Headlam caught our attention with the Chairman buying stock last week. Being familiar with distribution businesses (like Rexel, DCC, Brenntag) we decided to do a deeper review.
The most important aspect of investing in a distribution business is to ensure that it is the market leader. This allows it to maintain pricing power with its supplier and buyers and to gain network efficiencies. Headlam is that type of business in floor coverings and distributes carpets, vinyl, wood & laminate, commercial, rugs and underlays to thousands of retailers and contractors. It has 30% market share in the UK which makes up 85% of its revenue. In addition it has 15% revenue from continental Europe.
It has consolidated the floor covering market since 1992 through organic growth and over 50 acquisitions. It has a strong position as the independent retail market, that it supplies, is highly fragmented and it is the largest distributor. In a typical year it is 2/3rd exposed to residential and 1/3rd to commercial demand. This does mean a correlation of demand to GDP growth, confidence and a healthy housing market – so you do have to accept some cyclical fluctuations. However, looking at 30 years of history you are being more than compensated with its current market cap to trailing revenue at 0.3x representing an all time low.
The market structure for floor covering distributed is illustrated below. Its suppliers are based in 19 countries and it has 70,000 customer accounts spread across the UK, France, Switzerland and Holland serviced by 23 distribution hubs/warehouses. The key driver of demand is repair, maintenance, improvement, housing activity and construction.
A steady dividend grower recovering from the COVID shock
The last 10 years of financials shows revenue growth at 3 to 6% following a 4% decline in 2009. Headlam has stable EBITDA margins of 7 to 9% and consistent free cash flow generation. This has supported 10 years of dividend growth and a return on equity over the same period averaging 12%. This is a high quality company.
The Lockdown impact
The timeline from Headlam’s recent trading update tells the story of the impact of the last 6 months and how disruptive it has been. However, daily trading in July and August has already recovered to prior years – they gave very detailed disclosure in their H1 trading update in September for July and August as well.
H1 was brutal with revenue declining by 31% year on year with the impact of lockdown. They provisioned for losses from receivables but to date the cash collection for deliveries has surprised positively. They have also committed to resuming dividends once there is a period of more normalised trading.
Is Headlam in a strong position to ride out the turbulence?
This is a well managed business operationally and financially. At the end of June, Headlam had £30mn of cash to hand. It is estimated this year it will burn £15mn of cash flow, most years it would generate £30mn+ of free cash. It discussed a number of factors a few weeks ago in relation to its financial position on release of its H1 results:
- Agreed revised covenant tests with banks for 30 June 2020 on the existing facilities which run to 30 April 2023
- In August 2020, agreed extended revised covenant tests for 31 December 2020.
- As at 30 June 2020, net debt was £22.4m (as at 30 June 19: £32.4m net funds), with available banking facilities of £110.7m and headroom of £88.3m. Even on a very depressed EBITDA forecast of £10mn in 2020 the company is at 2x net debt / ebitda. Next year that drops to less than 1x.
- Only £1.6m of outstanding PPE commitments as at 30 June 2020.
It also provided a H2 outlook and update on trading for July and August and said they had seen a return to profitability in H2:
• Net debt reduced to £7.3m as at 31 July 2020
• Pleasing post Period-end performance given the economic backdrop
• July 2020 revenue above July 2019 driven by strong residential sector performance, and August 2020, traditionally more weighted to commercial activity in the educational sector, only marginally below prior year
• Cash collections continuing to exceed expectations
• Q4 historically the most important trading period due to redecoration in residential accommodation prior to Christmas
Conclusion is that this does not look to be a company that will need to raise cash, in addition based on the detail they have provided the daily trading activity in the UK has already recovered.
Outlook, valuation and insider buying
Being exposed to residential, how is the macro and the outlook for the UK housing market? The attached index is New Buyer enquiries market survey by RICS for England & Wales. Will the pent up demand persist is a big question but so far the government is throwing significant stimulus into the economy. Once again, we believe the Headlam are more than discounting a negative outlook.
What is Headlam worth? We believe that in 2 years the company will be generating 40 pence of earnings per share again. It will emerge from this period, like many businesses, leaner and with more operating leverage. Given the quality of the business we believe that a 14x price earnings multiple is warranted on a medium term view. A p/e multiple of 14 versus 40 pence of earnings points to a fair value of £5.60 and where Headlam traded in March of this year and compares with £2.70 today.
The Chairman bought stock on Thursday 8th October at 266p. This was an open market purchase and not an award of stock. At the end of July, another board member bought stock at 282 pence. While neither were large amounts they do show a vote of confidence in H2 trading and outlook.
Conclusion – 100% upside with a growing dividend to support.
We believe that Headlam has 100% upside based on a recovery with its end retailers and contractors over the next 2 years. It is uniquely positioned as the leading floor covering distributor and deserves to trade at 14 times recovered earnings. The company has delivered revenue growth, dividend growth and stable and growing margins for 20 years.
While the company may be prone to cyclical headwinds, like 2009, we do not believe its sound fundamentals and commitment to dividend growth will change. If it can recover 40 pence of earnings per share, its dividend payout ratio has typically been around 60 to 70%. An investment in today’s uncertain times could mean a 25p dividend in 2022 or 2023 versus a current price of 271p. So not only could you double your investment but you will have a very nice dividend compounder to support as well (with a 10% recovered yield versus today’s price). Time to start accumulating.
Lot’s more to follow….
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