OFFICE FURNITURE MFG. (US Based) doc

Important disclosures appear on the last page of this report. April 13, 2012 Investment Recommendation: UNDERWEIGHT Henry Fund Research OFFICE FURNITURE MFG. (US Based) Ryan Jennings ryan-d-jennings@uiowa.edu Source: Google Finance Key Industry Statistics (Averages) Pure-play Public Companies 4 P/E Ratio (LTM) 18.30 P/E Ratio (FWD) 11.97 Growth (Next 5 Years) 3.2% Beta (3 Year Monthly) 1.23 1-Yr % Change -18.6% Constituents % of Industry Rev. Mark. Cap (B) Herman Miller (MLHR) 6.8% 1.30 HNI (HNI) 6.1% 1.26 Steelcase (SCS) 6.9% 1.21 Knoll (KNL) 4.6% 0.78 Primary Public Co.’s (qty. 4) 24.6% 4.55 Other/Private 2 (qty. 3,693) 75.6% N/A Total 100.0% N/A INVESTMENT THESIS  (-) Overvalued relative to S&P 500: The office furniture manufacturing industry is OVERVALUED relative to the S&P 500. This is based on the industries lower growth rate, higher beta, and higher price to earnings (P/E) ratio as compared to the S&P 500. The current industry P/E is 18.3 versus the S&P 500’s P/E ratio of 14.0.  (-) Strong competitive forces: The office furniture manufacturing industry is mature with low company concentration, which puts pressure on pricing and profitability. Over 3000 manufacturers exist in this industry, 70% of which have less than 20 employees and serve local communities. The top four public companies represent only 25% of the total revenue. We do not expect significant change to this landscape over the next 5 years.  (-) Negative historical revenue growth: Industry revenues declined by 4.5% per year over the last 9 years. US plants have been shut down or consolidated at a rate of 1.1% per year over the last 5 years.  (-) Pressure from low-cost imports: Less expensive imports from China have taken 0.8% market share per year from US office furniture consumption over the last 15 years. This trend is expected to gradually weaken, until 2018 when import’s market share stabilizes due to higher Chinese wages.  (+) Small but positive future growth: We expect positive trends in key industry drivers such as unemployment rates and GDP growth. This will provide annual industry revenue growth at 3.2% over the next 5 years and 3.0% thereafter.  (+) Input prices to stabilize: Steel is a major input cost of office furniture, and the price of steel has dramatically increased since 2004. However, we expect steel prices to level off at their current price for the next 3 years due to China’s weaker than normal GDP growth of 7.5%. China is a major user of steel, and a decrease in their usage provides relief to other users of steel.  (+) Emerging market growth opportunities: Opportunities for industry growth exists in emerging markets. Currently emerging markets is estimated to constitute only 10% of the 4 public companies’ revenue sources, although they all have strategies to pursue this region. Growth of 5 - 8% is expected in key emerging market regions, such as China and India, over the next 5 years. Henry Fund Research THE UNIVERSITY OF IOWA Henry B. Tippie School of Management 2 EXECUTIVE SUMMARY We propose to UNDERWEIGHT the US office furniture industry based upon its current overvaluation relative to the S&P 500. The office furniture manufacturing industry bears strong competitive forces that minimize profitability. 6 There are more than 3000 businesses in the US that supply office furniture, of which 70% have less than 20 employees and supply local communities. There are 4 major public competitors, which make up 25% of the industry. 2 The industry has seen steady declines in revenue, averaging -4.5% growth from 2003-2011. 3 Many factories have shut down or consolidated, reducing capacity by 1.1% per year over the last 5 years. In addition, low cost imports (primarily from China) have continued to eat away at existing market share at a rate of 0.8% per year over the last 15 years. 