin and a prolonged reduction in profits could see this dividend come under threat.

Source: SharePad/Investors Chronicle

One of the things I like to do when weighing up the valuation of a business and its shares is to calculate the yield on cost at different rates of future growth. You can do this using numbers for earnings per share, free cash flow per share or dividends per share and divide them by the current share price.

What you want to achieve is a rising yield on cost that compensates you for the risks you are taking as a shareholder – the fact that  you are last in the queue to get a share of the company’s profits. 

I’ve looked at James Halstead’s earnings yield on cost in this instance. I’ve taken current consensus analysts’ forecasts out to 2021 and have then grown them at 5 per cent and 3 per cent thereafter out to 2029. The starting yield is 3.8 per cent and ends at 6.1 per cent with 5 per cent growth and 5.3 per cent with growth at 3 per cent.

That’s much better than you would get on a government bond or savings account – which is not difficult these days – but is it good enough? I’m not sure it is, and James Halstead’s share price over the last few years suggests that the market agrees. This leads me to conclude that as good a business as it is, James Halstead does indeed look like an expensive chugger.