Buy into the Kingfisher turnaround

While lockdowns have been a thorn in the side of most retailers, for DIY specialist Kingfisher (KGF) it has meant a sales surge. The group has benefited from its shops being catagorised as "essential", which has allowed them to trade during lockdown. Meanwhile, housebound individuals have discovering a passion for home improvement. 

This  jolt in demand could not have come for a better time for the group, providing a tailwind for the turnaround strategy of recently appointed chief executive Thierry Garnier. Indeed, many of the consumer trends that have been accelerated by lockdown, such as increased online shopping, play directly to the group's long-term goals.

The buoyant trading conditions coupled with strategic changes have led to a flurry of broker upgrades, with the shares hitting a new 52-week high and the evaporation of historical short interest. These are all very positive signs and we see potential for more good news to come as the lockdown-dust settles and the benefits of the jump-started turnaround become more evident. 

Kingfisher's problems and potential

Kingfisher operates stores for the DIY, trade and discounting markets. In the UK and Ireland, its largest markets, it trades under the B&Q and Screwfix marques and in its second-biggest market, France, it operates as Castorama and Brico Dépôt. Kingfisher is also present elsewhere overseas, including in Poland and Romania and has several exclusive product brands, such as "Cooke & Lewis" and "Veuvre".

But for several years the company has struggled despite strong market positions, brand recognition, and less online disruption than most other retailer sectors. Chiefly, Kingfisher seems to have been dogged by competition and an overly centralised approach leading to poor execution.

Since peaking in 2012, gross margins have gradually dropped from 37.5 per cent to 36.3 per cent in the year to the end of January 2020, while operating margins are down from 7.7 per cent to 6.2 per cent, which excludes substantial exceptional charges over the last two financial years. Sales progress has been sluggish over that time, too, with top-line growth of just 8 per cent and a drop in pre-exceptional operating profits of 12.5 per cent.

The decline in profitability, partly reflects depressing like-for-like sales trends over the period, which can be seen in the accompanying graph.

The experience in France, where Kingfisher has faced stiff competition from rival ADEO, has been particularly gruelling. ADEO has historically pursued a decentralised model, allocating greater responsibility to divisions and stores decisions over areas like range selection, a model Kingfisher is now adopting. The French division has seen retail profits drop by over 60 per cent since 2012 to £164m last year. That puts profit almost on a par with the group’s Polish operations despite France generating almost three times the turnover (see pie charts).

In the UK, B&Q has also struggled, although not quite as badly as the French operation. Fortunately, the UK has  benefited from the growth of trade-focused Screwfix. True, as Screwfix has rapidly grown its UK store numbers from 147 to 686 over 10 years, new openings have begun to mature and like-for-like growth rates have trailed off significantly in recent years. But Screwfix is the jewel in Kingfisher’s crown.

Its shops are based in high-density areas, and last year 97 per cent of the UK population was within 30 minutes of a Screwfix store. Tradespeople tend to need products at short notice, which drives footfall into Screwfix shops and facilitates a high turnover of stock. This appeals to Ninety One fund manager Alessandro Dicorrado, whose UK Special Situations Fund (GB00B1XFJS91) holds Kingfisher. “We like to ask [Kingfisher’s rivals] the question, ‘if you had a bullet to take out a competitor, which one would it be?’” he says. “Almost to a man, they say Screwfix.” 

Fixing the roof while the sun is shining

Mr Garnier arrived at Kingfisher from his role as the head of Carrefour’s Asian business in September 2019. His plan is to “Focus and Fix” the business this year, before moving on to a plan to "Simplify and Grow". The overall strategy has been dubbed “Powered by Kingfisher”, which underscores the desire to devolve decisions from the centre.

As part of this drive, new management has been put in place in key parts of the business. This has helped a push to source products more suited to local markets through Kingfishers different ‘banners’ (for example, B&Q and Screwfix). The company will use its scale to source inventories from top suppliers and strengthen its exclusive product brands.

One area where problems related to the old centralised approach had been reflected was a build up of stock. Based on FactSet data, days of sales held as inventory rose from 98 in 2012 to nearly 130 in 2019. It's therefore encouraging that this trend began to reverse last financial year, even before the Covid-19 demand spike emptied shelves.

Supply chain inefficiencies had also created an unsatisfactory level of product availability, especially in France. But product availability at Castorama rose from 93 per cent to 98 per cent at the end of 2019 following the implementation of a new IT system. Importantly, there are signs that consumers have been warming to the new ranges as Covid-19 restrictions have boosted demand. For the first time in years, the company appears to have gained market share in France, from June to August. 

A revamp of Kingfisher’s store portfolio is also under way. The company is experimenting with smaller stores staffed by a handful of experts, providing an improved service and the opportunity to renegotiate its spending on rent. As of its most recent half year, it had slashed its rent outlay on seven stores by around a fifth. Kingfisher has also moved a large portion of its rents from being paid in advance on a quarterly basis to monthly.

Stores will play a big role in expanding Kingfisher’s e-commerce offering, which was a fifth of its half-year sales compared with just 7 per cent in the prior year. While this figure was inflated by lockdown, stores are critical to facilitating click-and-collect sales, which are its most profitable online sales. They accounted for over 90 per cent of online orders over its first half.

And while the recent strength of trading should not be expected to continue, there are signs that DIY habits are becoming entrenched. Nearly three-quarters of those who have carried out more home improvements themselves during lockdown expect to maintain their new hobby, according to a June survey by broker Jefferies.

Forecasts up, shorts down

Over the last two financial years Kingfisher has booked large exceptional costs of just over £700m. Among other things these relate to store closures, disappointing IT projects, property impairments and a £130m write down of its troubled Russian business. While the exceptional costs reflect the challenges the business faces, it also provides something of a clean slate for the new boss. This has helped underpin a raft of recent upgrades. With so much ground to make up, especially in the French business, further upgrades could be on the cards even as the lockdown-boon recedes. Encouragement can also be taken from the recent fall in short interest.

One Kingfisher constant, which will support the company through any volatility, is its balance sheet. Its net debt was around level with its cash profits (Ebitda) at its recent half, sitting far below its target of 2 to 2.5 times cash profits. Its pension schemes, meanwhile, are fully funded.

While the shares have risen as trading has boomed, we think momentum should continue as focus switches from the temporary bump to the long-term value the turnaround strategy has the potential to create. While there is still plenty that could go wrong, valued at 15 times forecast 2022 earnings we thing the shares represent a good bet.

Last IC View: Buy, 283p, 22 Sep 2020