Does Checkatrade check out for Homeserve investors?

A large chunk of Homeserve’s core membership business is mature with limited growth prospects. The exception to this is the US, where there is still more to go for. The company has made a big bet on online marketplace websites such as Checkatrade to deliver a step change in the company’s profit outlook. Will it pay off?

The business

Homeserve is based around three main businesses with the aim of being the world’s most trusted provider of home repairs and improvements.

Memberships

This is essentially an insurance business. It sells policies to households that cover home emergencies in areas such as plumbing, heating and electrics. In return for a monthly payment, customers have the peace of mind that if a pipe starts leaking or their boiler breaks then Homeserve will send someone to fix it.

Homeserve gets the bulk of its customers through partnerships with utility companies, insurance companies (typically as an add-on to a home insurance policy) and heating equipment manufacturers. Homeserve markets its services to their customers and pays them a commission for every one that signs up to or renews a policy.

The company has a strong competitive position in its chosen markets. It is the market leader in all of them except the UK, where British Gas still holds the top spot.

A closer look at the business highlights that it is heavily dependent on insurance companies to underwrite the costs of claims by policyholders. While Homeserve does the job of fixing problems with its own employees and subcontractors, it pays insurance companies such as Aviva in the UK to underwrite the risk that costs get too big or too frequent and blow a hole in its profits.

In essence, Homeserve is largely selling insurance policies on behalf of underwriters who pay it a commission for each policy sold. Its income from selling policies is therefore the net amount of income paid by policyholders less the underwriting fees paid to third-party insurers. It therefore has two sets of customers in this business: Policyholders who require it to put things right in the event of an emergency and insurance companies who pay it commissions for policies sold.

Buried in the notes to its annual report, Homeserve reveals that insurance companies accounted for nearly 60 per cent of its revenues in the year to March 2020.

As well as receiving commissions, Homeserve earns money from doing one-off repairs for its policyholders.

Heating, ventilation and air conditioning (HVAC)

Homeserve has been buying up installers of boilers, central heating systems and air conditioning units across its key markets, as well as providing these services itself. Not only does it see this as an area of growth as millions of pieces of equipment will need replacing over the coming years, but the employees that come with the acquired businesses can be used to serve the membership business, reduce the cost of serving them and drive up profit margins.

Apart from in the US, HVAC is not a major source of revenue for Homeserve at the moment.

Homeserve: Key performance measures by geography

Source: Annual report

Homeserve’s membership business is very profitable with high profit margins. Repairs are not as profitable, as shown by its Spanish business, where Repairs dominate the revenue mix.

The company has been able to grow its profits from its four key markets, but the underlying growth of the business in the UK, France and Spain is questionable, while the US has been a resounding success and has become the largest source of profit and future profit growth.

The UK business is shrinking in terms of customers and the number of policies held, but profits have been very healthy due to a reduction in costs, the loss of unprofitable customers and existing customers taking on more cover. Average revenue per customer has surged in recent years.

Profitability in France has been maintained at very high margins, helped by its very high policy retention rates, but there is not much sign of growth.

The Spanish business has suffered due to the loss of a key utility partner, Endesa, but has seen income per customer increase by 50 per cent since 2016. Customer numbers and policies have been falling.

Homeserve has made a tremendous success out of its US business. It has almost doubled its customer base and more than doubled its policyholders since 2016 as it has rapidly increased its utility partners. It has also received a boost from the devaluation of sterling against the US dollar, which has seen US operating profits surge from just £12.1m in 2016 to £85.4m in the year to March 2020.

Home experts

Homeserve is investing heavily in the home experts market, which seeks to connect tradespeople with customers over the internet. It has invested £200m in buying up online marketplaces including Checkatrade in the UK, Habitissimo in Spain and eLocal in the US.

By vetting tradespeople for the quality of their work and customer service they can then list their services on online marketplaces where customers looking for a trusted trader can contact them to do jobs for them.

Homeserve is trying to tap into a younger customer base that does not tend to buy membership insurance policies or take on do-it-yourself projects but wants someone reputable to do jobs in their homes.

Homeserve earns money from these businesses from collecting monthly listing fees from tradespeople and from advertising.

This is a business that needs scale to become meaningfully profitable in order to leverage the fixed costs involved in running the websites. To do this, Homeserve needs to build up a big network of tradespeople with the skills that people want. 

Home experts: trades and site visits

Source: Annual reports

The number of trades and website visits of the businesses is increasing, but so are the losses as the company is spending lots of money marketing its services.

Profitability is good but free cash generation has not been great

Despite the losses at the home experts business, the membership business means that Homeserve is making very good profit margins and making decent returns on capital employed (ROCE), especially on its operating assets (when goodwill paid on acquisitions is included). That said, ROCE is being depressed by heavy investment in home experts, where losses are increasing.

