In our original report on the office furniture market entitled: “Generating Returns in an Industry in a Deep Freeze” we advocated going long Herman Miller against a short position in HNI Corporation. Thus far the trade has generated a negative return of 3.3% compared to a 9.9% gain for the S&P 500 – not exactly the kind of alpha generation we were hoping for. Historically, demand for office furniture has been highly correlated to employment trends, which does not bode well for near term industry growth. We thought it might be helpful to take a look at the state of the industry from the dealer perspective. We have conducted a survey of approximately 40 independent office furniture dealers from across the country. The respondents are well diversified geographically and sell a number of brands including: Herman Miller, HNI (their portfolio of brands), Knoll, HON, Kimball, Haworth and others. From a size perspective based on annual revenues: 40% of respondents generate less than $10 million, 38% $10-$25 million and 20% more than $25 million. Here are some of the key conclusions from our respondents:
1) Approximately 85% of dealers have witnessed a decline in orders year-to-date compared to 2008. The median decline has been approximately 20% on a YOY basis. This compares to a 35-40% YOY decline in revenues for HNI and MLHR in their most recently reported quarters. We attribute the gap in the revenue decline witnessed at the dealer level and that for MLHR and HNI thus far in 2009 to significant inventory de-stocking at the point of sale.
Source: PAA Research
2) Order trends have stabilized, if not improved in the third quarter compared to the second quarter. Even though we have yet to witness complete stabilization in the labor market (historically getting worse at a slower rate has not been enough to prompt growth in the office furniture market), it appears that many dealers have witnessed a solid sequential improvement in revenue trends in the third quarter. Approximately 50% of respondents have generated an increase in orders thus far in 3Q compared to 2Q.
Source: Paa Research
3) Even though order trends appear to have stabilized, pricing pressure remains prevalent. More than 75% of respondents indicated that they were witnessing pricing pressure in some, if not all of their product lines. Additionally, it appears more clients are trading down to lower priced products. Almost 90% of respondents indicated that clients have been trading down to lower priced products “somewhat” or “a great amount”.
Source: PAA Research
4) From an industry vertical perspective, government remains the strongest source of new orders. As one might expect, orders coming from the healthcare, education and government sector have been much stronger than the traditional corporate office space. One respondent indicated that: “Our business has grown from 33% federal government last year to 66% this year, so growth is largely due to this increase as other vertical markets are down”. A few dealers indicated that they thought the corporate market was poised to pickup, but that they have not seen any improvement yet.
Source: PAA Research
5) It appears inventory destocking in the dealer channel is largely complete. 65% of respondents indicated that inventory levels were “adequate”. It is important to note that approximately 25-30% of dealers we surveyed do not carry inventory and fulfill orders on a real time basis. Interestingly enough only a handful of dealers have witnessed an increase in inventory thus far this year. This survey does not capture responses from traditional office supply retailers to which HNI has significant exposure.
Source: PAA Research
6) Approximately 60% of respondents expect to witness a YOY increase in order growth in the fourth quarter. For the most part, dealers expect a modest increase in the 0-10% range. A few dealers still expect 4Q09 order volumes to be down considerably on a YOY basis. Most dealers have indicated that they expect a modest increase simply because 4Q08 was “so bad”.
Source: PAA Research
7) Dealers are increasingly cautiously optimistic about an improvement in order trends in 2010. More than70% of dealers expect orders to increase in 2010 compared to 2009. We are somewhat surprised by what appears to be a fairly rosey outlook from dealers about prospects in 2010 given ongoing weakness in the labor markets. It is important to note that we conducted a similar survey in the fourth quarterof 2008, at which time approximately 48% of dealers expected to generate a YOY increase in order volumes in 2009. Obviously that proved to be far too optimistic, so take the current outlook from dealers with a grain of salt.
Source: PAA Research
Overall, 62% of dealers characterized the current outlook for the office furniture market as “fair”. The results of our survey imply that inventories are at adequate levels, orders have stabilized and there is the possiblity for a modest upturn in growth in the next 3-6 months. Here are a few other comments from dealers that we thought you might find interesting:
“I do not think that the recession is anywhere near the end. We are concentrating on medical and institutional sales at lower margin as we wait for the commercial market to reshape itself”
“2010 will be a liitle more settling for most of the market”
“I think we are almost at the bottom and things will be getting better very soon”
“Large clients are the hang up primarily. Small firms stil buying some. Our showroom business will lead the charge.”
