Kingfisher Builds on Its Competitive Advantages

We believe home-improvement retailer  Kingfisher's (KGFHY) agreement to sell 70% of its loss-making B&Q China business to Wumei Holdings for GBP 140 million represents one of the best possible outcomes following the strategic review of the business. Although we think the deal is a modest net positive for Kingfisher shareholders, it does not materially affect our fair value estimate. We continue to believe Kingfisher has a narrow Morningstar Economic Moat Rating, with competitive advantages over online competition that retailers in other categories do not possess.

We were not surprised that the first action of new CEO Veronique Laury was to announce a new strategic plan for B&Q China following the announcement a year ago that the firm was looking for a local strategic partner. Several Western retailers have exited China in recent years, including U.S. do-it-yourself retailer Home Depot (HD) and consumer electronics retailers Best Buy (BBY) and Media Markt, having failed to capitalize on the country's economic growth. Nevertheless, we remain optimistic on the long-term prospects of the DIY industry in China, so we are pleased that Kingfisher retains an economic interest in the business, although we think material growth and profitability remain many years away.

Despite the recent housing boom and the growth in disposable income of the middle class, DIY retailing has failed to take off in China. However, we believe it is possible that within a decade, if productivity increases no longer keep pace with wage inflation, the labor pool could tighten in China, making DIY a relatively more attractive alternative to professional installation. If this coincides with a slowdown in residential property construction and an aging of the housing stock, we believe these factors could be powerful driving forces for the DIY retailing industry. Until then, however, we believe it is prudent for Kingfisher to focus its management efforts and financial resources on the European housing market.

Sharpened Focus Improves Advantages
There is a lot for long-term investors to like about Kingfisher. A decade ago, the company was a multicategory retailer, an ineffective conglomerate of primarily no-moat businesses. Today, it is focused solely on home improvement, and we believe management is building on some competitive advantages that are likely to sustain excess returns on capital through the major secular challenges that traditional retailers currently face.

We believe the strategy to sell common products across its banners will allow Kingfisher to finally exploit its scale and help strengthen the company's economic moat as one of the cost leaders of the industry in Europe. Products will have instructions in several languages and will meet cross-border safety standards in order to be sold in multiple geographies. However, even at its target of 50% common own brands, the company will lag Lowe's (LOW) and Home Depot in leveraging its scale, and we do not expect the company to achieve the double-digit normalized EBIT margins that we forecast for its U.S. counterparts. Instead, our valuation assumes that almost all cost savings are reinvested in the business, and we regard management's strategy as a revenue driver rather than a margin expansion opportunity. Common own brand products could also strengthen Kingfisher's intangible asset economic moat by making its store brands more recognizable and by increasing pricing opacity in more categories.

Even among the brick-and-mortar retailers, Kingfisher is a fairly solid operator. Despite its smaller scale (GBP 11 billion in annual revenue versus GBP 34 billion for Lowe's and GBP 51 billion for Home Depot), Kingfisher generates a lower total asset turnover (1.1 times versus 1.6 times and 1.9 times for Lowe's and Home Depot, respectively) and has sustained a negative cash conversion cycle for a decade. Its revenue growth, profitability, and working capital management metrics are all superior to its closest competitor, Home Retail Group, which operates Homebase in the United Kingdom.

Cost Advantage Is Main Moat Source
A cost advantage that allows Kingfisher to compete in the online channel and undercut its brick-and-mortar peers in the small trade segment on price is the primary source of Kingfisher's narrow economic moat. In addition, intangible assets give Kingfisher pricing power in several categories.

Moats are generally difficult to build in retail. In the U.K., Kingfisher's largest market at around 41% of revenue, Internet sales have reached 11.8% of total retail sales (excluding automotive fuel), according to Office for National Statistics data, and grew in 2013 at a rate of 11.8%. Traditional brick-and-mortar retailers are taking only around half of that growth, as e-commerce retailers exploit their cost advantage to take share. In most retail categories, the distribution centers used by online retailers such as Amazon (AMZN) are a more cost-effective distribution platform than the heavy fixed-cost store networks of the brick-and-mortar retailers, particularly small-format High Street chains.

However, the large-format home-improvement players have some inherent defenses against the encroachment of e-commerce and discount players. First, DIY retailers are able to use their big-box stores as distribution centers for their own omnichannel platform.

Second, some categories, such as kitchens, are infrequent purchases at very high price points that often require financing. Consumers are reluctant to make such purchase decisions on line because they cannot return the products and they require assistance from sales associates before making a commitment, a service that online-only retailers cannot replicate. Furthermore, there is value to the customer in the convenience of completing a project in one store and with the help of one assistant. The smaller range of product offerings of the discounters often prevents them from offering a one-stop-shop service and the lack of a perfect alternative drives footfall at large-box retailers. The exclusive product ranges on offer at Kingfisher's retail brands hinder pricing transparency for the consumer and make online comparisons more difficult, which helps the firm to convert this footfall into sales.

Third, in some other categories, such as timber, joinery, and plumbing, there is often a demand for immediate consumption, either because of an emergency situation or because customers do not want to delay completion of a job while products are delivered. The do-it-for-me segment, in which Kingfisher's subsidiaries provide installation services, holds significant advantages over online competitors that do not provide such functions.

Despite these competitive advantages, Kingfisher falls short of having a wide moat because it also competes in some commodified categories in which identical products are available from a large number of suppliers and no switching costs exist. In such categories, such as cleaning and laundry, it is forced to compete on price and must accept below-company-average margins. In addition, cyclical trends can have a material impact on Kingfisher's financial performance. During the recent economic financial crisis, the company's returns on invested capital dipped below our estimate of its weighted average cost of capital in 2008 and 2009. Before that, it failed to achieve excess returns on capital because of its unprofitable subsidiaries.

Housing Market Dictates Sales
We have a medium fair value uncertainty rating on Kingfisher. The company's revenue is closely correlated with housing market data, particularly housing transactions, house prices, and the relative level of house prices to household income. Our ability to model the company's revenue, together with our confidence in the sustainability of its moat, gives us greater confidence in forecasting Kingfisher's cash flows over the next few years.

Kingfisher operates cyclical businesses, and upside or downside to the housing markets, particularly in France or the United Kingdom, represent the greatest risks to our cash flow forecasts. Currently, we think the greatest risk to Kingfisher's cash flow generation is the U.K. housing market. We believe it is the wealth effect that drives DIY spending in the U.K., although the correlation is less pronounced in France. Historically, turnover in Kingfisher's U.K. and Ireland segment has trended with how wealthy consumers feel as a result of the change in the value of their homes, particularly at peaks and troughs in house prices. In the event of a weakening or negative wealth effect, which could be triggered by rising interest rates or by the British government reversing the Help to Buy scheme, for example, the housing market would be at risk of a significant decline and Kingfisher's sales would be materially affected.