4 Despite the gloom of recent years, we expect there to be moderate revenue growth of 3.2% for the next 5 years, and 3% growth thereafter. This growth is a function of positive trends in key economic drivers for the industry, which includes employment rates, GDP growth, commodity prices, manufacturing utilization, and office construction spending. VALUATION Industry Valuation The office furniture industry is a slightly overvalued industry. The 3 primary factors in valuation are growth, risk, and profit. We averaged these metrics for the 4 public competitors, Knoll, Herman Miller, HNI, and Steelcase, and find that each industry metric is worse than the S&P benchmark. Source: Data from Yahoo Finance as of April 13, 2012 (5 yr. growth figures are consensus projections of sell-side analysts. The beta is based on 3 years of monthly data.) Peer Valuation Although we feel the industry in general is overpriced, some firms within the industry are more attractively priced than others. The following analysis shows the drivers of valuation (profit, growth, and risk) for each of the 4 public office furniture manufacturers. Out of the group, Knoll appears to be the greatest investment opportunity, as its profit and growth are above average, while the price reflected in the P/E ratio of 11.1 is relatively cheap. Note that Knoll is the smallest of the 4 competitors, although the small company risk is already accounted for within the beta. Source: Profit data from FactSet, Other data from Yahoo Finance (Note: growth data is from Yahoo Finance’s sell-side analyst consensus) INDUSTRY DESCRIPTION Background The US office furniture industry dates back to the 1800’s. With the invention of the telephone it became efficient for companies to have their manufacturing and administrative work separated, giving birth to the modern-day office. 1 Since that time, the US office manufacturing industry has matured. In 2011, there were over 3000 office furniture manufacturers headquartered in the US. The industry has low company concentration, and has 4 large public companies (Steelcase, Herman Miller, HNI, and Knoll), which account for only 25% of the 2011 industry revenues. Products Products sold by this industry include chairs, desks, cubicles, conference tables, bookshelves, filing cabinets, and more. We separate the products into 5 categories, as follows. 2 Seating: This is the largest category, which includes chairs (made of plastic, metal, wood, and fabric), and constitutes 1/3 rd of industry revenues. Within recent years there has been growth in this segment due to customer appreciation for the benefits of proper ergonomics. Office chairs now commonly have adjustable back supports, heights, and armrests. We expect this ergonomic trend to continue, as businesses continue to provide comfort and safety to their employees. Seating replacements (due to innovations in ergonomics) will cause this segment to grow faster than other product segments, with a 5-year CAGR forecast of 4.5%. Office systems: This is the 2 nd largest product segment, constituting 27% of revenues, and includes standardized office desks and cubicles. The office cubicle was invented in 1965 by Herman Miller, and is still popular today. We expect that the cubicle will continue to be a staple in this industry, and will grow at 4% annually over the next 5 years, highly correlated to white-collar job growth in the US. Case goods: This is the 3 rd largest segment, constituting 22% of revenues, and includes furniture that is un-upholstered and solid wood (such as executive desks, conference tables, and bookshelves). Typically, case good sales benefit from substantial positive corporate cash flow. As cash flow and profits increase, companies provide their executives with better office furniture. However, over the last 2 years, companies have been stockpiling their cash. As economic tensions reduce in the next 5 years, we expect a gradual increase in spending in line with GDP growth of 3%. Henry Fund Research THE UNIVERSITY OF IOWA Henry B. Tippie School of Management 3 Storage: This category is the smallest, and includes filing cabinets/office document and supply storage. We expect this segment to decline relative to other product segments, as fewer filing cabinets are needed due to the increasing prevalence of electronic document storage. The following graph summarizes the product segments, drivers, and growth forecast: Source: 2011 data from http://www.ibisworld.com/industry/default.aspx?indid=870 Customers The customers of office furniture manufacturers are rarely the end users. Currently, only 7% of office furniture is sold direct to the customers. The following section provides the revenue breakdown by customer, along with our projections for the future. 