Sohn Conference|November 29th 2018

Wei Yang Tey

London School of Economics
teyweiyang@gmail.com
Introduction
Howden Joinery is the UK’s dominant kitchen supplier.
• Howden Joinery is the leading manufacturer and supplier of fitted kitchens and
joinery in the UK, with 675 depots in the UK and 24 in Continental Europe. HWDN Capitalisation Table
Share Price 460.70p
• It is a trade-only business, meaning it sells its kitchens through local small builders. Dil. Shares Outst. 614
Howden operates out of depots which takes 7 years to fully mature. Market Cap £2,824
Net debt -£213
• Management has a target of 800 depots in the UK. Enterprise Value £2,610
• Howden has consistently maintained a net cash position, solely relying on its cash FY1 P/E 14.5x
flow generation to fund depot expansion. It is highly profitable, with a lease-adjusted FCF yield 5.4%
return on capital of 26%, and EPS has compounded at 16% over the last 5 years.
Revenue by Geography Kitchen Market Share by Value Revenue by End-Market
2% 5%
22%
41% 25%
9%
7% 70%
98%
11% 6%
4%
UK Europe Howdens Wren, Ikea, other retail Owner-Occupied Rental Homes
Wickes, Homebase, others Magnet New-Build Housing
B&Q Contract with housebuilders
Independent studios 2
Investment Thesis
A fundamentally high-quality business mispriced by the market.
Mispricing Thesis summary
Worries around revenue growth sustainability
I) Howden’s growth runway and its ability to continue
• Kitchen market is widely expected to remain weak taking market share is not being fully appreciated.
due to stagnant housing transactions.
II) The market fails to see that the drivers of the
• Fears of depot cannibalisation as Howden
kitchen market have evolved, and these new
increasingly penetrates the UK market.
dynamics will drive incremental kitchen demand.

Shorter-term worries around gross margins III) Gross margin concerns are overblown and margins
• The market has overreacted to Howden’s 1H18 will revert upwards as industry pricing has improved.
gross margin fall, believing that it represents a strategy
shift towards pursuing volume at the expense of price.

~62% cumulative return in 3 years

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 Part I
Howden’s growth runway is not
being fully appreciated
Depot rollouts are highly accretive to shareholder value
A new depot provides a 28% IRR in its first 7 years.
Depot return profile, £000 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Assumptions
Capex for fitting out depot (450) Disclosed average fit out cost in FY17
Working capital investment (24) (40) (43) (59) (62) (78) (82)
Revenue 300 800 1,040 1,280 1,520 1,760 2,000
(-) COGS (113) (300) (390) (480) (570) (660) (750) 62.5% gross profit margin
(-) Employees (250) (250) (250) (250) (250) (250) (250) 10 staff, average wage: c.£25k (Glassdoor)
(-) Distribution & Overhead (93) (93) (93) (93) (93) (93) (93) FY17 distribution & selling expenses/depot
(-) Rent (55) (55) (55) (55) (55) (55) (55) 10,000 sqft depot @ £5.50/sqft
(-) Tax 0 (19) (48) (76) (105) (133) (162) 19% marginal tax rate
Net cash flow (685) 43 161 266 385 490 608
IRR + 27.9%

What drives such a high IRR?

1 Selling through the trade channel leads to lower operating expenses and fit-out capex.
2 Unbeatable value proposition allows Howden to earn 60+% gross margins.
3 Excellent execution because of profit-sharing model.

Being a relationship driven business, each depot takes 7 years to fully mature, i.e. grow trade accounts and volume.
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1 Selling through the trade channel provides superior profitability
Lower capex costs and stickier customers.

