Howden Joinery: The IKEA of fitted kitchens

The starting point for any long-term investment is to understand the business. Howdens (HWDN)’ annual report shows it does the same thing as it did last year and every year since it was founded in 1995, which is supply kitchens. Howdens describes how it makes money so well, I used it as an example of good strategy in a recent article.

That article referenced two books by strategy gurus. One of them, Understanding Michael Porter, by Joan Magretta, a book by one guru about another, chose the furniture retailer IKEA to illustrate an important point about strategy: Even though firms must be different to be more profitable than rivals, being different is not enough. High profits attract imitators, and once copied you no longer have an advantage.

  • Getting serious about strategy

To deter imitators, being different must require painful choices, which Magretta and Porter term “trade-offs”. The more trade-offs, the better.

To become IKEA, a more traditional furniture store chain would have to sack its sales assistants, stop selling ready-made furniture, and move into unfashionable out-of-town locations. It would design its own furniture kits, ask customers to pick them up from self-service warehouses in far off locations using their own vehicles, and assemble them when they got home.

To IKEA’s rivals, it must have been unthinkable that their customers would do this, but for customers on a tight budget the IKEA experience was preferable. Even better from IKEA’s point of view, the trade-offs reinforce each other. Locating out of town not only lowered rents, it meant free parking.

The IKEA of fitted kitchen supply

Howdens’ business model reminds me of IKEA’s. It too operates in unfashionable locations, which customers can drive to easily. It too was the first to identify and exclusively target a specific customer type: local builders, who unlike you and me, come back week after week, month after month, every time one of their customers needs a fitted a kitchen.

Howdens makes life easier for builders, because they are its retail salesforce and installers. Like IKEA it has grown to become the market leader, but fortunately for builders, a trip to Howdens doesn’t require a forced one-way march around its warehouses.

Howdens provides promotional material and kitchen design services, gives tradesmen enough credit to fit a kitchen and receive payment before they have to pay Howdens, keeps nearly 100% of its range in stock at all times, designs cabinets so they’re easy to fit, and does not advertise prices so the builders can determine their own profit margin.

When Howdens chose to focus on builders, it made the hard choice not to retail. High stock levels and generous credit are costly trade-offs too, but overall Howdens is a low-cost business.

Howdens does not operate expensive showrooms, run national TV advertising campaigns, maintain large fleets of vans (it does operate efficient logistics between its manufacturing sites and depots), or fix kitchens that have been installed badly. Howdens may not do as much as rivals, but it meets the needs of tradesmen better.

The result is a business that is not only profitable, but deters competition.

Source: interactive investor                Past performance is not a guide to future performance

In the year to December 2017, Howdens’ profit was flat, and profitability (the profit Howdens earned compared to the capital invested in its operations – blue bars) declined. I don’t think there’s anything sinister in this. Howdens operated 53 weeks this year, during two of those weeks (between Christmas and New Year 2016 and 2017) its depots were closed.

Consequently, it bore an extra week of costs in 2017, without earning revenue. The price of imported raw materials and kitchen components also rose due to the weak pound. Howdens earns high profit margins, and fluctuations like these are no danger to the business or its long-term profitability.

Times are a changin’

But there may be more significant challenges ahead.

First of all, leadership. Howdens is founded on the principle that its business should be worthwhile for all: customers, homeowners and tenants, local communities, suppliers, staff and investors.

Howdens says depot managers can receive ‘life-changing’ profit-share bonuses, and the comments on employment websites generally bear this out, highlighting the generous incentives (though the performance culture also has detractors) and training opportunities.

Howdens gives shares to all employees who stay longer than three years and routinely features in The Sunday Times Best Big Company to work for list.

The founding principle has been executed by founder, Matthew Ingle. He retired as chief executive last week. He is now ‘lifetime president’, which sounds like an honorary title. But I’d be surprised if a business model as successful and well defined as Howdens’ did not survive a change of leadership.

Generally, we replace our kitchens when they are tattered and torn but we also change them when we move into a new home. Howden’s fortunes may be tied to the housing market, and if the number of transactions were to fall substantially, it might make substantially less profit.

While house prices are high by almost any standard, the number of houses bought and sold in the UK has a long way to go before it reaches the previous peak just before the financial crisis, so perhaps prices and transactions are not closely correlated. Even if house prices were to tumble again, the effect on transactions might not be as severe as ten years ago.

Source: HMRC                                          Past performance is not a guide to future performance

In any case, Howdens was profitable in 2008 and 2009 when house prices slumped and transactions did too, and it has done very well as they’ve recovered. This gives me some confidence.

To grow, Howdens must open new depots. In 2017 it opened 19 bringing the total to 661. In 2018, Howdens plans to open 30 new depots. The day will come when it has filled the UK, and that day might not be far away. Howdens says it can sustain “up to” 800 depots, although it has raised that estimate before and could do again.

When it runs out of prospects in the UK, or sooner perhaps, the most likely outlet for expansion is Europe. Howdens operates twenty depots in France and less than a handful spread across our other close neighbours. It’s been tinkering overseas for over a decade, which has led some investors to conclude it may not have found a winning formula.

I’m more relaxed about its slow progress in Europe. Howdens says its gaining a greater understanding of each local market, and I’m not sure why it would move aggressively overseas while it still has opportunities closer to home. Building out a new network would surely be more expensive and less profitable, at least for a while.

That’s not to say there definitely is room for more than 800 Howdens in the UK, or that it will conquer Europe. I just think its worth the risk there isn’t, and it won’t. The current share price doesn’t anticipate much growth. An earnings yield of 6% implies a half-decent return without it.

Scoring Howdens

This is how I score Howdens, using an abbreviated version of my Decision Engine scorecard:

How does the business make money?

What’s special about the business? How does it perform through thick and thin?

[2/2]

How will it make more money?

Describe the strategy. Will it make the company more competitive?

[2/2]

What could go wrong?

Describe the risks. How well does the strategy address them?

[1/2]

Will shareholders benefit in the long-term?

Does management look after staff, suppliers, customers and shareholders?

[2/2]

Are the shares inexpensive?

Does the share price undervalue the firm, considering its prospects?

[1/2]

Howdens scores 8/10. I consider any share that scores more than seven to be suitable for long-term investment.

Contact Richard Beddard by email: [email protected] or on Twitter: @RichardBeddard

Richard owns shares in Howden Joinery.

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