Halfords (OTCPK:HLFDF) has a dividend yield of 5% at its current share price of 342p. That’s an attractive yield for a somewhat defensive retailer, but in recent years its go-faster stripes (or at least its previously high growth rates) have fallen off. So is Halfords a future dividend champion or dividend trap?
I think it’s more likely to be the former, and here’s why:
A mature retailer with a dominant market position
Halfords is far and away the UK’s number one retailer of car maintenance products (e.g. wiper blades, bulbs and batteries) and car enhancement products (e.g. big chrome exhaust pipes, dash-cams and in-car connectivity equipment). Car products make up about 70% of its retail business, with the other 30% coming from selling bicycles and bike parts, accessories and clothing. As is typical of large national retailers, Halfords’ retail business operates mostly through out-of-town superstores. The other side of its business is car service and repair, carried out through a national network of several hundred garages which were acquired in 2010 as part of Nationwide Autocentres.
A somewhat bumpy track record of growth
Here’s a snapshot of Halfords’ somewhat up and down progress in recent years:
Boom, Bust and Recovery
As you can see, revenues have been going up fairly steadily while profits and dividends have been through a boom, bust and recovery cycle.
Looking at Halfords from a different angle, here are a few of the company’s key metrics relative to the FTSE 100:
- 10-Year growth rate = 0.3% (FTSE 100 = 2.2%)
- 10-Year growth quality = 63% (FTSE 100 = 50%)
- 10-Year profitability (ROCE) = 15% (FTSE 100 = 10%)
- Total borrowings/five-year avg. profits = 1.0 (FTSE 100 avg. = 4.0)
- Defined benefit pension liabilities = zero (no DB scheme)
Those metrics tell the following story:
- Halfords overall growth was very slow thanks to a decline in profits and dividends in the middle of the period (revenue growth was better at 3.4% per year)
- Although slow, its growth has been more consistent (i.e. higher quality) than the market average
- It has good profitability, low debts and no pension liabilities, which are all positive signs as far as I’m concerned
One interesting point is that Halfords managed to do very well during the financial crisis of 2008-2010. To some extent that was the result of deferred car purchases - people spending money servicing and doing up their existing cars rather than upgrading to a new car. To a smaller extent Halfords’ profits increased thanks to its acquisition of Nationwide Autocentres in 2010, which added hundreds of car service and repair garages to the Halfords brand and millions of pounds of profit.
But as often happens during a boom – and especially during an unexpected boom – management’s optimism went through the roof. In 2010, in the middle of the financial crisis, the dividend was increased by 26%. Even more surprising was that year’s annual report, which mentioned a new acquisition-fueled growth strategy expected to deliver sustainable growth of 15% per year.
Personally I find it hard to believe the directors were so optimistic. With the benefit of hindsight, targeting a 15% growth rate appears to be borderline delusional (at that rate Halfords would double in size every five years). Despite the incredulity of this target, the dividend was increased again in 2011, this time by 10%, but after that the music stopped and from 2012 to 2014 Halfords’ growth went into reverse.
In simple terms, the sluggish UK economy eventually caught up with Halfords, as it had so many other retailers. Profits fell and in 2012 and 2013 the dividend was cut. However, I think this early dividend cut was a positive sign.
Decisive action by management produces a rapid turnaround
Rather than burying their heads in the sand and sticking to an arbitrary dividend policy no matter what (as many companies do), management did the sensible thing and cut the dividend early, which allowed them to re-think where that cash could most profitably be directed.
After a period of review, the answer that came back in 2013 was that far more cash should be reinvested back into the company’s core retail business.
Why? Because during the period from 2009 to 2013, investment in capital assets such as stores, warehouses, IT systems and so on, was not enough to keep up with the depreciation of the company’s existing capital assets. As a consequence, things were wearing down and becoming outdated (like the in-store environment) and were not being fully replaced, let alone upgraded and expanded as should be the case for a company targeting any sort of growth, let alone growth of 15% per year.
As far as I can tell, cash that should have been reinvested into the cash-generating retail business was instead seen as fuel for dividend growth, share buy-backs and acquisitions. There is an important lesson here:
If you fail to feed the golden goose, it dies (or at least it gets sick and stops laying so many golden eggs).