The trade channel is superior because… FY17 Margins vs Competitors

I) Ability to generate recurring revenue from sticky customers as builders 63%
remodel numerous kitchens/year instead of a kitchen once every 10 years.
38%

II) Can locate in cheaper areas instead of a high street showroom. Allows 17%
8% 5%
Howden to save on rent and fit-out capex.
Gross margins EBIT margins
III) Save on advertising spend as builders act as a free salesforce that Howden
consumers trust. Nobia UK
Wickes and Toolstation (Under Travis Perkins)

“Retail competitors try to wow customers with their showrooms

to win business […] But it costs a lot more to build […] A
competitor’s fit out cost might be around £1.2 million.”
– GLG Expert

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2 Unbeatable value proposition makes builders very sticky
Allows it to earn 60+% gross margins.
“For the majority of builders, if they start with Howden, they will stick to them. For some reason, they
just have this loyalty to the brand.” – GLG Kitchen Expert

Howden makes the small builder’s life easier
I) “Always in Stock” model provides convenience to
builders as they can do the kitchen fittings anytime
― Crucial as customer appointments are always
changed at the last minute.
II) Sell to builders at a confidential trade discount,
giving them the autonomy to charge their own mark
up to the end consumer.
Why this is a sustainable moat
• Competitors can’t replicate its stocking model.
“Howden’s decision to focus on simplicity at the onset
means their production strategy and inventory
management is very different and a lot of competitors
can’t follow them down the route now.” – GLG Expert
• Economies of scale allows Howden to sell to
builders at lower prices than competitors.

“Howden must be buying at the absolute best price,

III) Extend credit to builders for a month, which is from the same component supply base that is shared by
important as these small businesses often have cash other manufacturers.” – GLG Expert
flow issues.
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3 Excellent execution at the depot level
Unique profit-sharing model ensures that revenue ramp-up is executed consistently for new depots.

How it works
I) Depot managers and staff operate on a profit-sharing “Howden gives more autonomy over
model, where they receive a share of their depot’s profit
pricing than competitors. A focus on
and are financially responsible for any stock losses.
profit instead of turnover means less
discounting and less corners being
I) Depot managers get a high degree of autonomy: cut to get the sale over the line.”
– They hire their own staff – GLG expert
– Manage pricing and level of discount for builders
– Manage their own stock levels
– Conduct their own marketing
“I get a phone call from the local
Howden depot every 3 weeks asking
II) Creates a powerful incentive for managers and staff to about new projects” – Tradesmen
chase leads and build relationships with builders to open
new trade accounts.

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Cannibalization fears are unfounded
Depot economics will not deteriorate even with a continued rollout towards 800 depots in the UK.

There are fears that Howden is past its saturation point and is growing by cannibalizing other depots

“We […] believe it will be hard for Howden to completely avoid

the effects of cannibalization on certain sites within its portfolio”
– Berenberg, 1H18

Howden still appears relatively underpenetrated, and there is an opportunity to take new market share

I) Depots are a local service, and the value proposition is enhanced the closer depots are, as builders don’t store inventory
and are not willing to drive beyond a certain distance to collect stock before customer appointments.
– Howden is very careful about where they set up new depots, with the main consideration being the drive-time radius
around existing depots. No cannibalization occurs outside of a c.20 minute radius.

II) Incremental revenue for new rollouts will come from:

(i) Market share donors like Homebase, which is undergoing restructuring, and B&Q, which is moving away from
providing kitchen installations.
(ii) Fragmented independent studios (41% of the fitted kitchen market).
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Cannibalization fears are unfounded
Let’s take a look at Howden depots in the Exeter postcode area.
15 minutes driving radius from Exeter Depots No. of residents per km2 in Exeter

Exeter has one of the highest depot density, with 1.57 depots/100,000 residents, compared to Howden’s
group average of 1.05 depots/100,000 residents. Even at this point, we see very little overlap.
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There is a significant opportunity beyond the UK
There is scope beyond 800 depots, with potential Europe and Northern Ireland expansion providing optionality.
Current situation Competitive environment in France
• Howden has been running trials in France, Germany • Many of the competitors there are similar to the ones
and Belgium and currently has about 24 depots in in the UK, for example, Castorama and Brico Depot
Europe, with 20 in France. (subsidiaries of Kingfisher), and Ikea.

• Management has indicated that they are currently
tweaking the business model to the local markets.
– It has been ~3 years since it introduced the
second edition depot in France.
• Evidence of a disciplined approach towards market
entry is reassuring.
• In particular, there appears to be no dominant fitted
kitchen players with a similar business model to
Howden in the trade-only space.
“I'd say now that I will be reviewing the international
operations during the course of this year”
– Andrew Livingston, CEO (1H18 call)

Currently, depots in the UK will grow at 30/year, contributing 4% revenue growth for the next 4 years.
A successful rollout into France would allow this to continue for much, much longer.