2 Wholesalers and Custom Outfitters: The most common way to distribute furniture is to sell through wholesalers, which represents 45% of industry revenues. Wholesalers include companies like United Stationers, who sell a wide variety of furniture and office supplies in bulk to corporations and the government. Manufacturers also sell to custom outfitters, who work with corporate clients to develop and implement office remodeling plans, and makes up 30% of industry revenues. Retailers, End Users, and Exports: These customers constitute the remainder of industry revenues. While these segments currently represent a small portion of overall revenues, we expect them to grow, as office furniture manufacturers will attempt to take out the middle man, and sell direct to its end users, both local and abroad. Source: 2011 data from http://www.ibisworld.com/industry/default.aspx?indid=870 Historical Revenue and Projections Declining Revenues: Office furniture industry revenues have declined on average 4.5% per year over the last 9 years. 3 This is primarily due to the economic crisis of 2008/2009 and the continued high unemployment rate. The industry also gradually lost a portion of their US consumption market share, at a rate of 0.8% per year, due to lower cost imports (primarily from China). 4 To cope with declining revenues, office furniture factories have been closing down operations in the US at a rate of 1.1% over the last 5 years. For example, in 2011 Herman Miller closed a plant in Wisconsin, while Steelcase announced it will close 3 plants in North America by 2012. 2 Revenue Projections, Minor Growth: The following graph shows industry revenues and our projections for the future. We expect revenues to stay relatively stable in 2012, while increasing in 2013 along with the GDP and the employment rate, providing a 5-year CAGR of 3.2%. By 2018, we expect growth in the industry will be in- line with long term US GDP growth. Continued… Products, Drivers, and Growth Forecast Customers, Drivers, and Growth Forecasts Henry Fund Research THE UNIVERSITY OF IOWA Henry B. Tippie School of Management 4 Source: Historical data from FactSet Industry Profitability The Office Furniture industry has had poor return on invested capital (ROIC) over the last 9 years, which is consistent with its poor revenue growth. Negative economic profit was also common. However, as the industry drivers improve and revenue growth trends positive, we expect that by 2013 the industry will once again regain breakeven to barely positive economic profit. Industry Profitability Source: Data from FactSet International Playing Field: Small but Growing International Exposure: The 4 public office furniture manufacturers headquartered in the US gain most of their income from the US market. A small portion of their sales (estimated on average about 10%) come from international markets. 3 Along with reducing manufacturing capacity in the US, the industry has simultaneously developed overseas plants in search for both cheaper labor and a larger market for their products. For example, in 2006 HNI acquired the largest office furniture manufacturer in China. We expect this globalization trend of the 4 public companies to continue, as they search for growth, which will primarily be found in emerging market countries such as China and India. Imports: Due to the space required, internationally shipping finished goods is costly. Customization and installation is also a benefit that cannot be obtained with imports. This is a primary reason why office furniture imports have not grown at the drastic rates seen in other industries, such as electronics. The following graph shows the gradual increase of office furniture imports into the US over the last 15 years. While the market share for US manufactures has been reduced by 0.8% per year over the last 15 years, we expect that this trend will subside to 0% market share depletion by 2018 as Chinese manufacturing costs increase. Source: http://www.bifma.org/statistics/index.html Limited innovation The industry has not recently developed innovation with the potential to ignite growth. The cubicle was invented by Herman Miller in 1968, but since then there have not been significant innovative breakthroughs. Within the last 4 years, a technology called “laser edgebanding” was developed, which allows an edgeband to be put on non-solid wood desks, making the desks appear to be constructed of solid wood. However, we do not foresee this technology as significantly impacting long-term industry revenues. Attractiveness of Industry (Porter’s 5 Forces) Porter’s 5 Forces is a model used to determine the competitive forces within the industry. Strong competitive forces put pressure on the industry constituents, and reduce industry profits. As shown in the following model, the office furniture industry has below average attractiveness due to moderately