Is life as good as it gets for Howdens?

However, for the past three years, its share price has been stuck in a trading range despite the business continuing to grow its revenues and dividends. Profits growth has been more of a problem, though.

Despite its exposure to the UK economy – and the housing market in particular – Howdens is a business that I’ve liked in the past. So I’ve decided to revisit it to see if its shares have been harshly treated or if life is as good as it gets for it right now.

The business

The company is a manufacturer and supplier of kitchen and joinery equipment. It makes kitchen cabinets and worktops at two sites (Howden in Yorkshire and Runcorn in Cheshire). It has its own brand of kitchen appliances called Lamona (ovens, hobs, extractors, dishwashers, fridges, washing machines, sinks and taps) and buys in other kitchen equipment from third parties. It makes around one-third of all the products that it sells.

Howdens is primarily a UK business. It does have 24 depots spread across France, Belgium and recently Holland, but as far as the value of the business and its immediate prospects are concerned it is virtually all tied up with its UK operations where it is the market-leading manufacturer and distributor of kitchens. It competes against other businesses such as Wren, Wickes, Ikea, B&Q and Magnet, as well as independent businesses.

The company has a number of characteristics that have given it a competitive edge over its rivals:

• By manufacturing its own cabinets and worktops, Howdens can supply its customers more cheaply than using third parties.
• It has its own in-house logistics operation of warehouses and trucks, which deliver to a nationwide network of 668 depots. This allows it to have a very tight grip on its supply chain not only in terms of costs, but also in terms of product availability to its customers.
• It sells to small builders rather than the general public and has an entrepreneurial culture. Each depot is managed as a separate local business. The depot manager has complete discretion on stock levels and pricing (with a confidential discounting policy) to adjust to local business conditions. All depot employees have a proportion of their pay based on the profit of the depot, which incentivises them to grow the business and offer high levels of customer service.

Howdens’ mission statement is to help local small builders make money. It aims to do this by having high local stock availability of quality products which are built to last and don’t break. This is complemented by an in-house kitchen design service offered to the builders’ end customers.

By competing on product quality and high levels of customer service, Howdens aims to build up a loyal customer base with a high level of repeat business. Most of its sales are made on credit, with builders typically given eight weeks to settle their invoices. This is very attractive to builders because it allows them to do a job and get paid by their customer before they have to pay Howdens.

Depot economics are very attractive

Howdens' depots are rented premises on out-of-town industrial estates in areas where there is an attractive potential market of small builder customers.

Each depot is around 10,000 square feet (sq ft), which costs around £5.50-£6.00 per sq ft in rent per year. The fit-out costs are typically around £300,000, with only 10 per cent of the space dedicated to showrooms and kitchen design. The bulk of the depot is used as cheap storage space in order to give high levels of stock availability to customers.

This approach is a lot cheaper than having high-street showrooms and all the extra overheads that come with them and is another source of competitive advantage for Howdens, allowing it to offer competitive prices.

Depots require around £650,000 to £700,000 of annual sales to break even, which tends to take around two years to achieve. Sales and profitability then tend to continue maturing for another five years.

This seven-year maturation process for a depot can give Howdens an important source of underlying sales and profit growth. Given the scale of the depot opening programme in recent years, around a quarter of its depots are still maturing, which is a nice situation to be in and shows up in its like-for-like sales performance.

Howdens' UK performance

As you can see from the table below, the number of depots and sales has grown significantly over the past decade. As I mentioned in my column last week, it is a good idea for investors to pay close attention to the quality of growth – is it coming from a good and sustainable source?

One of the things that stands out for me is the growth in the number of trade accounts per depots. This spiked significantly in 2016 and has remained static since then. One of Howdens’ key attractions to builders is its generous credit terms of eight weeks. The big jump in accounts does raise concerns that customer credit quality may have deteriorated – and increased business risk –  rather than a reflection of the depot managers’ ability to grow their business.

I’ll have more to say on bad debt risk shortly.

Howdens' UK depot performance

Source: Company accounts

Since 2009, Howdens has opened a lot of new depots in the UK. As these depots have gone through their natural sales maturation the business has delivered very good rates of like-for-like (LFL) sales growth. During the first half of 2018, LFL sales growth was a very impressive 10.7 per cent.

Average sales per depot have also been on a rising trend and have improved significantly during the past five years. Group operating profits have increased from £138m in 2013 to £237.4m in the 12 months to June 2018. What is slightly concerning is that operating profits have barely grown for the past 18 months as costs have grown faster than revenues and profit margins have come down.

Howdens is a very seasonal business. Its peak trading period is in October and November and over 70 per cent of its trading profits are made in the second half of its financial year (July-December).

How recession-resilient is Howdens?

The big concern for investors is whether Howdens’ profits can hold up well in a recession. People tend to buy new kitchens when they are feeling confident about their finances. The purchase of a kitchen tends to be financed out of savings or by borrowing money. Access to credit is a key driver of the market, with large kitchens (such as those related to home extensions) often being financed with additional mortgage borrowing.

A decline in the economy and the housing market is therefore a significant risk to Howdens' sales and profit prospects. However, if the experience of the 2008-09 recession was anything to go by then Howdens’ business model seems to have a high degree of resilience built into it.

LFL sales fell significantly in both 2008 and 2009, but profits held up well (when the end of the contract to supply its former business MFI is stripped out). The company stopped opening new depots from May 2008 and took £35m of stock out of the business. This helped it sell stock at the prices and margins it wanted to rather than being forced into fire sales of stock at depressed prices.

When the UK economy and housing market turns down again, it seems reasonable to expect that the company will try to deploy similar tactics. It will be dealing with a much bigger business, but its financial strength would put it in a good position to take market share from weaker competitors.

