My posts on Howdens Joinery tried to understand its business
model: how and why does it make money? That must be the very
first question that a prospective investor asks of any business that s/he
invests in. The arithmetic of valuation is the second step, and I’ll turn to
that now.
A Rough
Cut:
Howdens was once twinned with a low quality furniture retail
business. Howdens sold that business to a private equity firm in 2006 and, when
that business went bust in 2008, the legacy store lease obligations of the
bankrupt business were, for one reason or another, put to Howdens. Since 2008, therefore, Howdens had been both
paying rents on properties it doesn’t use and paying breakage costs in order to
rid itself of these legacy properties. These extraordinary payments are now
almost entirely in the past; annual payments of only £2 million remain.
Also, Howdens’ pension fund assets once enjoyed assumptions
that perhaps would have seemed reasonable at the time: an 8.4% rate of return
on equities and a 4.5% rate of return on government bonds. As these assumptions
crumbled in the face of the downturn, the net pension liability ballooned, and the
trustee insisted on large cash infusions to eliminate the deficit. As it stands
today, the deficit amounts to 154 million, the weighted average expected return
on pension assets has contracted from 7.39% to 5.07% (Equities: 6.25%; Bonds:
2.55%) and Howdens has agreed to inject a further 45 million a year for the
next three years. By 2015, the net liability should be eliminated: I doubt that
there’s a reasonable basis for suggesting that expected long term returns on
equities or bonds ought to be lower than they are now and the cash payments will therefore
be enough to make the retirement plan whole.
We’re ready, now, to make a rough estimate of the lower bound
of Howdens’ ability to generate free cash. We add back the legacy rent
payments, the lease breakage costs, the cash contributions to the pension fund,
and we are left with 23p in free cash per share, or, at the current market
capitalization, an 8% FCF yield.
This is a rough cut and it’s wrong: we know that Howdens is
growing, so that free cash flow doesn’t represent earnings; and we know that
the years 2008-212 are exceptional ones, such that earnings in these years understate the company’s long-term earnings capacity.
So what is Howdens’ true earning power?
Approximately
Right, from the Bottom Up
Let’s start with sales. We know that Howdens’ sales per
square foot is a function of cyclicality and store maturation. The combined
effect of these two factors can be seen below:
Average sales per square foot between the top and bottom of
the cycle, i.e. between 2005 and 2012, is £199.4.
We know also that the depots mature with time. We can
isolate this effect by calculating the CAGR in sales per square foot between
the two bottoms of the cycle, 2002 and 2012. It’s not a perfect approach – that
would take more information that we have available to us – but it’s good enough.
The maturation effect is 1.4% per year.
Put these two factors together and look out to 2016 and we
can estimate that sales will amount to something like £1,475 million: 700
stores, 10,000 sq ft per store, £211 in sales per sq ft.
We know that adjusted operating margin is 17.45%, that depot
rents approximate £5 per square foot, that the business needs 30 days of
noncash working capital, and that it costs £170,000 to build out each new depot
so, at this point, we can estimate earnings and cash flow:
The business will generate about £650 million in cash over
the next four years. Of this, 180 million will be contributed to the pension
plan, £46 million will be tied up in increased working capital, and £30 million
will represent cash capex for 171 new depots.
This leaves £390 million in free cash which, for the sake of
simplicity, I choose to keep on the balance sheet. In reality, some of it will
be paid out in dividends but it makes little difference to the valuation whether
it is or isn’t.
A 2016 equity valuation of £2,775 sees the shares being
worth 655p each, representing a return of 29% a year.
I’ll pause here to re-emphasize a couple of points:
· This
estimate of Howdens’ intrinsic value would be impossible without confidence in the
robustness of Howdens’ business model. One
can’t do this for some teen fashion retailer or low-grade home supplies distributor
and reasonably expect to be close: tastes change, and anything that can be
disintermediated will be, sooner or later; forecasting revenues and profits for
these kinds of businesses is, in my view, a fantasy.
· The above
valuation is dependent on two assumptions only, neither of which is fanciful: (a)
things stay as they have been; and (b) management’s 700 depot target is proved
reasonable.
If you'd like to take a stab at breaking my valuation, I’d welcome it in the comments below.
