Howden Joinery (HWDN): The Hidden UK Stock With a Competitive Advantage

During their recent episode, Taylor, Carlisle, and Todd Wenning discussed Howden Joinery (HWDN): The Hidden UK Stock With a Competitive Advantage. Here's an excerpt from the podcast:

So I've been a shareholder and my firm K&A Capital has been a shareholder since inception as well. So what Howden's does is they are a kitchen manufacturer. And in the UK, they primarily sell kitchens and joinery.

So joinery being carpentry, things like, you know, for the doors and things like that for the floors and things. And what's unique about their business model is they are business to business and they only deal with the trade customer. So that's the pro customer to us in the US.

They do not work with customers like regular homeowner consumers. So you can't just walk into the store and say, hey, I want a kitchen. So what's really great about their business is they've got a couple of different things going for them.

They do really well in high density areas. So UK being a fairly densely populated area, they have these very small, about 10,000 square foot stores or depots as they call them around the UK. And they've got some stores, maybe we'll talk about this later, in France and in Ireland and in Belgium, I think they might have a few left in Belgium as well.

But they deal primarily with the trade. And so someone will come in, the builder works independently with the homeowner. They say, hey, I want a kitchen remodel.

The builder works with the customer and with Howden's to come up with the plan for the customer. And they build a great kitchen. You can put it in very quickly.

And this is what Howden's major advantage is relative to what I think is the US model, which is way too decentralised. I mean, if you guys have ever looked into getting your kitchen remodelled, there might be six or seven different suppliers supplying the kitchen remodelling. And say, hey, this part broke, so we got to wait for that to come in.

And that just doesn't happen with Howden's because they control the entire kitchen. And so someone, if something breaks, they can just go back to the store five miles away, get a new one, come back, finish the job. So it's very appealing, the business model to the pro builder, because they can turn over jobs a lot faster and move on to the next one.

And so that's one aspect of their business. The other aspect of business that I really like is that they have an ownership culture at the depot level. So from the beginning, the depot managers get a share of the store profits.

And then it's a monthly bonus related to the profitability of the depot that they manage. And then everyone else in the store who works at the store, the staff members also get a cut of the monthly profits. And so it self-manages, right?

Kind of a left Schwab model. Right, right. So if you want to hire someone else, you have to convince the rest of the staff that, hey, they're worth sacrificing a little bit of your monthly bonus to bring this person on and make us more efficient.

So it's a very self-regulating system and it's a very profitable business with a consistent 60% gross profit margins. EBIT margins are about 15% because they have a lot of operating expenses, but it's a very strong business model. ROIC is probably about 20 in a normalised market.

So very strong business. And so the point of my article was that kind of going long, long loop here, but getting to my article, what I posted was they should come back to the U.S. And they haven't been in the U.S. in over 20 years. So my understanding early on was that Houdin's had a small programme in the U.S., maybe one or two depots back 20 something years ago. But it turns out they had a pilot programme when they were operating under a previous parent company called MFI Group. And MFI Group had their hands in a lot of pots. They had a retail operation on the home improvement side.

They had some other things around the world and they ran into some financial trouble in about 2005, 2006. And so they had to pull the pilot programme in the U.S. and elsewhere. And so the model was working really, really well.

It was starting to really hit scale because there's a bit of a J-curve in the adoption. So they launched in the Atlanta, Georgia region around 2001 and then started ramping up. They were starting to get a lot of home flippers around that time, going into the housing crisis, a lot of home flippers found their model very appealing.

And so one of their depots actually in the U.S. was on par with their mature stores in the U.K. and in a market that I don't think was actually an ideal market for them to be in. So long story short, you have this great business model that I think would fit really well in the U.S. and could eventually have a similar depot structure in the U.S. as they have in the U.K. They've got about 800 something, 870 depots in the U.K. They could have at least the same number in the U.S. over the next 10, 15, 20 years. So it looked like a huge option value that's just currently not even being considered for Howden's.

And if the kitchens are so great, why is the food so bad in the U.K.? I actually like the food in the U.K. I got used to it when I lived there, but yeah, I understand.

[Tobias]

So where do you see the valuation? Where do you see the next five years?

[Todd]

For Howden's, I think so. Howden's has had trouble scaling outside of its home region. It's been in France for about 20 years, and it has about 60 or so depots in France.

It just has never gotten to the scale that it was potentially hoping for. I think there is a number of reasons for this, but I think the model could be replicated in the U.S., right? And so I think the net present value, based on my rough estimates, being an outsider, not knowing all the details of how much everything would cost, I was trying to be as conservative as possible, but I think it would be a net present value positive for them to move into the U.S. and really give it a try because they really could scale their business quite substantially in the U.S. and deliver a lot of value for a long time. So I think a lot of the valuation you're seeing right now in the stock, I think the PE is about 16, depending on the day.

It's been up the past couple of days, but it's been about 15 or 16. And I think there's been some concerns about future growth because they're reaching full penetration in the U.K. market. They've got about four or five years left of depot growth there before they've hit what they term to be the full amount, about 1,000 stores.

So they have to find a new growth market. One of the things that they've done over the past year is they acquired a company in the U.K. called DIY Kitchens, which is a direct-to-consumer DIY DIY kitchen. So it's not in the trade.

So they're holding it completely separately from the trade-only Halodins, but it indicates to me that management needs growth. They want to find new opportunities to grow for the longer term. And for me, I look at how much they spent on the DIY acquisition, which is about £370 million.

They could have done that investment in the U.S., kept focused on the trade, and it could be just as big as the home market is in a 10-, 15-, 20-year period.