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 Part II
The new drivers supporting the
kitchen market recovery
Kitchen market recovery yet to run its full course
Proxy shows the kitchen market is still c.11% below mid-cycle volumes
Howden’s Real Revenue/Depot (2010 Pounds)
2.4 2.33
Rapid growth as a large % Still a distance
2.2 of Howden’s depots were 1.98 below adjusted
2.0 immature 2006 volume peak
1.8 1.95 1.91
£m

1.6 1.77 1.80 1.76 1.79 1.80

1.67 1.63 1.60 1.66
1.4 1.53 UK housing transactions 1.54 1.57
1.2 1.39 reached its peak
1.0 1.12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Real Revenue/Depot (2015 Pounds) 2006 Volume peak adjusted for depot maturation

• As the UK kitchen market is poorly researched, Howden’s real revenue/depot (adjusted for the UK kitchen furniture
producer price index) is used as a proxy to understand where today’s kitchen market volumes lies in the cycle.

• Two factors drive real revenue/depot:

a) Cyclical – Kitchen market volume cyclicality
b) Structural – Organic maturation of depots (This contributes ~1.5-2% revenue growth)

• Adjusting for the structural factor, true peak volumes in FY17 should be £2.33m/depot, suggesting that kitchen market
volumes are c.11% below mid-cycle numbers. 13
Home improvement market has seen a strong uplift
Yet, market is still overly focused on housing transactions as an indicator of the kitchen market’s health.
Home improvement market has recently picked up even as housing transactions stayed flat

Change in sales, 2016 versus average of 2014 & 2015 (%)

Home Negative
improvement correlation
market has between home
diverged improvement
from housing applications
market and change in
transactions housing sales
since 2015 over the last 3
years

Private housing RMI (£ ’000) Housing transactions ‘000s (England & Wales) Home improvement applications per 100 private homes

• Traditionally, housing transactions have been the main catalyst for home improvement activity and new kitchen purchases.

• However, a divergence has formed in recent years, with housing transactions staying flat due to poor housing affordability
and stricter lending criteria introduced by the UK government.
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Shifting dynamics will continue to support the kitchen market
The desire to “Improve rather than Move” will drive incremental kitchen demand.
“In this market, where people are a bit uncertain about the future, they
understand the benefits of investing in their own properties. They are
putting off moving homes and instead, are conducting structural
renovations.” – GLG Expert

• Stricter rules on mortgage affordability have caused many

homeowners to substitute moving for improving, for which capital is
still readily available.

• Based on industry surveys, kitchen improvements provide a very

attractive ROI for homeowners à which means most people
conducting renovations would also be re-fitting their kitchens.

• Positive knock-on effect for Howden

– Homeowners who are re-fitting their kitchens together with other
structural renovations will be purchasing it through a builder Monthly home improver applications
instead of a high-street kitchen retailer. Applications 12 month moving average

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Shifting dynamics will continue to support the kitchen market
Kitchen replacement cycles have been shortening.

“The new statistic is that the average household wants to change a kitchen
every 8 years instead of 20 years because it’s a fashion-led market now”
– GLG Kitchen Expert

• Consumers are changing kitchens more often because it is becoming

less of a homogenous product, and consumers care more about
design trends, which has become a catalyst for purchasing new kitchens.
– One example is the rise of “Painted Kitchens” in the last 3 years

• Howden is capitalising on this by accelerating product range additions

to capture new demand, as other competitors have moved in the wrong
direction by shrinking their ranges.
– Howden’s kitchen range is expected to increase to 90+ in 2018,
from 50+ in 2016.