Much like the rest of the economy, the road to recovery in the office furniture market is likely to be bumpy and potentially protracted. We still think the best way to play the space is through our pair trade recommendation long MLHR/short HNI.
What MLHR and HNI Dealers Are Saying
There is a widely held perception that HNI is more of an “early cycle” name in the office furniture space. The primary bull case on HNI is that the company has greater exposure to smaller clients, products at lower price points, and distribution in the traditional office supply channel all of which should lead to stronger performance in the early stages of an economic cycle. We have compared the responses from dealers that sell HNI products to those that sell MLHR office furniture to determine if there are any identifiable trends which might indicate that one company is outperforming the other. In our survey, we asked a few questions which we hoped would shed light on which company would do better in the early stages of a recovery. Approximately 50% of our respondents are HNI or MLHR dealers. Before we get into some of our key conclusions, we wanted to remind you that there is a fairly large margin of error for our survey results given that we only received responses from 12-15 HNI dealers and 10-12 MLHR dealers (depending on the question). The following is a summary of our key findings:
1) There is no discernable difference in order trends based on the size of the client. As we mentioned earlier, some investors argue that HNI is better positioned at the early stages of an economic recovery than some of its peers in the office furniture space due to its exposure to smaller clients. Of the 40 dealers we surveyed, 46% of our respondents indicated that there was no difference in order trends between small and large clients. 31% suggested that order trends for smaller clients was better thus far in 2009, while 23% indicated that activity from larger clients was better. Perhaps the trend will change once order volume picks up, but at this stage it does not appear that exposure to a client base of smaller companies is a material advantage.
2) It appears HNI dealers are doing slightly better on a year-to-date basis. In each of the following charts, responses from HNI dealers will be depicted in red, while those from MLHR dealers will be depicted in blue. It might be difficult to tell, but if you look closely at the chart below, you will see that more MLHR dealers have witnessed a 35%+ decline in orders YOY thus far in 2009. Additionally, 46% of HNI dealers have only witnessed a 0-15% decrease in orders thus far this year compared to 20% for MLHR dealers.
Source: PAA Research
3) From the second to third quarter, a greater percentage of HNI dealers have witnessed an increase in orders, although a large portion of MLHR dealers have seen order trends stabilize. Approximately 54% of HNI dealers we surveyed have generated a 0-10% sequential increase in orders compared to only 11% for MLHR dealers. However, 44% of MLHR dealers that responded indicated orders were flat quarter-to-quarter, compared to only 8% for HNI dealers. It appears that HNI dealers are SLIGHTLY ahead of MLHR dealers in terms of a recovery in order volume.
Source: PAA Research
4) HNI dealers are slightly more optimistic (and we emphasize slightly) about 4Q09 order trends. Given the sample size, one might argue that the difference here is statistically insignificant. In the chart below you can see t hat there are far more HNI dealers expecting 5-10% YOY growth in 4Q09, while a great deal more MLHR dealers expect 0-5% growth. For the most part, the difference is immaterial.
Source: PAA Research
5) Overall, MLHR dealers are SLIGHTLY (and we emphasize slightly) more optimistic about a recovery in order growth in 2010. Once again the differences here are almost statistically significant. In both cases approximately 77% of respondents expect order volume to increase YOY in 2010. However, there are more MLHR dealers that indicated that they expect a higher level of growth.
Source: PAA Research
Overall the results of our survey suggest that thesis that HNI fares better at the early stages of an economic cycle is flawed. Order activity among HNI and MLHR dealers is remarkably similar, yet HNI continues to command a sizeable valuation premium. HNI currently trades at 29-30x 12-month forward consensus EPS estimates, while MLHR trades at a more reasonable 20x. We have argued here and here that MLHR has a superior business model in terms of profitability, historical free cash flow generation and return on equity. MLHR will report results on September 16th. We expect the company to generate strong free cash flow and highlight its recent debt reduction efforts, which should leave the company in a position to begin share repurchases in the near future. Our survey results imply that consensus estimates for MLHR for FY10 might be too conservative. We continue to see upside for MLHR shares into the low 20’s, while HNI shares appear to be over-valued.
As always, please act accordingly…
