Kingfisher: Europe Should Still Count For Something

| About: Kingfisher plc (KGFHF)
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Summary

Kingfisher is the 4th largest home improvement retailer in the world behind Home Depot, Lowe's, and Groupe ADEO through its ownership of the B&Q, Castorama, Screwfix, and Brico Depot chains.

The company is well positioned to capitalize on positive cyclical trends in the UK housing market. It should also benefit from secular growth in per-capita 'Do-it-Yourself' spending as household-formation changes.

The company embarked on a multi-year transformation known as ONE Kingfisher and tasked new CEO Veronique Laury with overseeing it. Earnings could grow to £0.40-£0.50+ over the next few years.

Strong balance sheet with net-cash of £900m, surplus pension, and almost £3bn of unencumbered "freehold" real-estate. Funds a 3% ordinary dividend; and more recently has started to aggressively repurchase shares.

Valuation is compressed at 11x-12x current year earnings. Expect £7.50+/sh through earnings growth and moderate multiple expansion, providing upside of more than 100% from current trading levels.

Introduction

The investment case for Kingfisher plc (KGF.L)(OTCQX:KGFHY)(OTCQX:KGFHF) is relatively simple. It is predicated on the belief that people all over the world care deeply about their living situations; and that fundamentals in the housing market remain solid looking ahead.

Kingfisher ranks as the 4th-largest Home & Garden / Do-it-Yourself (DIY) retailer in the world, topped only by Home Depot (US), Lowe's (US), and Groupe ADEO (France). The company's flagship brand, B&Q, is the largest chain of DIY super-centers in the UK; and American investors can simplistically think of it as the "Home Depot of Britain" since it resembles the US counterpart in terms of store layout, offering, and even color scheme.

Homepage for DIY.com -


Homepage for HomeDepot.com -


That comparison goes deeper than just looks though, as Home Depot (NYSE:HD) had also long been rumored as a potential acquirer of the group back in the 1999-2001 timeframe as a way to finally enter the European market. The businesses rely on the strategic use of company-owned real estate; and operationally both companies have found success by promoting the value discipline historically referred to as 'customer intimacy'-a term coined by Michael Treacy in an article for the Harvard Business Review.

Keeping any comparisons and potential combinations aside though, Kingfisher represents a solid investment choice in its own right.

Besides the B&Q division, the group also owns Castorama, which maintains a strong market position in France, Poland, and Russia.

It owns Screwfix and Brico Depôt which are smaller-format stores predominantly located in the UK, France, Spain, and Romania. These 'ironmonger' stores primarily operate "click-and-collect" service on around 10k+ SKUs per location; and are very popular among professional tradesman.

The group also holds a 50% partnership interest in Koctas, the top home improvement retailer in Turkey, through a JV with Koc Holding (OTCPK:KHOLY), one of the largest public companies in that country.

Investment Case

Any investment thesis for Kingfisher needs to at least in part be predicated on fundamentals within the housing market; and in that respect, cyclical housing trends across its core regions appear solid. The economic crash of 2007-2008, along with secular trends in education, labor force participation, and credit availability, created a significant amount of pent up demand in household formation. Construction has not kept pace with that demographic change; and the resulting shortage in the stock of quality dwellings has led to price appreciation for the average home. This has stressed various measures of affordability and made it more difficult for first-time buyers to secure a mortgage.

While this presents a challenging economic backdrop, particularly to the younger generation of 20-34-year-olds that have been most affected, it should also be a harbinger for development growth, housing turnover, and home remodel activity-mirroring positive trends in other developed markets such as the U.S.


This dynamic should support the current level of operations, on which the company appears to be priced at a compelling value. The company also has ambitious growth plans through a multi-year transformation known as ONE Kingfisher. It promoted former Castorama chief, Veronique Laury, to group CEO in Feb-2015 in order to oversee the plan; and if successful, it could dramatically increase the group's earnings power to an estimated £0.40-£0.50+ over the next few years. With multiple expansion into the 15x-18x range it would imply a valuation target in the £7.50+/sh range, implying well over 100%+ potential upside from current trading levels.

The balance sheet is in excellent shape with a net cash position of almost £900m. The company also holds a sizable portfolio of "freehold" property which was externally valued at almost £3bn. With the group over-capitalized relative to its working capital needs, this has created a renewed priority for capital allocation & growth initiatives. Internal investment remains the key priority with approximately £800m earmarked to the transformation plan over a multi-year period. The company also pays a modest dividend of ~£0.10 per year, which equates to a 3%+ yield; and more recently it has also been fairly aggressive about purchasing shares in the open market-a rarity among British companies.