These new dynamics should support 4% kitchen value growth going forward, even if housing
transactions stay flat.
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 Part III
Gross margins will revert
upwards
Gross margins will revert upwards
Removal of depot margin floor was only minimally dilutive
What happened in 1H18 Howden gross margins %
• Factors that led to a fall in gross margins from 1H17 to 1H18: Nov ‘16: Hiked list prices Apr ‘18: Hiked list prices
by 10%, in anticipation of by c.5%.
1) Lower prices in 1H18 due to list price reset in Apr ’17, and rising material costs.
higher input costs. à 1H17 is a poor comp for 1H18
Apr ‘17: Reset list prices
2) Removal of depot gross margin floor in 2H17, which gave
as volumes fell
depot managers more pricing flexibility.
64.5%
64.0% 64.1%
• The removal of the gross margin floor for depots has induced
worries of continued margin deterioration. 62.7%

61.3%
• If we normalise for the lower prices in 1H18, gross margins 1H16 2H16 1H17 2H17 1H18
should have been 63.2%, meaning the impact of removing the depot
margin floor is only c.90bps. Howden’s depot profit-sharing model “There is a barrier to it, a healthy barrier in the
provides a natural barrier for pricing. sense that the depot manager gets a share of
its profit… So there is a natural inclination to
maximize profit.”
– Mark Robson, CFO (1H18 call)
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Gross margins will revert upwards
Industry pricing has improved and will allow Howden to offset its input costs.

Going forward UK Kitchen Furniture pricing growth %

• Howden has hiked list prices by c.5% in Apr ’18. Amidst a c.3.5% 12.5%
increase in input cost for 2H18, I expect gross margins will recover to 11.8%

63.3% for 2H18, and FY18 gross margins should stabilise around
62.5%. Nov ‘16: Howden 7.7%
previously attempted
hiking list prices by 10%, 6.9%
• Industry pricing has only just started increasing, providing when industry pricing was
leeway for Howden to raise prices without affecting their relative flat.
3.6%
pricing vis-à-vis competitors.
3.0%
1.6%
1.2%
“Because of the exchange rate situation caused 0.8%
0.3%
-0.1%
by Brexit, most manufacturers have
implemented significant price increases in the 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18
marketplace, 10 to 15%, in 2018.”
– GLG Kitchen Expert

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 Part IV
Valuation & Risks
Valuation
Free cash flow growth together with capital return will provide a 62% upside by FY21.
Valuation summary Assumptions
Bear Base Bull
I) Free cash flow growth
Revenue scenario '18E-’22E CAGR % ’13-’17A CAGR %
FY22E FCF 129 212 233 Bear Base Bull Historical
'18E-’22E CAGR % -2% 14% 16% UK organic growth -4% 4% 5% 7%
(x) 1 year-forward EV/ FCF 16.0x 18.6x 18.6x Volume -4% 2% 3%
Historical 3-year average 20.7x 20.7x 20.7x Pricing 0% 2% 3%
FY21 Enterprise value 2,071 3,940 4,329 New depot growth 2% 4% 4% 3%
(+) Excess cash 96 164 191
FY21 Market value 2,167 4,104 4,520
Part I Upside % -23.3% 45.4% 60.1%
• Continued kitchen market recovery will easily allow mature
3 year IRR % -8.4% 13.3% 17.0% depots to grow kitchen values by at least 4% on a like-for-like
basis.
II) Capital return
Dividends 234 298 319
• UK depot rollouts at 30/year will continue at high rates of
(+) Share repurchases 170 170 170 return and will take incremental revenue from competitors.
Total 404 468 489 • Continental Europe revenues are flat-lined and any expansion
Part II Upside % 14.3% 16.6% 17.3%
3 year IRR % 4.8% 5.5% 5.8%
there is treated as option value.

Cumulative upside -9.0% 61.9% 77.4% Margins

3 year IRR % -3.1% 17.4% 21.1%
• Base case: Gross margins stabilise at 62.5%, with 70bps of
Implied 1Y forward multiples in FY20 operating leverage over 4 years.
EV/EBITDA 7.9x 10.0x 10.1x • Bear case: Gross margins fall to 61.5%, and EBIT margins -
Historical 3-year average 10.0x 10.0x 10.0x 133bps over 4 years due to volume declines.
P/E 12.1x 15.0x 15.2x
Historical 3-year average 15.4x 15.4x 15.4x
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Risks & Mitigants
Howden appears to be priced for a weak market, providing a high probability of upside surprise.
1. Kitchen market could decline in a recessionary environment
• However, Howden’s volumes will not experience significant declines because:
– Its pricing range provides strong value to consumers allowing it to take market share from consumers who are
trading down in a recessionary environment.
– Its ability to offer credit to its builders becomes even more valuable in a downturn.
– Historically, in 2008, Howden’s revenues rebounded within a year, while margins continued strengthening.
• Multiple de-rating should be minimal as Howden is trading below historical multiples, despite consistently
outperforming competitors in what many perceive to be a weak market today.

