Hornbach Baumarkt AG revisited- Where are the market share donators ?
Hornbach Baumarkt is one of my few remaining initial position after almost 5 and a half years.
Looking at the stock chart we can see that compared to the German small cap index, Hornbach looks pretty lame:
At the time of writing, within my portfolio Hornbach clearly was a drag on performance with a total performance of 13,7% since 01.01.2011 vs. 109,5% for the portfolio and 73% for the SDAX.
What really irritates me is the fact, that despite the bankruptcy of major competitor Praktiker 2 years ago and a veritable real estate boom in Germany, Hornbach seems to struggle hard just to stand still. Yes, market share and sales increased but profitability dropped.
This leads of course to some questions. I think one can nail it down to those 3:
- Why did Hornbach perform so badly ?
- Did I make any mistakes along the way ?
- Should I keep the stock ?
- Why did Hornbach perform so badly ?
According to the just released annual report, non-German stores accounted for 73% of EBITDA and 105% of EBIT (!!!). Which means that the core German business earns close to nothing.
Germany is in a veritable building boom right now. Low interest rates and more than 1 mn refugees last year have substantially increased building activity in Germany. I would argue that fundamentally, it doesn’t get much better than that.
Hornbach itself names 3 main reasons for lower profitability in the German business
- former Praktiker stores are now run by better competitors
- aggressive “special offer” pricing of competitors
- increased costs due to “digitization”
Another reason can be found if we look at how market shares have developed in 2015 vs. 2014 in Germany’s DIY industry. The detailed table shows clearly that from the top 10 DIY chains, 9 increased their numbers of stores both in 2014 and 2015. Especially market leader OBI expanded significantly, interestingly without gaining in sales.
Basically everyone is expanding store count, there are no “market Share donators” anymore. My personal guess is that the overall positive situation in Germany combined with very low-interest rates makes it tempting for the DIY chains to expand their store base despite the fact that there are far too many DIY stores in Germany already. If the table is correct, 2016 will bring even more new stores than 2015.
Even in my own hometown one can see this easily. Market leader OBI lost 16 Franchise stores in Munich in 2013 to Hage Baumarkt, and then “of cours”e directly opened up 5 new stores in the next years.
Munich was saturated with DIY Baumarkts already before, but now there are 5 more.
So we clearly have a market where the participants are not cooperating and everyone seems to try to outgrow the others which in aggregate of course cannot work and will hit everyone hard in the next downturn. This could mean that the industry itself is really screwed for some time to come and until more than 1 of the top companies goes bankrupt.
With regard to prize competition however, Hornbach is not free of guilt. One of their cornerstone features is that they have a low price guarantee. So whenever you see something cheaper elsewhere, they will not only offer you the same item for the same price as the competitor, but they will sell it 10% cheaper than that. Other competitors offer similar guarantees for instance Hellweg , Globus and Nr. 2 Bauhaus even takes of 12% if a product is cheaper elsewhere. Interestingly the Bauhaus guarantee does not apply to internet offers whereas Hornbach even guarantees against pure internet offers. Market leader OBI doesn’t offer this kind of guarantee but maybe that has to do that around 50% of OBIs branches are franchises.
There is a lot of literature on the impact on prize guarantees on a market. I do think that the most likely outcome is the one that is mentioned here: When consumers have little hassle to compare prices (Smartphones !!!) then price guarantees will make prices very competitive which means low prices for consumer but also thin profits for companies.
I am also not sure if it is smart for Hornbach to guarantee (and deduct 10%) vs. pure internet competitors. Someone like Amazon with intelligent pricing algorithms could create a lot of issues for Hornbach.
Store format issues ?
It looks like that Hornbach rolled out a new store format: So called “Hornbach compact” stores with overall size of 1500 square meters or ~1/6 of a normal store. I have to say that this irritates me somehow. Up until now, I thought that one of Hornbach’s competitive advantages is that they always run the same “super store” concept and that different formats increase complexity. So maybe the super store concept is not the final answer.
On the one hand it makes clearly sense to try different formats, on the other hand this looks like a defensive move as the “compact” format somehow looks and sounds like the new “Screwfix” format which Kingfisher tries to roll out in Germany after selling their Hornbach stake 2 years ago. So let’s wait and see but new store formats would clearly be an additional challenge and risk especially for Hornbach with its previous “one size fits all” approach.