high competitive forces. The strongest competitive force comes from industry internal rivals, which compete heavily on price in addition to quality and delivery. Continued… Office Furniture Industry Revenues ($B) Effect of Imports on the Office Furniture Industry US Manufacturers have lost 0.8% US market share per year over the last 15 years. This trend is expected to halt by 2018. Industry Average ROIC – All 4 Public Companies Expected to return to 8.5% by 2013 and level off, just above the average cost of equity of 8%. Henry Fund Research THE UNIVERSITY OF IOWA Henry B. Tippie School of Management 5 ECONOMIC OUTLOOK The health of office furniture manufacturing is closely tied with general economic factors, such as GDP, unemployment rate, commodity prices, industrial utilization, and office construction. In the following charts, we provide historical data for each driver, and forecasts, and projections of how this will affect the office furniture industry. US GDP growth is returning positive after its negative results 2008 and 2009. Henry Fund consensus estimates 2012 GDP growth of 2.8%. For 2013 onward, average GDP growth is expected to be consistent with historical averages of 3.1%. This is a positive sign for earnings growth within the office furniture industry. Source: http://www.tradingeconomics.com/united-states/gdp-growth US Unemployment A highly correlated driver of office furniture demand is unemployment rate (or inversely, the “employment rate”). As shown by the following chart, as the historical US employment rate trends, so trends the office furniture industry revenue. Source: http://www.ibisworld.com/industry/default.aspx?indid=870 Currently, unemployment is close to 9%, and we forecast this will continue to reduce to the 22-year average of 6.4% by 2018. As jobs are added, businesses will purchase new office furniture to accommodate their new employees. Source: http://www.tradingeconomics.com/united-states/unemployment-rate US Industrial Utilization US manufacturing utilization can be used as a proxy for office space utilization, since manufacturers typically try to match their manufacturing capacity with their office capacity. To meet constantly changing product demand, manufacturers do not operate at 100% capacity. The following graph shows that by 2013, US manufacturing will reach the pre-recession utilization resistance level. Therefore, in 2013 we expect there will be solid office capacity expansion, supporting short-term revenue growth in the office furniture industry. Continued… US GDP Growth Rate (% Change YOY) Expecting moderate growth of 2.8% for 2012. We expect unemployment to drop to 8% in 2012, leveling at the long term average of 6.4% by 2018. Long term average is 6.4% US Unemployment Rate US Employment % and Office Furniture Industry Revenue Porter’s 5 Forces Henry Fund Research THE UNIVERSITY OF IOWA Henry B. Tippie School of Management 6 Source: Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/graph/?id=MCUMFN US Office Construction The US office construction index is typically a trailing index, which does not provide foresight into office furniture demand. This is due to the long-term nature of construction. Nonetheless, it is useful to see that the US office construction market appears to have hit the bottom of the valley and is poised for cyclical growth. Source: YCharts.com, http://ycharts.com/indicators/us_total_office_construction_spending#series=typ e:indicator,id:us_total_office_construction_spending,calc:&zoom=10&startDate =&endDate=&format=real&recessions=false US Commodity Costs Commodity costs play a significant role in the profit margins of office furniture manufacturers. Due to the competitive office furniture environment, when input costs increase, the entire cost cannot always be passed onto the customers. Large customers such as Wholesalers and Retailers have significant power to reject price increases not accompanied by an increase in delivery or quality. The following graph shows how prices have consistently risen for steel, which is a primary industry input (other significant inputs include labor, wood, and fabric). We expect steel prices to remain approximately level at current prices in the next 3 years. This is primarily due to the expected reduced GDP growth in China of 7.5% in 2012 versus approximately 10% in recent years. Source: US Department of Labor, Bureau of Labor Statistics, http://data.bls.gov/pdq/SurveyOutputServlet INVESTMENT POSITIVES  (+) Small but positive future growth: We expect positive trends in key industry drivers such as unemployment rates and GDP growth. This will provide annual industry revenue growth at 3.2% over the next 5 years and 3.0% thereafter.  (+) Input prices to stabilize: Steel is a major input cost of office furniture, and the price of steel has dramatically increased since 2004. However, we expect steel prices to level off at their current price for the next 3 years due to China’s weaker than normal GDP growth of 7.5%. China is a major user of steel, and a decrease in their usage provides relief to other users of steel.  (+) Emerging market growth opportunities: Opportunities for industry growth exists in emerging markets. Currently, emerging markets is estimated to constitute only 10% of the 4 public companies’ revenue sources, although they all have strategies to pursue this region. Growth of 5 - 8% is expected in key emerging market regions, such as China and India, over the next 5 years. INVESTMENT NEGATIVES  (-) Overvalued relative to S&P 500: The office furniture manufacturing industry is OVERVALUED relative to the S&P 500. This is based on the industry’s lower growth rate, higher beta, and higher price to earnings (P/E) ratio as compared to the S&P 500. The current industry P/E is 18.3 versus the S&P 500’s P/E ratio of 14.0.  (-) Strong competitive forces: The office furniture manufacturing industry is mature, with low company concentration, which puts pressure on pricing and profitability. Over 3000 manufacturers exist in this industry, 70% of which have less than 20 employees and serve local communities. The top 4 public companies represent only 25% of the total revenue. We do not expect significant change to this landscape over the next 5 years. US Manufacturing Capacity Utilization (%) We expect businesses to add to infrastructure (including office furniture), as they reach pre- recession utilization rates. Pre-recession utilization resistance level. US Steel & Iron Prices (base 1982) US Office Construction (10 Year Chart) Expected to gradually trend up starting in 2013. Henry Fund Research THE UNIVERSITY OF IOWA Henry B. Tippie School of Management 7  (-) Negative historical revenue growth: Industry revenues declined by 4.5% per year over the last 9 years. US plants have been shut down or consolidated at a rate of 1.1% per year over the last 5 years.  (-) Pressure from low-cost imports: Less expensive imports from China have taken 0.8% market share per year from US office furniture consumption over the last 15 years. This trend is expected to gradually weaken until 2018, when import’s market share stabilizes due to higher Chinese wages. Market/Overweight Discipline: Our recommendation is to UNDERWEIGHT the office furniture manufacturing industry. If any of the following events occur we would reevaluate this recommendation:  The 4 public competitors make stronger advances in emerging markets, constituting a portion of sales over 30% (currently estimated at 10%).  The industry average P/E ratio drops to 20% below the S&P 500 average. (Currently it is 30% above the S&P 500).  A significant technological breakthrough in office furniture products, which enables businesses to substantially increase productivity.  The 4 public industry players take major acquisition steps to consolidate the industry and achieve increased efficiencies and reduced competition. REFERENCES 1 About.com, History of the Office”, Mary Bellis, www.inventors.about.com/od/ofamousinventions/a/office.htm 2 IBIS World, "33721 - Office Furniture Manufacturing in the US", March 2012, www.ibisworld.com. 3 FactSet, www.factset.com. 4 BIMFA, www.bifma.org/statistics/index.html. 5 Yahoo Finance, www.finance.yahoo.com. 6 S&P NetAdvantage, Sub-industry Review, “Office Services and Products.” www.netadvantage.standardandpoors.com 7 Herman Miller, 2011 Financial Report 8 HNI, 2011 Financial Report Additional sources of data are cited under the applicable charts throughout this report. IMPORTANT DISCLAIMER This report was created by a student(s) enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa’s Tippie School of Management. The intent of these reports is to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. . Investment Recommendation: UNDERWEIGHT Henry Fund Research OFFICE FURNITURE MFG. (US Based) Ryan Jennings ryan-d-jennings@uiowa.edu Source:. propose to UNDERWEIGHT the US office furniture industry based upon its current overvaluation relative to the S&P 500. The office furniture manufacturing