Financial performance – great ROCE but working capital a possible concern?

Howdens does produce very high returns on capital employed (ROCE) even when its rented premises are taken into account. Note that ROCE did turn down during the last recession in 2008 and 2009. It has also been on a declining trend for the past couple of years as the increase in money invested in the company has not been matched by an increase in trading profits.

Where Howden has perhaps fallen short in terms of a quality company threshold has been in its inability to consistently turn its operating profits into operating cash flow.

For many years, operating cash flow has been less than operating profit, although the gap between the two has closed during the past couple of years. In 2008, operating cash flow was negative due to issues related to the company’s ownership of MFI and the slowdown in trading conditions.

Poor operating cash flow conversion can be a sign of very poor profit quality and even worse that profits are being manipulated. I don’t think that’s the case with Howden, but rather a reflection of how it conducts its business.

The business carries high levels of stock (inventories) in order to provide high levels of customer service while also making the vast majority of its sales on credit. This makes the business very working-capital-intensive when sales are growing. That said, trends in stock and trade receivables levels need to be closely watched in a business such as Howdens. It is possible for an investor to spot possible warning signs by crunching a few numbers from the annual report.

Let’s look at stock levels first. As with any analysis of ratios and trends it’s always worthwhile to do this over a number of years – preferably an economic cycle.

Howdens stock analysis (£m)

Source: Company accounts

One of the most common ways of analysing a company’s stock is comparing it with its revenues. You should be wary of a rising ratio as it may be a sign that demand for a company’s products is softening and that stock values will have to be written down, which will reduce profits. Overheads can also be allocated to stock values and increases in stock levels can be a way of shifting expenses away from the income statement to the balance sheet to boost or preserve profits.

Stock has to be shown on the balance sheet at the lower of cost or net realisable value (NRV). If the value of stock falls below cost then the balance sheet value is written down and the reduction in value is charged as an expense against revenues and reduces profits. A rising stock to sales ratio can increase the likelihood of this happening.

Howdens' stocks as a percentage of sales have been rising in recent years and are almost back to the levels seen in the last recession. Stock write-offs have also been increasing as well.

What we can see with Howdens is that the allowance against carrying value (the write-down in value) as a percentage of the gross value of stocks increased significantly in 2016 and again in 2017 when over 11 per cent of the value of stock has been impaired. While not as bad as the level of stock write-off seen in 2009 during a recession, could this be a sign that the demand for some of Howdens’ products is softening and this is requiring a reduction in value of stocks? Alternatively, it could be explained by a stock build-up in advance of new depot openings.

The other ratio worth calculating is the value of finished goods as a percentage of sales. A rise in this ratio can be a sign of a slowdown in sales ahead or poor inventory management. This ratio has increased in every year since 2009 and is almost as high as it was during the last recession. I think this trend is worth keeping an eye on.

Are trade receivables as good as they seem?

Comparing trade receivables with revenues is a good measure of profit quality. A rising ratio can be a sign of a company over trading or offering more generous credit terms to drive sales. Earlier, I mentioned that the trade accounts per depot had increased significantly and that this might be a concern.

Trade debtors as a percentage of sales have been coming down, which at first glance is a good sign. But a deeper dive into Howdens' trade receivables suggests that all might not be as well as it first looks.

Howdens' provision for bad debts has been very similar for the past decade at between £8m and £10m. It represented 8.7 per cent of gross trade receivables in 2017. However, within the net trade receivables figure (stated after the provision of bad debts has been deducted) the number of accounts receivable that have not been paid and are overdue has been rising.

Trade receivables

Source: Company accounts

These debts have not yet been declared bad, but their proportion (23.2 per cent) of the net trade receivable figure on the balance sheet has increased significantly since 2013 and is approaching levels seen in the last recession.

I think this trend needs to be watched closely as well, as it could be a sign of deteriorating credit quality and a risk to profits if an increasing number of overdue invoices turn into bad debts.

Can Howdens deliver meaningful profits growth?

Profits growth has been lacklustre for the past 18 months and is expected to grow modestly in 2018.

The company is facing rising cost pressures on a number of fronts. Its cost of materials and bought-in products is rising and this is adding to rising costs from IT, new distribution capacity and higher depreciation. This is putting pressure on profit margins, yet City analysts are currently forecasting that margins will improve in 2019 and 2020.

I am a little bit cautious on whether those forecasts can be met. Sales growth will come up against quite tough comparatives also during the first half of 2019. Stock levels and credit quality also need to be watched closely. The UK housing market is also sluggish.

The company remains confident that it can increase the number of UK depots to 800 and is also eyeing the Northern Irish market. I’d be surprised to see much growth from its small base in Europe, given the lack of new depots in recent years.

More depots in the UK should see Howdens continue to pick up market share over the next few years. An ongoing share buyback should also support earnings per share growth. Yet I can’t help thinking that profits are close to peaking with this business given current trading and market conditions.

Profit growth issues aside, there’s not too much wrong with this business at the moment. I think there’s a lot to like about its business model and its market position. The fact that the new chief executive has come from Screwfix intrigues me a little. Both Howdens and Screwfix are very well run, trade-focused businesses and there could be some logic in merging them at some point in the future to create a trade retail powerhouse. Whether Kingfisher would want to part with its star performer remains to be seen.

Finally, there is the issue of Howdens' valuation. The shares don’t look overly expensive on a one-year forecast rolling PE ratio of 13.2 times at a share price of 462p. However, given its high working capital requirements and ongoing investment, it does not looks as attractive on a free cash flow basis, offering a forecast free cash flow yield of 4.5 per cent. Consequently, I think things could be as good as it gets for Howden and its shareholders right now and its shares could struggle to move higher for a while.