The economics of the furniture business is not rosy. Sift through the financials of any publicly- traded furniture company and you will see that for every $100 of sales, $80 is consumed by building and delivering the furniture, $15 is paid to managers and about $5 to $8 are left to pay taxes to the U.S. government. Common shareholders are left with $2 to $3, a minuscule profit margin.
Outlook for the furniture business is gloomy, too. Recent tariffs enacted by the U.S. Congress raised the price of furniture imported from China by over 10%. And it is questionable how likely companies will succeed in passing the extra cost to consumers. How ecommerce will shape the future of buying and delivering furniture is a guessing game, too. What is certain is that the demand for furniture will weaken should the economy soften.
It is simply a tough business to be in. A typical furniture-maker must keep up with current consumer trends, work with few distributors that have bargaining power (think Home Depot, Costco and Amazon) and deal with many unforeseen challenges. One visible challenge is that selling furniture online is not easy, as management teams had thought. This year, for example, Flexsteel (FLXS on Nasdaq) took a $18.7 million impairment charge due to "software integration difficulties."
Whether you visit the website of Bassett Furniture (BSET on Nasdaq), Hooker Furniture Corporation (HOFT on Nasdaq) or La-Z-Boy Incorporation (LZB on Nyse), you will not find any visible difference in their product offerings - neither in price nor in style. Popular today is the rustic, natural wooden feel, compared to the slick and modern style of the early 2000s. For the untrained eye, the furniture business is a commodity business.
In numbers: Ethan Allen’s (ETH on Nyse) growth in revenue over the past 5-years was less than 1%. The company traded hands for $25 five years ago and now trades at $24 per share; Bassett Furniture’s 5-year CAGR growth was 6%, but shareholders who bought 5-years ago at the stock price of $13 can now sell their positions at $14. Flexsteel showed a 2%, 5-year CAGR growth and its stock price has halved over the past 5-years, from $35 to $18.
At a low price, even the most depressed company can become attractive. Flexsteel is now trading at less than 60% of the reported book value. It is trading slightly less than 10 times the 10-year average earnings per share of $1.98, and it’s yielding 5%, exactly 3 times higher than the yield on a 5-year Treasury (Flexsteel has consistently paid dividends to its shareholders since December 15, 1988).
So, why did the stock market slash by half its value? Two causes, I believe, are at fault. First, when Flexsteel closes its books for 2019 this month (its fiscal year ends June 30, 2019), it is likely to report a decline in revenue. So, the stock market fears that the unfortunate trend will continue. Second, management will report at least $27 million in expenses related to impairment losses and costs related to exiting the commercial office and the custom-designed hospitality products as management explained in May 15 of this year link.
For a company whose average 5-year, pre-tax income was $32 million and in June 2018 pre-tax income of $25.1 million, the expected $27 million in losses will completely wipe earnings for 2019, and the company is likely to report a loss, the first to be reported since 2009.
In addition, there's been a shakeup in management. Jerald Kittmer, Flexsteel's President and CEO, joined the company less than 6 months ago; Marcus Hamilton, Flexsteel's CFO, joined the firm in January 2018, and it is still uncertain how well the two will get along.
I plan to patiently wait a few years. Kitmmer is a veteran in the furniture business and Hamilton has over 20 years’ experience in finance, accounting and supply chain management. I also don't foresee any changes in the near term, because Flexsteel hardly carries any debt. As of March 2019, its third quarter filing, the company reported total assets of $265 million and total liabilities of $39 million, a 15% debt to asset ratio.
Competitors who offer similar products are trading at much higher valuations. For example, with a stock price of $27, Hooker Furniture is trading at 1.3 times its reported book value. With a stock price of $31, La-Z-Boy stock is trading at a whopping 2.4 times its reported book value. If Flexsteel was to trade at par, its stock price would be about $30.
While Flexsteel is trading at a ratio of 5 times the pre-tax income per share, the average price of pre-tax income per share ratio for its peer group is 10 times. If Flesteel was to trade at 10 times the pre-tax income, the stock price would be $35.
Flexsteel also passes the "four-proxy rule" coined by Charlie Dreifus of RoyceFunds link. When buying shares of publicly traded firms, Dreifus looks for management compensation metrics that are tied to GAAP earnings and not adjusted earnings (check). He also looks for folks with deep financial backgrounds that serve in the audit committee (Eric Rager meets his definition - check). He also reviews how often the audit committee meets (Flexsteel’s audit committee meets quarterly - check). And he verifies that senior management does not have extreme executive perks (check).
Dreifus, the 51-year stock picker veteran, was one of the reasons why I bought Flexsteel stock. His Special Equity Fund link owns 775,000 shares in Flexsteel. (RoyceFunds owns a total of 1,126,078 shares, 14.3% of the outstanding stock per the latest proxy statement). Perhaps, Dreifus, like yours truly, saw something beyond the gloominess of the furniture business.