HOWDEN JOINERY GROUP (LSE:HWDN)

 

10/10 for Howdens business model

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Howden Joinery has enjoyed a spectacular turnaround since 2005 when MFI, the once ubiquitous retailer, appointed the head of its trade business as chief executive.

Mostly due to problems in the retail division, profitability had collapsed, the company made a loss that exposed it’s financial vulnerability from debt, pensions liabilities, and leases that were no longer productive.

The new chief executive, Matthew Ingle, sold MFI, which subsequently went into administration and now exists as an online brand. He sold or closed a number of peripheral brands including Sofa Workshop and businesses in the USA and France.

All that remained was Howden Joinery, the company he started in 1995, and Howden Kitchens, the division that manufactures kitchen cabinets and most of the worktops Howdens sells, and sources frontals, sinks, taps and other kitchen products. Ingle’s team merged them into the entity that is listed today.

Then it executed what insiders must have known was a very profitable business model to restore the company to financial health. Now Howdens is highly profitable, onerous leases are diminished and probably not significant, the company has net cash (excluding lease obligations), and though the pension deficit is still large and volatile Howdens has demonstrated it has the means to plug the gap between liabilities and assets should it remain the stalwart it appears to be.

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Prudently, the company is still cautious enough about the hidden leverage in depot leases and the pension fund that it intends to operate without incurring bank debt.

Were it not for the relatively high valuation, Howdens’ earnings yield is just 6% according to my model, it would be a very strong candidate for the Share Sleuth portfolio because, with considerable help from Ingle who articulates the strategy articulately in the annual reports, I can identify its competitive advantage and that should enable it to remain highly profitable.

Carving out a unique business model in a fairly mundane industry means being good at a lot of things, each of which is dependent on the others. It’s the interdependence of the capabilities that makes the model hard to copy, or at least that’s the theory.

Management expects Howdens to grow by opening new depots, twenty in 2012 out of a total that now stands at 529. It thinks 700 are feasible, but 30% of the existing depots have yet to mature and should also make a greater contribution to profit in future.

To prosper, Howdens must maintain its strong position in the market, which it does by concentrating on one customer, the small builder. It gives builders enough credit to enable them to install the kitchen and receive payment from the customer before paying for it. In return builders are its retail sales force and the end point of its distribution network.

Trading with Howdens confers a number of advantages beyond credit. The company keeps its entire range in stock so builders can be confident they won’t experience delays. Changes can be made to the specification of the kitchen after it has been designed right up until the builder picks it up. Howdens provides the designers.

Remaining fully stocked is only affordable because of Howdens' high volumes, up to 120,000 cabinets a week, and lean manufacturing which means it can match supply to demand and only keep one week of stock. Depots are typically located on trading estates where the rent is cheap, and manned by only 10 staff members who are motivated to develop strong relationships with local builders by a share in the profits of their depot.

Although it provides well made kitchens, its competitive advantage is it can supply kitchens of sufficient quality at low cost to builders.

Ingles says:

What this all adds up to is that Howdens outperforms because we are clear about what we are doing. We design and build a professional product, with an up-to-the-minute design, that requires a professional fit, and we sell it to professional fitters who can go and pick it up from local stock day in, day out; and because we give them a truly reliable service, and a confidential discount, they can make a living out of it.

Unfortunately I’ve discovered Howdens after a big run up in the share price, and the price is more than I’m prepared to pay. This fine looking company joins the watchlist and enters the yellow zone of the matrix.

Watchlist Matrix (5)

Esteemed fellow bloggers Expecting Value and the red corner found Howdens first. Red’s research includes a much more deft valuation and Howdens was one of EV’s first portfolio holdings.

Some notes:

  1. Although 2012 was a week longer than 2011, the company did not trade in that week and still incurred costs so it probably had a detrimental effect on the results.
  2. Ingle is required to own 200% of his salary in shares. In 2011 he owned nearly 500%. The rule is a positive sign, and so is the fact that he exceeds it.
  3. The defined benefit pension deficit is £155m
  4. My figures include all leases, including unproductive ones, which should properly be removed as the model evaluates the operating business. Although removing those leases would reduce the market’s valuation somewhat, I don’t think it’s significant.
  5. The company pays annual rent of £4m net of sublets on unproductive leases. This should halve by the end of 2014 and peter out by 2025 when the last lease expires. Howdens will probably have negotiated its way out of the remaining leases before then.

Comments

Hi Richard,

I follow everything in you calculations except this:

Working cash = 2% x Turnover = 17 million
So excess cash = 80 million and EV = 1735

Also, have you not given HWDN credit for lease breakage costs and legacy leases?

Arghhh! Thanks Red. I've made so many silly mistakes today, I think ought to just lie down for a while. You're right about the working cash calculation and the impact on enterprise value. I really appreciate you pointing it out as there was an error in my spreadsheet (it works out .2% not 2%) that affects a couple of other companies I've written about recently.

It doesn't make much difference to the earnings yield calculation though. In fact so little, I'm not going to republish the table.

I have not given Howdens credit for legacy leases. I mention that in point 4. I don't think it's significant. Perhaps you could explain more about lease breakage costs?

No worries, I'm a far bigger culprit in spreadsheet mistakes than you have ever been.

Lease breakage costs: the company's had to rid itself of the legacy (MFI) leases so as not to keep paying rent for space it doesn't use. Ridding itself of these leases has involved paying penalties to the concerned landlords:
6.5 in 2008,
28.3 in 2009
25.5 in 2010
17.9 in 2011
and
11.7 in 2012.

Again, these are one-time cash payments for breaking (MFI's) lease commitments. The're done now; most of the legacy properties are no longer HWDN's liabilities and only a few properties with 2 million in annual rent expense remain.

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