[Jake]

Seems like with 10,000-square-foot footprints, you could find a lot of those in the U.S. for probably not insane rents.

[Todd]

Right. And that's the key to their success. So they had a competitor in the U.K. called Wren Kitchens move into the New York City area about six or seven years ago, and they recently went bankrupt. So you might think, that's a terrible precedent. Maybe that's a sign that they shouldn't come in, but they had a very different model. So Wren's is more of a traditional showroom where they work directly with the homeowner.

And so they had to get real estate in these glitzy, high-traffic areas, whereas Howden's, what they'd like to do is find these sort of industrial parks around the population centre and build networks around there so that they have the inventory always in stock, but they're in locations with very low fixed overhead costs. So by having that, it's an initial cost advantage that Wren's Kitchens did not have. So I think that would be, it's understandable if management says, well, I'm concerned about going in because Wren's just got kicked out.

I think it's a completely different business model than what Wren's was offering.

[Tobias]

So assuming they get to saturation, which seems likely in the U.K. in the not too distant future, what do you see that sort of no growth valuation versus where it's trading right now?

[Todd]

So the market's currently pricing it with a very low growth forecasted, but I do think that they can continue to add services to what they're currently doing in the U.K. So similar to what Home Depot did in the U.S., where they ran out of store locations and what they did was monetise those locations even better by adding more services. So one of the things that Howden's has done in the past couple of years is they've added bedrooms in addition to kitchens. So if you want to redo your bedroom, they've got bedrooms that you can just kind of plug in and upgrade and they look great.

So you can see how they could go to other locations in the house. They could go to bathrooms maybe next. These are additional markets that they could move into within the home and expand their current footprint.

[Tobias]

So the stock's on 16 times earnings. And what sort of expected return are you at that level? And then where do you see the valuation?

[Todd]

Strong to quite strong. Strong to quite strong. I mean, I think there's a great opportunity.

I think the U.K. housing market has been in a real rut over the past, since really since Brexit. It's been under a lot of pressure. Interest rates have been high.

Housing turnover has been pretty stagnant. Their other big market, France, has not been much better. And so if you have a return of more normalised interest rates, more normalised housing environment, I think the stock could very well be growing at the current or the earnings could grow at the P.E. ratio right now. So you're looking at a peg potentially of one, right, where it's growing 15, 16 percent for a couple of years at a P.E. of 15. So I think it's a very, very attractively priced right now. It's mid single digits, mid to high single digits, free cash flow yield.

I think there's some growth left and mid-teens is, I think, quite reasonable for this stock going into if it recovers back to at least the mid cycle.

[Jake]

Aside from the reports that you like, how do you feel about management? Because you're sort of betting that they're going to figure it out, right?

[Todd]

Yeah. So I think very highly of management. And this was not this was not meant to be any sort of knock on on management's capital allocation.

I just don't think anyone has been really thinking about it. And so I really wanted to bring it really to their attention that, hey, there's there's this huge market. I mean, it's been it's been 20 years and there's been a new management team since then.

I think it's I think it's very easy to dismiss the U.S. markets, because you can easily talk yourself out of it because we don't operate on the metric system. Right. So you can't make.

And so Howden's tried this when they were in the U.S. originally. They were shipping cabinets from the U.K. to the U.S. in metric terms and trying to teach the U.S. home remodeler how to use the metric system.

[Jake]

Yeah.

[Todd]

And that's just a really big uphill battle. Right. So so part of my thesis and my argument is that, hey, come into the U.S., build your own facility, because that's what they were actually trying to do before they got the rug pulled out. So they were very close to building their own U.S. facility. And that way they could design products for the U.S. customer, right, directly for the U.S. customer in inches and feet and in the imperial system and start delivering what the builders are looking for, making the builders jobs easier, because that's who they're trying to serve. They're trying to serve the builders, not the homeowners necessarily.

But the homeowners are the builders customers. But they're trying to enrich the trades persons. The trades person comes back to them over and over again.

So that's the key, I think, to the argument is build a mini mill. All right. Start producing things at a small level.

And if they start going well, start building more and more and more. It's a it's a very you can scale it very quickly once you have the blueprint in place and word starts getting around between builders in different regions like, hey, have you tried these guys before? They're really good.

And I think that's right where they were. They were just about there and they got pulled pulled out. So it's a it's a it's one of those what ifs, right?

Like what what could have happened? And I'm always drawn to those types of stories. But so anyway, get back to your question about about management.

I think that the DIY acquisition was something that's still I'm still working through because they when they when they kicked out the MFI retail business, right, the focus was to focus on the trade. And then they brought retail back into the mix. And so it was kind of like, are they going to be focused on this this brilliant business model that they have?

Right. This trade business model. The company also issued shares to acquire DIY kitchens at a what I believe is a pretty attractive valuation.

Yeah. But on the other hand, the sellers of DIY kitchens took the stock and held it. Right.

They wanted the stock. They wanted to participate in what they saw as the value for Houghton's. They think very highly of each other, both both parties.

And they've been you know, they they know each other quite well. And so I think it could it could work out. And maybe there's something to the effect of, hey, maybe we can move into new markets with leading with this retail concept with DIY kitchens, getting a better feel for, hey, what do the customers want in those regions, and then following it up with the with the trade business, which is a much better business, in my opinion.

And I think that could be something they could do to integrate the businesses, because there's really no synergies other than other than that. So I think so I think there's been a lot of big capital allocation decisions that management has to make. And I think the US is as good as option of any of those probably better, in my opinion.

[Jake]

Is that 15% EBIT margin? Is that before or after the profit sharing? Do you know?

[Todd]

That's after.

[Jake]

Yeah. Okay.