Kingfisher (KGF) reported fiscal 2015/16 results that exactly matched our forecasts on the top line and were ahead of our expectations at the EBIT margin. We are reiterating our £4.30 fair value estimate for the ordinary shares and our narrow economic moat rating, as defences against online competition remain stronger in home improvement retail than in most other retail categories. The fourth-quarter earnings beat gives us higher conviction in our thesis that Kingfisher’s strategy to rationalise its merchandise range should help deliver low single digit margin expansion.
Where Kingfisher offers high-ticket private label products its pricing power is strong
Adjusted constant currency sales growth of 3.8% was consistent with our forecast, with the U.K. and Ireland segment delivering healthy like-for-like sales growth of 4.4%, driven by Screwfix. France remains the drag, with like-for-like sales down 0.4%, and management’s commentary on the French market gave little cause for optimism.
We do not factor in a recovery in France into our growth rate assumption of 2.6% over the next four years, however, and we think the strategy at the Group level is the more likely catalyst for the stock. Through its ONE Kingfisher strategy, management has targeted a recurring annual profit uplift of £500 million in five years by streamlining its SKU range, leveraging its group buying power and extending its digital platform. The full year EBIT margin of 7.2% was 60 basis points above our forecast, and demonstrates that the strategy is already beginning to yield results and that Kingfisher may finally be ready to seize its margin opportunity.
We model less than half of the £500 million targeted benefit, and assume £220 million per year in cost savings. We think the source of Kingfisher's narrow economic moat – its defences against online entrants in categories in which the weight/value ratio is high, and in categories where receipt of the product is required immediately - the cost savings will likely be margin accretive.
Our analysis shows that in categories such as kitchens and bathrooms, where Kingfisher offers high-ticket private label products around 20% of its mix, its pricing power is strong, but in categories in which it sells brands or commodified products, pricing power is weak. We assume, therefore, that only 20% of the targeted £350 million in savings from product mix realize gross margin improvement, and that the rest is passed on to consumers amid an intensifying competitive landscape.
The remaining £150 million in annual cost savings in our forecasts is generated by operational improvements and efficiencies from the shift to digital platforms. These assumptions yield a sustainable uplift to profitability of 30 basis points, and we forecast a medium term EBIT margin of 9.3%. Although this is at the higher end of the historical range but below the peak margin of 10.4% achieved in 2012 we believe the merchandise mix strategy should lead to a structurally higher mid-cycle margin going forward.
Upside remains to Kingfisher’s shares, and we think continued execution on the firm’s strategy should mean Kingfisher comfortably achieves this profitability improvement.