Operations

Operationally, Kingfisher is well-established with a footprint of almost 1,200 total stores. Using rough calculations, the company is expected to generate sales of around £11bn-£11.5bn for the current year. Gross profit has remained consistent in the 35%-40% range. Selling & distribution costs typically run around 25% of sales and allocated/central administrative expenses add an additional ~5% of revenue-putting OP margin into the ~8% range.

That implies an EBIT range of around £850-£900m at the current run-rate. With minimal movement below the operating line since Kingfisher is in a net cash position; and using a tax rate of ~25% from a blended average of its primary jurisdictions, it implies current year earnings of £0.25-£0.30 on a base of 2.3bn shares.

From a P/E perspective, this would place shares at only ~11x-12x current earnings. Adjusted for the cash position, this implies shares trading around ~6x EBITDA; and that multiple would move even lower on an EV/EBITDA basis if adjusted for the substantial portfolio of "freehold" real-estate.

Considering that housing fundamentals should be able to sustain the current level of operations, shares would therefore appear attractively valued under either methodology.

Growth Opportunities & Strategy

Beyond just sustaining results though, Kingfisher also appears to have some specific opportunities for growth.

The company is poised to benefit from any secular increases in per capita spending on DIY within its core markets. It can also continue to expand geographically by growing its store count in select markets; and most importantly, it has a very sizable opportunity to improve efficiency, expand margins, and dramatically increase its "owner" earnings power through a unified multi-year strategy being called ONE Kingfisher.

The company installed Veronique Laury as group CEO in early 2015 to oversee that next phase of growth; and to date the company has made good progress with the most exciting elements of the plan still to come. On a reported basis, results should also continue to benefit from weakness in the £GPB, which makes shares more attractive to foreign investors.

Per Capita Spend & Market-Share Gains

Despite being an established presence in Europe, Kingfisher still has a sizable opportunity to grow organically and take share within its home markets. This is reflected in its comparable-store sales (i.e.: "like-for-like") figure, which has remained positive on a consolidated basis in FY'17 (Jan), despite being dragged down by economic weakness in France.

In the UK, Kingfisher has seen organic growth of higher than 6%+ yr-yr with the increase being driven by mid-single digit gains at B&Q, along with low-teens organic growth from Screwfix. This makes sense given the solid fundamentals in the housing market; and it is also reflective of natural momentum in share shift from independent stores to larger chains, along with an increase in average spend. Per capita expenditure on DIY in the UK is approximately £220 per year. That puts it around 40% below Germany; and almost 70% below North America, which has the highest average DIY spend at a little less than $1k per year.

France is closer to Germany in terms of DIY per capita spending making it an attractive region, but Kingfisher's segment has struggled as of late seeing modest low-single digit organic declines on a constant currency basis. This decline primarily stems from general economic weakness in the country, as France narrowly dodged going back into a recession. Recently though, home prices have been on the rise again, according to statistical releases from INSEE (National Institute of Statistics and Economic Studies); and building permits and housing starts should continue to recover.

DIY expenditure within some of the company's smaller markets, such as Poland and Russia, could also show significant increases over time. For example, per capita spend on DIY in Russia was estimated at less than €25 in a report by fediyma-the European Federation of DIY Manufacturers. As this gradually expands, it should materially improve sales turnover on the existing store base, which would help leverage fixed-costs to improve profitability; and indeed, Poland as an example had comp-sales up 9% through the half-year figures, yet reported a 33% increase in retail profit as the operation reached more meaningful scale.

Store Growth & Geographic Expansion

The global DIY home & garden market is enormous at approximately £450bn annually and the vast majority of that market is concentrated in North America and Europe. So beyond just trying to ride the wave of market growth as a means to increase turnover within its existing store base, the company can also look to expand its reach over time.

Most of this expansion is likely to come from countries where Kingfisher already has an existing presence, as well as select other parts of Western Europe and Scandinavia. So while the endeavor is mildly constrained, it still represents a sizable opportunity to grow sales and earnings.

Within the UK for example, Screwfix has nearly doubled its rate of organic growth by coupling it with store expansion. The company continues to demonstrate that there is a meaningful opportunity to advance the "click-and-collect" service; and more recently expanded the chain into Germany in 2014. It now operates 12+ stores in the Rhine-Main area and is seeing traction as it serves the tradesman market in a differentiated way with professionally managed inventory.

The big-box market in Germany is less likely to be a top priority, as the company had previously been in the DIY center market through an ownership interest in Hornbach. The strategic alliance with Hornbach dated back to 2001 when the group acquired a strategic stake in Hornbach Holding (HBH.DE), as well as an equity stake in Hornbach Baumarkt (HBM.DE)(OTC:HBAUF). Kingfisher withdrew from the Supervisory board in late 2013 and exited the position shortly thereafter receiving proceeds of almost £200m from the sale of its 21% stake in Mar-2014.