So in 2013 a new strategy was born that would involve far higher levels of capital investment in order to improve the stores, the website and other infrastructure, as well as introduce a Halfords loyalty card in order to capture information about the lifetime value of each customer (which Tesco has been doing for 20 years).
Over the last three years capex has almost doubled compared to the period of underinvestment, and it’s set to be at that higher level for at least the next three years as well.
Here’s what that period of underinvestment and recovery investment looks like:
Capital investment is usually unavoidable
This is a good counter example for investors who like to focus on free cash flow. Yes, having lots of free cash flow is good, but not if that free cash flow means the core business is starved of cash.
That’s why, as part of my capital cycle analysis, I like to look at the capex to depreciation ratio, because depreciation can be used as a crude estimate of maintenance capex. If capex is consistently below depreciation then underinvestment is a real risk.
So in the last few years Halfords has been through an unexpected boom, followed by a decline that to some extent may have been driven by underinvestment, followed by a swift dividend cut and much higher levels of investment in the core business.
Halfords seems to be turning around, but what about its longer-term future?
Slow growth for the company, but Halfords’ investors could do better
Halfords has been around since the end of the 19th century and I expect it to be around for many more years to come (or at least until we all start travelling around in Uber/Google self-driving transportation pods).
However, it is a very mature business with more than 400 stores in the UK, and I think it would be hard to double that number, let alone triple it, so high rates of future growth are unlikely.
The company’s own analysis shows that the car market is growing at less than 3% a year while the bike market is growing at less than 8%. With its current 70/30 split of car/bike revenues, perhaps growth in the region of 5% a year is an optimistic but realistic target (far more realistic than 15%).
Of course the company could try to expand overseas, but it has already tried that several times in the past and failed, and has no plans for international expansion in the near-term.
So with its current dividend yield of 5% and an optimistic future growth rate potential of 5% a year, I think Halfords could be a good long-term investment, with a possible yield-plus-growth total return of around 10% a year.
That’s a pretty good rate of return, but not anything to get excited about.
However, with a bit of luck investors could achieve a much higher rate of return.
That’s because Halfords is a retailer, and retailers are usually cyclical (although as retailers go, Halfords is somewhat defensive because a significant part of its business is the sale of non-discretionary MOT-related products and services).
Cyclical retailers go through booms and busts and investors have a tendency to over-extrapolate both, driving the share price to excessive and sometimes ludicrous highs and lows.
In this case, Halfords' share price has broken through the 500p barrier twice in the last few years: first, in 2010, when everything was going well, and then in 2015, when the company’s profits and dividends increased for the first time in several years.
Following both highs the share price subsequently collapsed when reality failed to justify the lofty price, and at one point in 2012 the share price fell below 200p.
With a price of 342p as I write, I think there is a reasonable chance that sensible investors can benefit once again from the irrational exuberance of other investors.
If at some point in the next few years things start to go even slightly better than expected for Halfords, I think there’s a real chance a share price of 500p or more could be on the cards again.
If that were the case, and if I were a shareholder at the time, I would almost certainly sell in order to lock in those outsize capital gains.
But whether or not that actually happens is another matter.
Target buy and sell prices for Halfords
With the shares at 342p Halfords currently has a rank of 61 out of 225 dividend-paying stocks on the UK Value Investor stock screen. This is slightly outside the top 50, which is where I usually restrict my purchases to.
So although I think Halfords is probably a good value at its current price, it’s not quite in my buy zone yet. For me to invest the price would have to drop below 300p, giving the shares a yield of 5.7%.
That may seem like a bit of a stretch, but you only have to look at Next (OTCPK:NXGPF) (which is a holding in the UKVI model portfolio) to see how far a well-established retailer’s shares can fall in a very short space of time.
As for a target sell price, for me that’s what I call the “fair value” price, which occurs when a company sits at the halfway point on the UKVI stock screen. For Halfords that would require a share price of 550p, which is about the same as the maximum value reached during the 2010 and 2015 peaks. At that price it would have a dividend yield of 3.1%, assuming its current dividend was maintained rather than grown, and I think that’s a reasonable yield for a company with a potential growth rate of 5% per year.
Of course I’m not after a reasonable yield; I want an unreasonably good yield, so if Halfords did reach 550p in the next few years, I’m pretty sure I would have sold out before then.
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