A peerless profit machine

James Halstead is an improbable firm. It makes extraordinary profits from manufacturing a boring everyday commodity. It tells the competition how to do it, yet in terms of profitability it has no peers.

The company manufactures the durable, recyclable, and utterly unremarkable vinyl flooring we have treaded on without a thought every day in shops, offices, factories and hospitals and onboard ships for generations. Though the product is unremarkable, the company most certainly isn't.

If I were to choose one financial statistic to judge the performance of a business it would be return on operating capital, the profit a firm makes in a year compared to the money required to operate the business. James Halstead's return on capital over the last eleven years has averaged nearly 40%.

When you put money in a bank account, the return you get on that capital, your profit, is the interest rate. When James Halstead has invested shareholder's capital in offices and machinery, it's done a lot better than saving money in the bank.

Cold, hard cashflow

If I were to choose one financial statistic to verify the performance of a company, it would be cash conversion. How much of the accounting profit has actually flowed through a company's bank accounts.

Over the last eleven years, profit in cash terms has been just shy of 90% of profit in accounting terms. The discrepancy is not large and is easily explained by growth. Over the same period James Halstead has grown revenue 80% and profit nearly 180%. It has raised the dividend in 41 consecutive years.

It may have earned lower, but still very impressive levels of return on capital in previous decadesTo make and sell more flooring the company must spend money on new equipment: machinery, vehicles, and computers, say.

The cash flows out of its bank account immediately, but less is deducted from profit because the cost is spread (depreciated) over however long the accountants expect the equipment to last.

New investment reduces profit less than cashflow, therefore, but the investment will more than pay for itself in cash terms if the company continues to earn a high return on capital.

I haven't deliberately picked a favourable period to measure. When I first get seriously interested in a firm, I calculate the statistics for ten years if I can, and, while I follow the company, I add to my data-trove every year.

Looking even further back in SharePad, the company may have earned lower, but still very impressive levels of return on capital in previous decades.

That special something

Surely there must be something special about James Halstead's vinyl? Something that explains such high levels of profitability and growth from a product that has existed for over half a century.

Innovation has been an important factor in Halstead's growth since it developed Polyflor 50 years agoThere isn't. James Halstead's finance director stood on the carpeted floor of a small auditorium a couple of weeks ago and told a gathering of investors that if that floor were vinyl, he'd be hard pressed to tell whether it was one of his firm's or one of its competitors'. In some markets it buys vinyl flooring from other suppliers.

Every year, the company says a handful of multinational competitors, perhaps French groups Gerflor and Tarkett among them, paw over its financial statements to find out how it can be so profitable, so I asked Gordon Oliver whether he can explain. His reply was somewhat cryptic. He said he can't understand why competitors are so much less profitable! I reckon he has a good inkling, though.

Let's not throw the product out of contention completely. Innovation has been an important factor in James Halstead's growth since it developed Polyflor 50 years ago. Slip-resistant safety flooring, developed 25 years ago, has been a major factor in the company's growth and it regularly reports new innovations.

Last year it collaborated in a study into contrasting flooring for dementia sufferers. This year it's investing in the equipment to produce wood-effect flooring. Halstead's flooring must be as marketable as its competitors for it to stay ahead, let alone increase its lead.

But innovation is only one part of the value chain, all of the activities required to turn salt (chlorine) and oil (ethylene) into vinyl, and put it on the floors of buildings and boats. Companies don't just compete with each other for profit, they compete with their own suppliers, manufacturers and distributors to maximise their share of the profit from flooring.

Perhaps sales is JHD's 'secret sauce', and relationships with distributors, architects and consultantsLargely, James Halstead manufactures its own vinyl flooring in high volumes in Manchester and Teesside, but though it might have an edge here and there, Oliver suspects it has similar manufacturing costs to competitors.

Supply is dependent on commodity prices, principally ethylene, driven by demand from the construction industry which uses it to make uPVC windows and doors. Ethylene prices probably impact competitors similarly too.

So, by elimination, perhaps sales is James Halstead's secret sauce, and its relationships not just with distributors, but the architects and consultants that specify the products that furnish buildings are crucial to profitability.

Reasons for success

The last two points on a slide in Oliver's presentation entitled "Reasons for success" are "Focus of sales force on end specifiers", and "Strong management of relationships with stockists". Oliver emphasises he prefers to think of distributors as stockists. That, and the emphasis on the company's own sales force, seem to negate or diminish the role of distributors, often large successful businesses like Headlam, in sales.

Halstead needs distributors to supply large projects like hospital refurbishments by the van load as and when they need it. However, if it wins the contract it can negotiate down the distributor's profit margin substantially, and increase its own. A large part of the value, it seems, is in the sale.

Competitors, are less restrained, open to the costs of supporting big ranges of products in different marketsYou can tell a lot about a company by what it doesn't do. James Halstead only supplies the commercial market. It supplies sheet in the main, and not tiles. It doesn't have many customers in the USA, where they measure in inches and prefer glossy and gawdy (to our sensibilities) tiles.

Its competitors, though, are less restrained, which opens them up to inefficiencies brought on by the requirement to manufacture, stock and support huge ranges of products in different markets.

Another slide in Oliver's presentation is entitled "The UK Market for RESILIENT SHEET Refurbishment is VERY important" (his emphasis). Hospitals and shops and other public and private sector organisations refurbish surprisingly often, more frequently than the 15 or so years the flooring might last.

Oliver's table shows that refurbishment accounts for 70% of the market compared to 30% for new build, placing James Halstead in, perhaps, a surprisingly stable market.

A company that performs better than its peers for a long period rarely just does one thing better. Its advantage lies in the interaction of numerous factors. James Halstead is more focused on commercial sheet vinyl, and being more focused, perhaps it can put more of its effort into getting its brands specified, capturing more of the value in flooring.

The opportunity to buy the shares at a more obviously attractive price may be a distant prospectThere is a snag for investors, though. While the value in prosaic companies often goes unnoticed in the stockmarket, it's difficult to hide a record like James Halstead's. While it can reinvest capital at high rates of return, we can't invest our capital in James Halstead at an obviously high rate of return.

A share price of 460p values the enterprise at £951 million, about 25 times adjusted profit in 2016. The earnings yield, or interest rate, to use my earlier analogy, is just 4%.

I'm not one for speculation, but despite a halt in the company's growth in 2016, the opportunity to buy the shares at a more obviously attractive price may be a distant prospect.

Up until the UK voted to leave the EU, the strong pound had been holding back exports, which account for about 60% of revenue. Now that exchange rates are more favourable Oliver expects to target India and Canada, particularly with cheap vinyl exports.

Since neither of James Halstead's plants are operating above 60% of capacity, the company could meet greater demand without heavy investment.

*In case you are wondering, the other reasons for success given by the company were: Strong production focus, strong balance sheet, good reputation, customer service, and research and development.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.