Poland may be the company's largest near-term opportunity as it builds on the success its had in that market. The operation appears to have reached scale and I would expect the company to continue selectively adding locations.

Spain and Russia are also likely to see continued store expansion as both regions appear to be at an inflection point with a sales run-rate of ~£300m+ annually. There is no clear reason why either region couldn't mimic the franchise it has built in Poland and take the current footprint from ~25 stores to a store count of closer to 50-75 over time. This would provide it with much needed scale to leverage the fixed-expense of general administrative costs allocated to each region and dramatically improve profitability.

The Brico Depot franchise being built in Romania seems like it could expand to the level of where Spain and Russia are today. It is a country of more than 20m million people with a strong DIY culture and a rapidly increasing appetite for home development, particularly around the Bucharest area.

Turkey is harder to tell since investors can only glean a limited amount of information about the JV with Koc Holding. The country also isn't exactly the most stable place in the world these days, so it seems unlikely to be a major priority from an expansion perspective.

CEO Veronique Laury has specifically called out Italy, Scandinavia, and the Benelux region as areas the company is "keen to tackle" over time. While these are not markets in which the company has an existing retail presence, they are countries that the company should be familiar with; and it would face many of the same competitors it has seen in other core markets. For instance, OBI which is similar to the B&Q brand in Germany has a presence in Italy; and Travis Perkins (TPK.L)(OTCQX:TPRKY) recently expanded the Toolstation brand into the Netherlands with some success, which would bode well for Screwfix's ability to similarly capitalize on the preference for professionally managed inventory in other markets.

While Kingfisher is striving to be the leading home improvement retailer across Europe, the idea for even more ambitious geographic growth plans does appear unlikely at the moment as expansion into Asia, Australia, or North America are all almost definitely out of the equation.

In terms of Asia, Kingfisher had previously established footing on mainland China in the late-1990s through its B&Q brand. It expanded that position via acquisition of OBI Asia Holding in Apr-2005. That transaction essentially doubled the size of its store count to ~40 locations and fit with the strategy at the time to accelerate expansion in the region. The path for growth remained difficult though and eventually the company decided to exit the region by announcing the sale of a 70% controlling stake in B&Q China to Wumei Holdings in Dec-2014. That portion was sold for £140m and the transaction closed in Apr-2015 following approval from the Chinese Ministry of Commerce. More recently, it also exercised its option to dispose of the remaining 30% stake in Mar-2016; and based on similar terms received proceeds of £63m in Jul-2016 following regulatory approval. So while it isn't out of the question that Kingfisher would someday consider going back, it does seem unlikely that it would re-engage with that market, at least in the near term.

In Australia, Wesfarmers (WES.ASX)(OTCPK:WFAFY) appears to have a secure leadership position through its Bunnings Warehouse subsidiary. There is also a solid second in the Mitre 10 brand owned by grocery and liquor store conglomerate, Metcash (MTX.ASX)(OTCPK:MHTLY). Metcash further bolstered that position by acquiring the Home Timber & Hardware Group from Woolworths (WOW.ASX)(OTCPK:WOLZY) for A$165m. Woolworths' new CEO Brad Banducci had made it clear that exiting the home improvement business was a priority when he was appointed in Feb-2016; and in addition to the Metcash transaction, Woolworths also disposed of Hydrox Holdings, its JV formed with Lowe's in 2009 to hold the Masters Home Improvement chain. That chain was conceived to rival Bunnings, but it proved to be an extremely costly "trial balloon" and led to sizable write-downs before being shut. With Bunnings preparing to enter the UK market through the acquisition and rebranding of Homebase, it could serve as an ironic precursor, especially since the UK Bunnings group is now tasked with the same executive, Matt Tyson, who ran Masters and originally came from Kingfisher.

And the North American market is extremely "well-covered" in each market segment. The US is dominated by Home Depot and Lowe's (NYSE:LOW), which should continue to see moderate market expansion, as well as shares gains at the expense of the "old-guard" retail co-ops Ace, True Value, etc. These "tier-2" companies simply don't seem like they will be able to compete longer term as they are being pressured on the one end from the big-box superstores and by Amazon (NASDAQ:AMZN) and general trends in e-commerce at the other. In Canada, while Home Hardware Stores should be able to hold its ground, the US brands are likely to continue making headway in the region through organic expansion and via acquisition like Lowe's C$3.2bn purchase of RONA.

ONE Kingfisher

Market growth, share gains, and geographic expansion are all likely to be positive contributors to top-line growth, but by far still the largest long-term opportunity relates to the company's change in strategy.

The plan, known as ONE Kingfisher, includes three pillars: a unified offering, an enhanced digital capability, and improved operational/scale efficiency.


