Stockwatch: a share up 50% and still cheap?

After a huge bounce in just one month, Edmond Jackson gives his verdict on this UK small-cap share.

Is it still worth buying – even holding - Europe’s leading floor-coverings provider Headlam (LSE:HEAD) after a jump from about 250p to over 370p? If Brexit trade talks cannot advance this week, the risk of trade tariffs on the UK economy and exports will be palpable.  

Multiple factors driving a rebound in revenues 

At the end of July, I rated Headlam a ‘buy’ at 285p after a trading update cited strong revenue recovery in June and July, with UK revenue higher than 2019. This appeared to reflect pent-up demand and people having sat at home during lockdown, figuring they might spend money saved from eating out or travelling, on interior upgrades. 

Such a trend could persist if more of us work from home, though I imagine the aspect of stamp duty holiday is also driving demand, and home sales/refurbishments will ease when it does. There is speculation it will continue, but the Chancellor Rishi Sunak is already talking about how we pay for the big raft of recent subsidies. 

Headlam equity was also priced cheaply, which prompted a firm shift in sentiment. At 285p, it had represented a sub-10x forward price/earnings (PE) ratio assuming an earnings per share (EPS) recovery target of 30p relative to median EPS around 35p in recent years (see table). Lately, the consensus forecast appears to be for just over 28p next year after a drop to 14p in 2020, although brokers may be deferring to conservative guidance.

Moreover, if the dividend could recover anywhere near to the 25p of the last two years, the prospective yield would be 8%. The cash flow profile shows Headlam as amply capable of supporting such a pay-out level, with free cash flow often ahead of operating profit. Not only was there opportunity to lock in a potentially high yield, it might also be low-risk, hence implying the stock should re-rate. At 360p currently, it still implies recovery towards 7%.   

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So, despite the stock continuing to drift near to 250p by the start of November, it became an inflection point once the market was surprised by serial positive vaccine news. The new mood was reinforced by a 19 November trading update covering the previous four months, citing “exceptional” 10.5% revenue growth in the UK residential sector which compensated for a significantly weaker commercial sector across both the UK and continental Europe. 

UK domestic versus commercial, also European sales

Such a twist in the update shows how this bullish narrative of domestic home spending, is liable to be offset to some degree by lower demand from offices, leisure establishments and the like. More time for people at home implies floors wearing out less elsewhere, or such venues even closing. Headlam tends to talk of schools as representing relatively reliable demand, but UK local authority finances are in near or actual emergency.  

Segmental reporting at the 2020 interim results showed commercial sales representing 32% of UK sales and 41% of continental European, but not how profit/loss is split. It does by region though: Europe constitutes 20% of group revenue and contributes a £0.8 million reported operating profit versus a £0.6 million UK operating loss. This compared with £1 million profit for Europe in the first half of 2019, and £19.3 million for the UK. So, assuming trading normalises, potential extra tariffs in Europe would not be catastrophic, although Headlam’s European operations may anyway be able to source away from the UK. 

This is not a manufacturer but a network of companies supplying both retail and commercial trade. However, being a distributor limits scope for operating margin growth which has struggled to get much above 5%. This also explains why the price/sales ratio – i.e. market capitalisation relative to annual revenue – looks a very cheap 0.5x. Yes, Headlam is cheap in this respect, but so might a tech company on 3x sales but a 20-30% operating margin.  

Brexit risks therefore exist, but they do not look material enough to destabilise the essential recovery case for Headlam – which traded in a 530p to 560p range earlier this year and was 630p in May 2017. 

The only recent mention of Brexit came under the interims - “principal risk and uncertainties” section – concerning the supply chain and related chiefly to Covid-19.

“The company typically holds a significant inventory position at any one time… (which) will also assist in mitigating any potential disruption and help preserve customer service in relation to Brexit…”   

Teaser over promise to look at reinstating dividends

A key reason for investor interest being sustained on the back of the 19 November update was its concluding on a note of “cost savings over £4 million from 2022 following a modest net benefit in 2021…along with other projects that will provide additional financial benefits…” – this underlined by an update on reinstating the dividend at a 21 January 2021 trading update. 

Looking back to the 25 March 2020 Covid-19 update, management had said that, despite passing the 2019 final dividend of 17.45p, it would consider an augmentation to the 2020 interim dividend, even a special dividend. In practice, the interim payout was also passed, although net debt kept reducing – from £22.4 million at end-June to £7.3 million end-July. 

It seems a reflection of how the UK is becoming state-capitalism akin to China, how Headlam was able to shutter its UK operations during the spring lockdown and furlough staff, yet to have cut debt and soon to be entertaining a special dividend. During Covid-19 there has also been record repayment of UK personal debt. 

It is partly why the likes of Headlam and Walker Greenbank (LSE:WGB) home furnishings are enjoying bumper sales. Yet the bill for the chancellor’s “most generous scheme in the world” is yet to materialise by way of higher taxes. It could also mean higher inflation compromising disposable income - say if sterling suffers from higher public debt and a weaker Brexit economy.  

All considered, I believe it is fair to target ongoing medium-term upside, although bulls talking of 40p EPS may overlook the realities of Brexit Britain that are yet to dawn.  

Chairman bought nearly £30,000 worth of shares at 267p

It was a modest and isolated purchase by the chairman on 8 October, easily overlooked. It compared with 222p net tangible assets per share as of end-June that ought to have risen simply due to debt coming down. 

The chief trigger for his now sitting on a 35% gain was the 19 November trading update proclaiming “strong and sustained recovery” in UK sales, despite the lockdown in England and restrictions across much of the country. Focus on costs meant underlying profit materially ahead of market expectations for breakeven: after a £1.2 million underlying loss in the first half of 2020, the four months to end-October generated £13.3 million pre-tax profit.  

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December sales may be affected by demand hitting capacity constraints by way of floor fitters. However, an underlying annual pre-tax profit range of £14-16 million was guided for, which affirms consensus for net profit around £12 million and EPS roughly 14p. 

Despite the stock jump, I think it over-cautious to downgrade to ‘hold’. As the dividend likely re-builds, it should support upside to 400p to 500p a share, according to its extent and perceived risk. Targeting is compromised by the effect of Brexit on spending patterns, consumer and commercial alike. So, watch for opportunities to accumulate while keeping Headlam under review. Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.