HomeServe: Key financial performance measures (£m)

Source: Annual reports/Investors Chronicle

The one area that does not look too great is free cash flow generation. Free cash flow margins picked up to a respectable level in 2020, but the conversion of profits into free cash flow was not great (anything above 80 per cent is deemed to be acceptable).

Granted, Homeserve is investing for growth and as long as the returns come through in the future the free cash flow performance should not be a concern.

One thing that is very striking in terms of its cash flow is that it has a very high rate of trade receivables as a percentage of revenues. This is largely due to the timing of payments of underwriting costs to insurance and the receipt of commissions back from them. This relationship would appear to favour the insurance companies in recent years, which means that Homeserve’s growth is coming at the expense of working capital cash outflows – the increasing receivables balance cannot be offset from increasing payables.

Homeserve: Trade receivables, payables and working capital cash flows (£m)

Source: Annual reports/Investors Chronicle

US Membership growth potential looks good, but Checkatrade could be an expensive gamble

Homeserve still looks very well placed to grow its membership customer base and profits in the US. Compared with the UK, the US remains an underpenetrated market for home emergency cover policies. 

The company’s ambition is to take its customer base from its current 4.4m to 6m-7m over the next few years, while increasing revenues per existing customer from $102 per year to $120-$125.

With the help of some operating leverage, this could see operating margins increase into the mid 20 per cent range, which would more than double operating profits from $109m currently to $230m (c£184m). The timing of such gains is unknown, but at the current rate of growth in policies could take at least another five years.

This on its own should enable Homeserve to deliver a reasonable rate of profits growth. However, its UK membership business looks as though its profits have been squeezed very hard in recent years, and in the absence of revenue growth it’s hard to see much in the way of profits growth coming over the next few years.

The good news is that the membership business has been very robust in response to the impact of Covid-19. Emergency repairs have been going ahead as normal while marketing expenditure has been cut back.

The big concern that I have with Homeserve is that its Checkatrade and other home expert investments could be a flop and have a long way to go to generate acceptable returns on the money invested in them.

Homeserve management has talked bullishly about the prospects for this business. They have compared it with other online marketing businesses in areas such as property (Rightmove), cars (AutoTrader) and travel.

It is true that these types of businesses can make fabulous profits as they acquire scale and leverage a large fixed-cost component of running and managing a website business. Homeserve has provided some very ambitious targets and profit numbers to make the case to investors that it might be sitting on a potential pot of gold with Checkatrade.

By taking trades from the current 39,000 at an average revenue per member of just over £1,000 per year to 150,000-200,000 members at £1,200-£1,300 per year, it estimates it could be making operating profits of £45m-£90m. This would imply profit margins of 25-35 per cent.

This looks very ambitious to me and ignores the fact that businesses such as Rightmove, AutoTrader and Hargreaves Lansdown, which utilise similar website platform economics to great effect, have monopoly market positioning and tremendous scale.

Checkatrade is already competing in a crowded field in the UK. it has to compete with websites such as MyBuilder, Rated People, Local Heroes (British Gas) and Facebook community sites. On doing a bit of digging on internet trades forums it would appear that Checkatrade has a decent reputation but that its fees (around £80 per month full price) are seen as expensive.

There is also a concern that the structure of the website needs to change as too many of the new jobs generated by the site go to the businesses at the top of the list, which can make it difficult for new tradespeople users to feel they are getting a good deal.

This is possibly highlighted in Checkatrade trade numbers last year. They increased by 3,200 to 39,000, but this was after 16,000 new additions which meant that 12,800 left, implying a churn rate of more than 35 per cent on the 2019 year-end level.

Perhaps the most powerful force against the likes of Checkatrade is that by far the best way for tradespeople to win business and for customers to have confidence is by word of mouth.

The business is also likely to be very cyclical and vulnerable in a downturn, as we are seeing right now. Nearly 80 per cent of trade members on Checkatrade are receiving a 50 per cent fee discount, with the remainder moving to a free affiliate membership. Around half of new sign-ups are opting for a paid membership. 

Checkatrade is now only expected to break even in the year to March 2023 and will continue to act as a drag on any US membership profits growth until then. How big a drag remains to be seen.

I will be happy to be proved wrong on Checkatrade, but I can’t help feeling that it is going to be very hard work to make this investment pay off. A weak UK economy could mean it ends up doing more harm than good for a few years.

A resilient business, but the share price is up with events

There’s much to like about Homeserve’s very profitable and resilient business model and the prospects for further growth in the US. Despite the disruption from Covid-19,  earnings per share (EPS) is expected to increase very slightly from 41.3p last year to 42.3p for the year to March 2021 and 48.8p for 2022.

At a price of 1,310p, the shares trade on a forecast price/earnings (PE) ratio of 31.7 times 2021 forecast EPS, falling to 26.8 times. That’s not out of kilter for high-quality businesses in the current stock market environment, but the company’s move into home expert websites looks very risky to me and could dilute the good work being done in the US membership business. This makes me think that the shares are fairly priced right now.