While these targets won't do much for top-line growth, they will go a long way to make Kingfisher a better business; and as Warren Buffet wrote in his original Owner's Manual, it is not correct to measure economic performance in terms of size, but rather by per-share progress.

By all accounts, ONE Kingfisher would dramatically increase the intrinsic value of the business on a per share basis if the company can execute successfully. Started in FY'17 (Jan), the five-year transformation is expected to deliver a sustainable uplift in annual profit of £500m by the end of the plan. That would imply per share earnings figures moving towards £0.40-£0.50+ over the next few years.

Through its initial year of the transformation, the company has reported "good early progress" and next year will include even more activity as it reaches towards a handful of important milestones. So far the company has said it remains on track; and management has indicated it remains confident in its ability to deliver on the ambitious plan.

Many of the largest components of the plan center on taking advantage of the company's scale in order to improve its cost structure, particularly within shared purchasing areas ("goods not for resale") such as procurement, media, etc. Given that this is fairly standard practice in more centralized organizations, it should have good line-of-sight on the plan's achievability. This is setting Kingfisher up as a "self-help" story, with the largest carrot to achieving significant fixed-cost leverage being well within its own control.

Much of this will come down to the direction of CEO Veronique Laury; and based on her track record from Castorama and her long-term view of the market based on interviews and presentations, I have confidence that she is up to the task.

Capital Structure

As mentioned earlier, Kingfisher's balance sheet is in terrific shape with net cash of about £900m. The company does also have pension liabilities, however the plan's assets are fully funded and are actually in a modest surplus position.

The balance sheet also holds "freehold" real-estate with a net carrying value of £2.1bn. That figure is based on historical cost though, since the Group does not revalue properties within its financial statements. Based on an annual valuation exercise performed by an independent external firm, the market value of the property was closer to £2.9bn at the end of FY'16 (Jan). This implies moderate "hidden" asset value even relative to the value that has been locked in place in 2004; and it is based on a 7% cap-rate in a sale-leaseback to the company which would likely be conservative.

The company also funds a modest ordinary dividend of £0.10+ per year, which it has consistently raised over the past few years. This equates to a yield of around 3%. It has distributed special dividends in the past, although this seems less likely to be part of the capital allocation plan going forward.

More recently, Kingfisher has turned its capital return plan to share buyback and has been fairly aggressive about repurchasing shares-something very uncommon to British public companies. Kingfisher bought back £200m of stock last year and it has announced its intention to return a further ~£600m of surplus capital to shareholders over the next three years via share buyback. While I am not always a fan of share repurchase plans, especially not buybacks for buybacks sake… it is hard to argue that it won't create value when shares are trading at a low multiple of earnings and the balance sheet is already over-capitalized to begin with.

Valuation

With regards to valuation, Kingfisher trades at a very reasonable multiple of current year earnings at only ~11x-12x on a P/E basis. Given the various levers and drivers of earnings growth-market increases, store expansion, weakness in £GBP, and efficiency gains from the ONE Kingfisher plan-this multiple would be trending even lower going forward, exclusive of any adjustments for net cash and/or freehold property.

With earnings growth towards the £0.40-£0.50+ range and moderate multiple expansion into the 15x-18x range, it would imply a valuation target in the £7.50/sh range over the next 12-24 months.

Risks

Risks to the thesis in the short-term primarily center around Europe. With Britain PM Theresa May committed to invoking Article 50 by the end of this month, fears surrounding 'Brexit' are likely to remain heightened. The strength of the European economy as a whole is also likely to remain contentious among money-managers; and quant/macro funds are unlikely to reverse the Sector bias that has been in place.

Longer term, the largest risk likely centers around E-Commerce. Home improvement stores such as Home Depot & Lowe's have generally been considered to be insulated from the trend towards online as the hands-on, project-based nature of the store-visit, along with the service and technical know-how of staff is a differentiated model relative to online. This view is validated in the multiple those stocks trade at with investors still clamoring to own shares at over 20x forward earnings. But over time, this view could subside, particularly on the margin for soft-good, decor-type items; and to the extent that occurs it would likely impact multiple over time.

Summary

Overall, Kingfisher is about as out of favor as it gets right now. Macro/quant investors continue to shun both the Consumer Discretionary retail sector, as well as European equities as a whole. But given its low multiple of current earnings, a coherent strategy for growth, and an inspiring management team in place to execute against it, there is no clear reason why it should be.

The company's market position is secure, its balance sheet is solid, and interest rates in Europe remain some of the lowest in the world. With even modest multiple expansion the stock could easily see price appreciation in the 50%-100%+ range and I'm willing stake out that it does.

Disclosure: I am/we are long KGFHY, KGFHF, TPRKY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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