In the debate over “green shoots” we have directed our attention in large part to the state of the housing market as an indicator as to when the economy might actually improve (as opposed to getting worse at a slower rate). From that perspective, at best there are some encouraging signs and at worse some very mixed signals for economic growth over the next several years. However, we would be remiss if we didn’t acknowledge the true devastation ongoing in the labor market. Simply stated this is the worst labor market in the past 70-years. The US is on pace to hemorrhage close to 7 million jobs this year. The level of job loss for this recession is more than twice that of any other recession over the past 70 years (click on chart for full image view).

Source: Bureau of Labor Statistics

Unemployment is likely to remain elevated for several years to come, which will significantly dampen the magnitude of any economic recovery. In this type of environment, we think it is reasonable to bid up early cyclicals based on “green shoots” or “second derivative” improvements, but we find ourselves hard pressed to believe how late cyclicals (those stocks whose fundamentals are typically more dependent on job gains) should rally.

Outside of staffing, we cannot think of another group of companies that is more dependent on employment trends than office furniture manufacturers. We have been watching the price action of a leading office furniture manufacturer, HNI Corporation, of late with considerable consternation. The stock is on a roll, up 19% YTD and an amazing 89% since 3/31/09. Even though we are not bullish on the office furniture manufacturers we think investors can generate strong returns through a pair trade – long Herman Miller, Inc. and short HNI Corporation. Our thesis is based on the following:

• This is the worst labor market in 70 years, don’t forget it. We recognize that a peak in weekly jobless claims might have formed and that the rate of decline in non-farm payrolls has lessened. However, even the most optimistic economic forecaster is not looking for meaningful job growth until next year at the earliest. The playbook on the office furniture manufacturers has always been to buy these names in the early stages of an economic recovery (not to be confused with the bottom of a recession). However, if this economic downturn has proven anything, it’s that the portfolio management playbooks compiled in the past 25-years are not nearly as effective in this recession. We are concerned that the stocks of the leading office furniture manufacturers and HNI in particular have had a false dawn. BIFMA currently forecasts a peak to trough decline in industry-wide office furniture production of approximately 30%, which we think is too low given the magnitude of job losses. Additionally, BIFMA currently forecasts a modest recovery in office furniture production in 2010, which we think might be optimistic. As the chart below demonstrates, meaningful job GROWTH is a necessary condition in order for revenues and earnings to recover for this group. We anticipate this could take a few years, which is not fully reflected in consensus estimates (click on chart for full image view).

Source: BLS and BIFMA

• We think HNI will violate its total leverage covenant within the next quarter or two, which could cause the company to drastically reduce its dividend. We think HNI shares have been supported in large part by the company’s dividend. HNI currently pays out $0.88/share in dividends annually, implying a yield of approximately 4.7%. The dividend has become an increasingly unwieldy use of cash for the company. The payout ratio exceeds 125% and based on our projections the company will not likely cover the dividend payment with free cash flow generation in the next few years. Based on our EBITDA forecasts over the next two quarters, we think HNI will violate its total leverage covenant (total debt/LTM EBITDA) of 3.0x in the third quater. Given that the company now spends $38-$39 million on its dividend and free cash flow generation prospects are likely to be limited for the next 2-3 years, we think the company’s lenders will ask for a large dividend reduction as part of any amendment to HNI’s credit agreement.

Source: Company reports, PAA Research

• In a tale of the tape between Herman Miller and HNI, MLHR wins by a knockout. There is no rational reason as to why HNI commands a valuation premium relative to MLHR. Even though there are slight differences in the end markets they address, MLHR and HNI shares have been highly correlated over the past 15-years. Over the past 12-months and 15 years, HNI and MLHR have had a correlation of 0.874 and 0.809, respectively. However, since March 31st, HNI has outperformed MLHR by approximately 44%, which we find truly astonishing. There have only been two other periods in this decade during which HNI outperformed MLHR shares by more than 30% on a 3-month basis. In the month following those two periods, MLHR outperformed HNI by 20% and 30%. HNI now trades at almost twice the multiple of MLHR on a forward P/E basis and EV/EBITDA even though MLHR as a company is financially superior in almost every way, in our view. We think the recent outperformance has created an opportunity to hedge a short position in HNI with a long position in MLHR, a company which has superior revenue growth, operating margins, FCF generation and return on equity. We expect a dividend reduction and potential negative revisions to estimates for HNI to create mean reversion in its valuation relative to MLHR (click on chart for full image view).

Source: Company reports, Yahoo finance, PAA Research

We are targeting a total return of 25% for this pair trade. HNI reports on Wednesday before the market opens. We think the company could address its dividend policy in conjunction with its earnings release.

Please click on this link to read our full report on our pair trade – long MLHR/short HNI

As always, please act accordingly….