2. Depot expansion into Europe may come at lower rate of returns due to higher labour costs and inability to replicate
Howden’s decentralized culture.
• Management has demonstrated effective capital allocation, returning 95% of excess free cash flow in the last 3 years,
which provides reassurance that capital will not be allocated towards value destructive channels.

“I am carefully considered, and I certainly won't be allocating

capital if I don't see a positive return on it when we go into
another country” – Andrew Livingston, CEO (1H18 Call)
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 Special Thanks
The Sohn Conference Foundation
Gerson Lehrman Group
Sean Lim
Dylan Adelman
Darryl Wang
Global Platinum Securities
Appendix
Minimal de-rating risk.

EV/EBITDA vs EBIT margins EV/EBITDA vs 3Y Revenue Growth CAGR

10.0x Howden 10.0x Howden

8.0x Travis Perkins 8.0x Nobia

6.0x Nobia 6.0x

Travis Perkins
Kingfisher Kingfisher
4.0x 4.0x

2.0x 2.0x

0.0x 0.0x
0% 5% 10% 15% 20% 0% 2% 4% 6% 8% 10%

Revenue growth yoy % FY16 FY17 1H18 3Q18

Travis Perkins 4.6% 3.5% 4.4% 3.9%
Kingfisher (UK & Ireland) 5.5% 2.6% 1.3% 1.4%
Average 5.1% 3.1% 2.9% 2.7%

Howden Joinery 6.5% 7.1% 12.1% 7.5%

Outperformance 145bp 405bp 925bp 485bp

Howden has consistently outperformed on revenue in what is perceived as a weak market.

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Appendix
Highly cash generative business.
Improving free cash flow conversion Accelerating free cash flow distribution
• Capex expected to taper off to 2.9% of sales in
2022, from 4.6% in 2017 as Howden comes off its
80 47.9
heightened investment phase. 41 45.3 Share repurchase
Dividend
• This will improve EBITDA to FCF conversion 23.3 Balance sheet
68.4
from 48% in FY17 to 54% in FY22E. 74 59.9 65.4
39.5
7.9 9.7
-1.9
2013 2014 2015 2016 2017

“We want our ordinary dividend to be at 2.75 of
earnings. […] We need to retain GBP 100 million
because of the vicious working capital swing we have
around peak trading. […] Whatever is left we
distribute at the moment through share repurchase.”
– Mark Robson, CFO (1H18 call)
Over last 5 years, ~77% of free cash flow was
returned to shareholders
Over last 3 years, ~96% of free cash flow was
returned to shareholders

25
Appendix
Projected free cash flow bridge: ‘18E-’22E CAGR %

1% 16%
2%
4% 14%

1%
4% 8%

4%

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Appendix
Howden has historically managed well even in a recessionary environment.
In 2008, revenue rebounded within a year, while gross margins continued strengthening
Howdens Revenue Growth in 2008 Howdens Margin Profile

70% 64% 64% 64% 63%

60% 60% 61% 62%
60% 56%
53%
50% 47%

40%

30%
20%
20% 15% 17% 17% 17%
12% 13% 14% 13%
11%
8%
10% 14% 14% 14% 13%
8% 9% 9% 10%
0% 4% 7% 6%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Gross Profit Margin Operating Margin Net Income Margin

• Management maintains margins during a downturn via cost cuts: Reducing staff and slowing down depot roll outs.
• At the same time, slowing depot roll outs means the margin expansion from the maturing of younger depots will show
on Howden’s financials, providing a natural backstop for margins.
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