Investment Column: DIY dream scenario turns into nightmare

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The Independent Online
The do-it-yourself market is in crisis, casting a shadow over the prospects of a clutch of prominent high street names. Businesses accounting for 40 per cent of the majors' market share are thought to be loss-making, Wickes warned on profits this week and even the industry leader, B&Q, has seen its profits collapse. As our chart shows, demand growth is slumping yet the industry continues to add capacity. Something has to give.

To understand the problems dogging the industry in the mid-1990s you have to go back to the 1980s, when it developed, more or less from a standing start, in the most favourable conditions imaginable. With house prices booming, the number of transactions soared and DIY spending grew at mouth- watering rates for the companies, including Kingfisher, Sainsbury's, Ladbroke, Boots and WH Smith, that tried to steal a slice of the action.

The trouble was that the rapid growth of the industry created a business with very low sales density and a need for high gross margins to sustain profitability.

In a booming market high prices were achievable, but when the market slumped in the early 1990s on the back of stagnation in the housing market, and companies resorted to price-cutting to maintain their share of a faltering market, the impact on profits was dramatic.

B&Q, the industry leader, led the charge, slashing prices, not just during the traditional bank holiday periods, but throughout the year. In addition it developed what came to be known as category killer stores, giant warehouses designed to dominate a local market and put rivals out of contention.

It worked, but arguably too well and cannibalism hit its own stores as much as the opposition. In the short term nobody won. That is the background to the current market malaise which saw B&Q's profits slide 40 per cent last year and put its chief executive's job at risk. It is what has led to increasing calls on WH Smith and Boots to do something about their joint venture, Do It All, which is estimated to have eaten up pounds 150m of the two companies' money, with no apparent return. Only Sainsbury's Homebase seems to have differentiated itself from the crowded mid-market and prospered.

It is a classic example of over-supply that in normal circumstances might be expected to lead to a bout of closures and rationalisation of chains until a profitable status quo was reached once again. Why has this not happened?

Ironically, one reason is because it would be more expensive for some of the players to bail out than to keep going, albeit unprofitably. Closure of Do It All, the industry's biggest problem, could cost the two partners up to pounds 450m according to figures from BZW.

Even then they would face a cash outflow of about pounds 50m on rent and rates thanks to the lease structure of the chain which, set up only in the 1980s, still has a long unexpired tail to run. Also thanks to volume rebates offered by many suppliers, especially of commodity items such as paint, it can make sense for retailers to keep marginal shops going because of the cost benefits their volume throughput provides for more profitable sites.

Meanwhile, the ambitions of Wickes, Homebase and B&Q, albeit somewhat scaled back now, are adding to capacity. Effective space might rise by as much as 4 per cent this year, despite, in the absence of a substantial pick-up in the housing market, a second year of stagnant demand. So, is it all gloom? In the short term, yes, but further out there is a chink of light at the end of the tunnel, if only because the current status quo is plainly unsustainable. Rationalisation of some sort is inevitable and when it happens the most optimistic interpretation suggests a possible re-run of what has happened in recent years in the electrical retailing market.

There, a move out of town, together with slumping consumer activity, conspired to send profits at the big players, such as Dixons, Comet, Currys and the chains run by the regional electricity companies, into a tailspin.

The catalyst for change was a seemingly unrelated tightening of the regulatory regime for regional electricity companies, which forced them to reappraise whether they wanted to be in the competitive retail market at all.

When they withdrew, and the plug was pulled on Rumbelows, the economics of the business changed out of all recognition, mainly to the benefit of Dixons, the market leader.

Following the analogy through to the DIY market, the big beneficiary of a withdrawal from the market of Do It All, would probably be B&Q, and by extension its parent Kingfisher. For that reason one likely scenario being touted by analysts is the acquisition by Kingfisher of perhaps half of Do It All's leases for about pounds 75m.

Obtaining a modest return on the pounds 200m of sales that might add to B&Q's sales would cover the financing costs of the deal, and the closure of the remaining leases, at a manageable cost to WH Smith and Boots, would eliminate a direct competitor.

It is early days yet but the end of the DIY nightmare might be in sight.