2. Did I make any mistakes along the way ?
Mistake 1: Forgot to update my assumptions
I think the initial investment case was not bad. A well run, family owned company in a tough market but with the biggest competitor struggling and heading for bankruptcy didn’t look so bad, especially as the stock was relatively cheap. Add on top a cheap interest rate fueled building boom and it there could have been a good outcome.
On the other hand, looking back, I should have seen earlier that not everything is great.
If I look for instance into my initial valuation, I assumed that free cash flow (before growth Capex) would be ~103 mn EUR p.a. Looking back, we can see however that actual free cashflow was close to zero in 2015/2016 and only 43 mn EUR in 2014/2015. Actually, operating CF before maintenance Capex was only around 105 mn EUR p.a.. Assuming Maintenance Capex of 30-40 mn EUR, then Free Cashflow would only be 70 mn EUR p.a. Only in the best year of my holding period, 2013/2014, Free Cashflow was near my assumed level.
If I just use those 70 mn EUR as a basis for a valuation with different cap rates, the fair value would drop from a 25-45 EUR range per share (adjusted for splits) to a range from 17-32 EUR, indicating that the shares are fairly valued.
Anchored on Book Value
Another issue is that from a book value perspective, the stock also looked cheap.Taking into account their “hidden reserves” on real estate, adjusted book value per share would be around 40 EUR or so. Stated book value increased from around 23 EUR to 30 EUR per share.
However one thing that I learned over the past 5 year is the following: If you need to invest more and more just in order to keep your profits constant, than the additional book value is not value creating.
In Hornbach’s case it is also quite unrealistic that the book value will be realised anytime soon. With the KgAA structure, there is no chance for any activist investor and I don’t expect Hornbach to change its strategy and suddenly spin-off a REIT or so.
Installux in comparison also retains profits and has relatively constant earnings, but they don’t need to reinvest. They pile up cash and if you adjust for this, returns on capital are pretty stable.
So I would argue that I was also anchored too much on book value and did not take into account the deteriorating returns enough. Interestingly enough, even my own BOSS model showed a deteriorating value starting 2 years ago which I ignored.
Other issues: Hornbach family selling stocks
The Hornbach family disposed 1 mn shares in the Holding company in October 2015 for around 70 mn EUR, a couple of weeks later Hornbach came out with a (significant) profit warning. They now own 43,75% of the holding shares but via the KgAA structure effectively control the company.
The timing of the sale at least looks “lucky” to me.
The profit warning
The profit warning in late 2015 itself has been a big riddle to me. In the annual report of the Baumarkt on page 52 they explain why they had an unplanned write down. The trigger was the IFRS rule that if the stock price is below book value, you have to test your “Cash generating units” against their book value.
What I don’t understand is the following: First, the definition of cash generating units is not carved in stone. Especially for the retail industry, there is no fixed rule how to define cash generating units. If you want to avoid write downs, a very simply alternative would have been to just combine several stores in the region and then avoid the write down. Secondly, there is always the possibility to adjust assumptions (i.e. use longer time periods, higher ultimate growth rates etc.) to avoid write downs.
Finally they mention that they haven’t actually written down only stores but also some software and other stuff.
What then really surprised me was the fact that the actual net profit for 2015/2016 was higher than the year before, despite the extra write downs. Why is that ? The tax rate in 2015/2016 is a lot lower, it seems that they had built some tax reserves in Sweden which now however needed to be released. Interestingly, the Holding had lower EPS than the year before, so at the Baumarkt, the positive tax effect over compensated the write downs. In any case, for me this is not very good communication and in connection with the stock sale even looks kind of dodgy.
Finally: Should I keep the stock ?
First I will clearly put the off my mental “do not touch” list. Secondly, I think there is no urgent requirement to sell as the downside seems to be relatively limited. On the other hand, there is not much upside either.
So Hornbach will be one of the first stocks I would sell if better opportunities come up.
As a learning experience, I think I will need to make better updates at least on an annual basis plus I will need be more critical on using book value as a measure of value and look better at industry dynamics. It doesn’t help to look for the best house in the neighbourhood, if the neighbourhood is really bad and getting worse.