The small-cap gems in the DIY sector

It is a difficult time for home improvement businesses. This sprawling sub-sector – which encompasses specialist retailers, bathroom and kitchen suppliers, flooring distributors, builders’ merchants and a smattering of electronics companies – is bearing the brunt of consumer spending cuts.

After surging in lockdown, spending on home improvements and DIY fell by 4.7 per cent in 2023, while furniture stores experienced a 5.2 per cent drop in sales, according to Barclays analysis. This trend has continued into 2024. The amount people spent on ‘household’ purchases fell by 5.2 per cent last month, with one in six people delaying home renovations due to economic pressures.

This is reflected in the performance of individual companies. Most have seen revenue fall in recent months, and there have been profit warnings from Travis Perkins (TPK), B&Q owner Kingfisher (KGF), sofa specialist DFS Furniture (DFS) and Topps Tiles (TPT), which cited “subdued demand… especially for bigger-ticket projects”.

Government data released this month also paints a gloomy picture. Monthly construction output fell by 1.9 per cent in volume terms in February 2024, following a 1.1 per cent increase in January. Heavy rainfall may have been partly to blame. Kingfisher said market order volumes fell 16 per cent in January and February on the year before.

Here and there, however, there are signs of life. Despite the construction slowdown, private housing repair and maintenance actually grew in February – albeit by just 0.2 per cent. Meanwhile, some businesses seem to be through the worst.

Luceco (LUCE), which designs and supplies lighting products, managed to increase sales in the second half of 2023. The residential repair, maintenance and improvements (RMI) division – which accounts for 60 per cent of the group – outperformed the “slow” market and delivered modest sales growth of 0.8 per cent.

Responding to these figures, analysts at Peel Hunt said the residential RMI slowdown “looks to be bottoming out” and “may pick up, with a lag, as/when confidence returns to the housing market”. On a separate occasion, the broker said valuations in the sector “currently reflect tough earnings on tough multiples”.

Peel Hunt’s optimism is muted, but other brokers are more openly cheerful. In a recent note on Kingfisher, HSBC claimed the “macro [is] only getting better from here” citing an improving housing market and the prospect of base rate cuts. “An improving outlook for real wage growth, also a function of lower interest rates and inflation, should drive an improvement in repairs and maintenance spend,” it added.

The best and the worst 

This confidence might prove premature. However, some companies do look ready to rebound.

Norcros (NXR), the Cheshire-based bathroom supplier, appeared in our Ideas section in February as a result of its excellent track record, cash-generative business model and lowly valuation. Similarly, DFS cropped up in our list of British bargains last week on the basis that it has made significant cost savings and is growing market share.

Aim-traded James Halstead (JHD) is another small cap to consider. It manufactures and distributes flooring for the residential market, as well as for offices, hotels, hospitals and shops. The group is not immune to external pressures. In the six months to 31 December 2023, revenue shrank by 9 per cent to £137mn, which management attributed to a shortfall in luxury vinyl tiles which “cross into the domestic consumer market”.

However, the group managed to boost gross margins across all its major markets due to a big increase in manufacturing output. This – combined with a shift to more expensive products – meant the interim operating profit climbed by 14 per cent to £26.2mn.

Looking ahead, management said UK activity “is showing improved confidence” and “there is a similar zeitgeist of positive sentiment” in Europe.

James Halstead’s track record is also reassuring. It has increased its dividend for the past 47 years, with an average hike of 10 per cent a year since 1997. Aside from some modest lease liabilities, it is also debt free, with £55mn of net cash on the balance sheet, and its return on invested capital has consistently exceeded 20 per cent.

Despite all of this, it is currently cheap. According to Panmure Gordon, James Halstead has attracted an average forward price/earnings ratio of 24 over the past decade, but now trades at 20 times.

Travis Perkins sits at the other end of the spectrum. The builders’ merchant reported a 39 per cent drop in adjusted operating profit in 2023 and things seem to be getting worse. A recovery in the UK construction sector is “unlikely to gather any momentum before the UK general election” management said last month. Pricing increases – which bolstered sales in the first half of 2023 – are also expected to be “minimal” in 2024.

The pressing issue now is debt. Net debt currently sits at 2.6 times Ebitda, well above the target range of 1.5-2 times.

The outlook for home improvement stocks clearly depends on the strength of their balance sheets, and their ability to weather – and keep weathering – periods of low demand. The situation is far from hopeless, however, and investors are starting to show a cautious interest. After steep declines in 2022 and much of 2023, share prices have started to perk up in the past six months in a fragile display of optimism. A portfolio refurb beckons.