My thesis for Safestyle PLC

Safestyle PLC

Safestyle is a manufacturer and installer of replacement double glazed windows and doors, based in England and Wales.  Its business model is unique as it manufactures the product itself to order.  This ensures extremely low levels of inventory and a low fixed asset base and, as it receives payment as soon as the installation has been made, it is able to run with negative operating assets.  No other company currently pursues the strategy of focussing solely on the secondary windows and doors market. 

It listed on AIM in December and net income will double in the two years to 2013.

 

Why was I attracted to this company?

Its financial metrics are extremely attractive, and it may have persistent competitive advantages.  It has managed to nearly double market share during a 6 year period of general market stagnation, because it believes it has a cost advantage over its competitors. 

Offering Document: “Safestyle’s strategy … allows it to offer product at approximately 20 per cent cheaper than its national competitors and remain competitive with regional players”. 

CEO in newspaper interview: “We’ve got a value proposition.  We call in the Aldi effect.  People are pleasantly surprised that they can buy a good quality product for less than our rivals”.

One only needs to look at the likes of Sports Direct and Wal Mart to see how powerful a cost advantage can be.  In “Competition Demystified”, Greenwald describes it as one of the three real sources of competitive advantage.

This business is highly geared towards housing market recovery and the economy.  I don’t believe the market has yet priced in the fact that the UK’s housing market is rapidly recovering and booming in some areas, and that the economy may be undergoing sustained recovery.  A combination of market share gains and market growth should enable continuing profit growth and yet the stock is priced for no improvement.

Finally, very few investors are aware of Safestyle as an investment.  It floated on AIM in December, with little publicity.  I have seen only one reference to it in the press and it won’t show up on any screens as the likes of Bloomberg and Capital IQ do not seem to have uploaded the historical financials.  An annual report has not been produced and the only source of information is the AIM offering document.  Even finding this on the Safestyle website is not straightforward.  The company’s outstanding return on capital metrics are somewhat obscured by the fact that nearly 90% of its non-current assets are intangible and irrelevant for the future.

Industry Positioning

Safestyle has grown its market share since 2003 from 3.3% to approximately 7.9% today.  Since 2007, unit volumes have dropped from 4.6mln in 2007, to 3mln in 2012.  There are two other nationwide competitors – Anglian Windows and Everest.  The three make up 20% of the overall market, and small businesses make up the rest. 

Safestyle differs from Anglian and Everest as it is focussed exclusively on replacement uPVC products.  Anglian and Everest sell a range of other products including conservatories, garage doors and solar panelling.  Their accounts reveal inferior metrics, including unstable and low margins, debt and low returns on capital.  This is partly because they source their product externally, which reduces achievable margin.

The advantage that Safestyle have over local operators is advertising scale.  Its TV adverts are ubiquitous on daytime TV, although it has said it will divert resources to internet adverting, which it believes is more efficient.  Regardless, a local operator cannot hope to get the customer exposure that Safestyle can.  This advantage will become more and more apparent as Safestyle continues to grab share and is able to spend ever increasing amounts on marketing.

CAPEX

Safestyle requires extremely low levels of Capex, given it operates with PP+E of around £6.8mln.  It recently purchased its Wombwell manufacturing site for £3.8mln.  It estimates the plant has capacity to increase production by 50%, which means further growth CAPEX won’t be required for a while.

It receives payment as soon as installation is complete, and finances itself largely with payables.  At year end, it has had negative operating assets, although this may change now that it has bought the manufacturing facility.

Finance

Finance accounts for 21% of Safestyle’s sales.  Until recently, it tended to receive commissions for high interest finance that was provided to customers.  Due partly due to regulatory changes it is moving towards a model where customers receive a promotional interest free rate with Barclays, which Safestyle subsidises.  Receivables as a % of revenues have grown over the last few years.  However, overdue receivables as a percentage of revenues are less than 1%.  Intuitively, credit risk appears low, given that borrowers will be homeowners enhancing the value of their homes. 

Growth

Market share has nearly doubled since the credit crunch, a time of austerity in the UK.  There is an extremely close correlation between the housing and employment markets and demand for replacement windows.  People often want to get replacement windows either when they move in, or when they are preparing to move out, to make the property more attractive.  Now there are signs of growth in the housing market.  Mortgage approvals and Employment confidence, both leading indicators of housing market activity hit multi year highs in Dec 2013.  This activity is expected to continue in 2014 as unemployment comes down and government subsidises housing programmes.  Management have guided to 14% revenue growth for 2013, and has said sales thus far in 2014 are ahead of expectations.  Based on the assumption of continuing market share gains in a market getting bigger, it seems likely that good revenue growth can be maintained for a few years, at least.

Management Incentives

The CEO and one of the long term owners retain around 10% of outstanding shares.  Options and warrants totalling 8.25% of outstanding share price have been awarded under the ESOP and as warrants to Zeus Capital, who arranged the IPO.  This seems somewhat high, and award of further incentives should be closely watched.  It is assumed that the company will use some of its cash balance to buy back shares and prevent dilution.

Operating leverage

Wages make up around half of operating costs and it has demonstrated operating leverage here.  During a time when net profits have doubled, S&D and Admin staff count has been static, and overall staff count has increased only c10%.

Operating margins have therefore fallen:

In the near term, they will fall further, given that rental costs have decreased now that their manufacturing facility has been purchased.

Valuation

A business that can grow with very little additional CAPEX is a rare beast and consequently they tend to be very highly rated.  A simple FCF model shows that the P/E for such a company should be in the high teens at least, even with relatively modest growth.  Applying a 9% discount rate gives us a P/E in the 20s.  Conservatively then, I assume three scenarios, with revenue growth at 10%, 5% and 0% for two years, and applying an ex cash P/E at that point:

 

  

Even if the company experiences no revenue growth after two years, it deserves a double digit multiple, given it’s extremely high free cash generation.  The valuation exercise shows that with double digit revenue growth and a decent re rating, the valuation should double.  Given the valuation multiples the market is currently prepared to apply, it can conceivable go significantly higher.

A comp might be James Latham PLC, supplier of hardwood flooring and similarly geared to the housing market.  This trades at 13.7 * forward earnings, despite having inferior returns on capital and operating margins.

Uses of cash:  At some point, it may require a new manufacturing plant, if revenues grow by 50%.  Alternatively, it may choose to acquire rivals, though this seems unlikely given that its model is unique and taking market share anyway.  The dividend is currently slightly less than 5% and it seems there I ample scope to increase dividends and maybe buy back stock.

Downside protection:  The Company is debt free, with a generous dividend, and over 10% of stock owned by management, while the company potentially continues to grow.  It appears downside is limited.

Risks

First, unexpected recession in the housing market could cause a fall in revenues.  This does not prevent market gains from continuing, and mortgage approvals in 2013 were not higher than the long term average.

Second, the company could experience increased competition that copy of its business model, reducing the competitive advantage and returns.  This has not occurred yet, and would not happen rapidly.  Close monitoring of key KPIs should ensure that any deterioration in the business model is spotted early.