After calling this share right at the end of 2021, analyst Edmond Jackson explains why he now thinks the cyclical play is cheap and offers long-term value.
When value investors encourage us to focus on businesses well-established in their markets with shares out of near-term favour, what would be an actionable example?
Stocks may be cheap for good reason, especially cyclicals at the early stage of a possible downturn. The business might have deep-seated issues, or be in a highly competitive market.
It is so easy to get lured in, average down into paper losses and end up frustrated. If it proves a troubled business, then a substantial loss sets back portfolio performance.
Those who bought into DIY chain Wickes Group (LSE:WIX) after its 250p a share divestment from Travis Perkins (LSE:TPK) three years ago, saw its price fall 57% from a June 2021 high at around 271p to a 115p low last September.
At least a “double-bottom” long-term reversal pattern appeared to manifest itself and Wickes has since risen quite consistently. Yet it confounded holders with an 8% drop to 132p last Friday, the day after fairly decent 2022 results.
Fears of cyclicality and/or stagflation are the chief worry
Wickes’ balance sheet is not best to cope with current market conditions. After IFRS 16 has required leases to be included, £164 million net assets support £691 million of leases – albeit no bank debt - hence £29 million net finance costs relative to £104 million adjusted operating profit.
If interest rates continue to edge up in a stagflation scenario, that will not help. Wickes has been through various owners: floated by private equity in 2004 then acquired and later divested by Travis Perkins at the top of a DIY boom. It appears to have a sound offering, but the key question is whether enough people will continue spending on home improvements.
Scope to leverage profit if costs do not rise adversely
As with Costain Group (LSE:COST), which I recently noted as a deep value play, Wickes has nudged its turnover to over £1.5 billion yet 135p a share currently is capitalised at £350 million – hence a price/sales ratio below 0.2 times. Despite Wickes’ adjusted operating margin easing from 7.6% to 6.7%, it compares well with 2.5% at Costain.
A key question is therefore costs in an inflationary environment, although management says it has efficiency plans to offset such pressures, with the exception of energy costs which will be £10 million higher.
It does not help how the release is rather complex, not only with an adjusted versus reported profits split, but differentiating “core” revenue – meaning retail and trade sales – from “DIFM” – meaning “do it for me” installations of kitchens and bathrooms.
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Core revenue eased nearly 4% to £1,188 million, partly as a result of weaker comparatives on sales during Covid. “Cost of living crisis” is cited as a factor, however, despite stronger sales of energy-saving products.
Mind, this includes selling price inflation of 15% in the first half, moderating to 10% in the second; hence underlying volume performance fell 15%.
Market share gains were achieved because “selling price inflation was significantly less than cost price inflation” if hardly what shareholders want to hear.
DIFM sales rose 24% to £371 million, helped by achieving a target of 3,000 installer teams. The year-end order book was below end-2021, however, if higher than 2019.
Adjusted pre-tax profit of £75.4 million thus eased 11%, becoming £40.3 million at the reported level after £24.4 million of IT separation costs in the demerger from Travis Perkins, and £15.4 million lease impairments.
Priced to exact material yield for ongoing risks
The market is taking a cautious view that cost-of-living pressures will check much sales growth, and inflation will broadly remain a challenge.
A total proposed dividend of 10.9p per share in respect of 2022 represents an 8.1% yield, covered 2.2 times by adjusted earnings per share (EPS), although under 1.2 times reported EPS.
But unless guidance has been deliberately conservative, the analyst consensus for 2024 is for a decline in adjusted EPS from 24p to below 17p, hence the dividend per share easing to 8p. A yield more like 5.8% suddenly looks fair pricing based on these lower numbers and general uncertainty.
Yet management remains confident in its ability to drive market share gains, which would put the group in a stronger position to capitalise on the other side of any recession.
Barring a slump and cancelled dividend, there is a case to assume a circa 6% yield is fair compensation for the holding risks, and is why the stock has firmed to 135p early this week.
Wickes Group - financial summary
Years to 1 Jan, also 31 Dec
|Yr to 31 Dec|
|Turnover (£ million)||1,200||1,292||1,347||1,535||1,562|
|Operating margin (%)||4.7||4.4||4.5||6.3||4.3|
|Operating profit (£m)||56.6||56.2||61.0||96.7||67.1|
|Net profit (£m)||14.9||12.9||26.3||58.8||31.9|
|Reported EPS (p)||5.9||5.1||10.4||23.3||12.6|
|Normalised EPS (p)||11.0||14.1||17.8||34.6||23.7|
|Earnings per share growth (%)||28.5||26.1||94.8||-31.5|
|Return on total capital (%)||5.2||5.3||7.2||11.8||3.7|
|Operating cashflow/share (p)||70.1||43.0||30.5||40.2||48.4|
|Free cashflow/share (p)||52.7||33.4||22.5||29.7||33.7|
|Net debt (£m)||879||830||784||619||592|
|Net assets (£m)||264||279||130||161||164|
Source: flotation prospectus and company accounts.
Ageing UK housing stock may underpin home improvements
The lockdown-induced boom is over, but much remains to be done.
As I explained in my last piece on residential property, the UK has a fundamentally ageing housing stock. Wickes’ results provide detail: the oldest housing stock in northern Europe, with an average age of 65 years and one third built before 1945. Around half requires investment to meet an energy performance certificate (EPC) rating of C or better, where current proposals are for all homes to achieve this by 2030 and rental properties by 2025.
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Management says it is enjoying demand even from younger renters who are spending more to improve their accommodation. That’s despite European and US home improvement retailers saying they are being hurt by inflation and higher cost-of-living.
So if UK consumer spending continues to hold up better-than-expected – helped by a savings cushion post-Covid, and those in work achieving higher pay in a tight labour market – Wickes’ numbers have potential to surprise on the upside.
Mind an aspect of behavioural uncertainty, however, about pub revenues holding up better than expected, which might mean paying for higher-price food and drink involves cutting back elsewhere.
Extent of de-rating may over-compensate for risks
I last examined Wickes at end-2021, querying whether the DIY boom could last? The stock was then 242p and several brokers were bullish, targeting a multi-year growth phase based on its “market-leading position”, strong cash flow and the need to improve homes.
In my own experience, however, I found myself visiting Screwfix or Toolstation – logistically, because they are much closer, but also given it is a fairly seamless experience between all three. There is also Homebase, and Amazon has also entered DIY provision. A Retail Economics survey actually cited Wickes as the number four retailer.
I said in December 2021 that I was discouraged from calling a turn in the stock’s downtrend, amid higher raw material costs and drivers’ wages rising, which went against management’s pitch of containing costs. The lease costs burden was also a concern. “If revenues were to weaken, it seems reasonable to question the headroom for dividends.” The risk/reward profile therefore looked finely balanced.
Essentially different now is UK consumer spending holding up better than many predicted – especially later last year – and the stock being 44% lower. Does that now constitute long-term value?
I turn positive to say “yes”, with the qualification that all perceived cyclical stocks will trade lower if recessionary fears grip, especially if the Bank of England is in a greater dilemma than many assume to contain inflation.
The logical conclusion is a starter position ahead of a post-Easter trading update. On the basis that consumer spending continues to defy pessimists, this next one ought to be resilient enough and may help mitigate fear. Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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