As a shareholder of Knoll (NYSE:KNL), I'm not terribly upset by Thursday's 1.6%+ decline (after an afternoon rebound; shares had been down as much as 5%). I see KNL as a mid- to long-term holding, and I'd be thrilled to see shares decline even further to a price where I could add to my position.
That aside, I'm still rather surprised by the market's reaction to what looked like a very strong second quarter report. The Coverings segment did have a poor quarter, which was a bit of a disappointment, and Knoll management did seem to guide for a (slightly) more difficult environment in the second half of the year in Office. But the latter should be no surprise to anyone, and Knoll still sounds far more confident than rivals like Steelcase (NYSE:SCS) and HNI (NYSE:HNI).
Meanwhile, Knoll seems well positioned operationally, and a new line coming out in 2017 was received well at NeoCon. The path to continued margin expansion is intact. Knoll is taking share from publicly traded peers and some of the smaller rivals that have been a thorn in the majors' side of late, and Q2 results were well ahead of expectations. For a stock that's still relatively cheap and priced in line with peers, it seems like it should have been enough for more upside coming out of earnings. From here, it certainly looks like enough to expect more upside going forward.
Knoll generates a smaller proportion of sales and profits from its office business (particularly its North American office business) than peers, but as the company aims towards continuing its recent trend of operating margin expansion, the segment remains the key driver. CEO Andrew Cogan has said publicly - and repeatedly - that segment margins - 6.5% on an adjusted basis in 2015 - should be in line with peers at 10%+. Hitting that target alone would add another 100 bps+ to consolidated operating margins and imply further upside to earnings.
From that standpoint, Q2 looked like a roaring success. Office operating margin increased 190 bps to 7.6%, nearly double the 4.0% figure of two years ago. Sales were up 11.4%, the second straight quarter of double-digit growth. It seems clear that Knoll is significantly outperforming its industry, both relative to BIFMA (the office furniture industry's trade group) data estimating ~3% growth year-to-date, and relative to the most recent peer results:
- HNI (quarter ending July 2): -5.0%, -6.4% organic.
- Steelcase (quarter ending May 27): 0.1% growth (in Americas segment).
- Herman Miller (NASDAQ:MLHR) (quarter ending May 28): 7.6% growth.
That sales growth drove operating leverage in the space, while the segment also drove most of a 100 bps increase in overall gross margin. On the Q2 conference call, CFO Craig Spray attributed the improvement to the company's continuous improvement program and fixed cost leverage. This is an incremental, but encouraging change: As recently as Q4, 80% of the same segment margin improvement was coming from pricing and the lower loonie (Knoll has manufacturing facilities in Canada), and the same two factors were cited in a 110 bps improvement in the prior-year Q2. With those benefits gone, Knoll still was able to show further improvement off a more difficult comparison, which bodes well in terms of continuing those margin improvements going forward.
There's still room for optimism on the top line as well. In Office, both Knoll and Herman Miller clearly have outperformed Steelcase and HNI over the past few quarters. Knoll's growth in sales and operating income has been stronger than that of Herman Miller - but Knoll, particularly on the margin side, also had more room to improve than its nearby rival. But one reason I've been far more optimistic toward Knoll than Miller or other peers is that it looks particularly well positioned for the current trends in the office space: The 'blurring' of boundaries between office and home, for instance, or an increasing focus on common areas.
As I've pointed out in the past, Knoll and Steelcase - whose sales have been flat - both have pointed to weakness in energy and in Northeastern financial companies (as Knoll puts it; Steelcase mentioned insurance companies in the region, and there's likely some overlap between the groups). But Knoll continues to succeed in West Coast tech, the type of leading-edge business that would seem to bode well going forward, and it highlighted that success again in Q2. A new "Rockwell Unscripted" product line was well received at NeoCon in June, winning two awards. It will ship in Q1 2017, which could give Knoll a boost as it has to lap more difficult comparisons (particularly Q1, where the two-year revenue stack will exceed 20%).
Perhaps there's a little bit of a bubble given private investments in and valuation of startups in Silicon Valley and elsewhere, but from a brand/trend standpoint, it seems to bode well for Knoll going forward. Meanwhile, all four companies seem to agree that larger projects still are hard to come by. Cogan admitted on the Q2 call that "it's taking a lot more transactions to achieve the same amount of dollars." That too, seems to imply a fair amount of success for Knoll in terms of wins - and implies that there's still room for the overall industry to recover.
Cogan did give a bit of caution toward the back half, saying that "pricing has become more competitive and growth has narrowed geographically." But if that was a key takeaway by the market to explain the day's declines, then one would expect peers to fall in sympathy; yet HNI, SCS, and MLHR all finished relatively flat. From my standpoint, Q1 supported the long-term story in Office, and Q2 was even better. The gains in market share and in the margin profile aren't erased by potential macro volatility in the back half.
Studio and Coverings
Beyond Office, there was good news and bad news. The Studio business was stronger than expected, particularly given that European economic activity overall seemed to slow in June ahead of the Brexit vote. Revenue increased 14% year over year (against a reasonable comparison) and operating margin expanded 30 bps even after a 320 bps improvement the year before. Knoll seems to have taken share in Europe, and in North America, the company gained in both commercial and residential, with "some very nice project wins," per Cogan on the Q2 call.
There was a bit of caution in this segment as well: Holly Hunt saw "spottier" growth in the quarter, which Knoll attributed to macro weakness in some areas. Knoll has some exposure to the UK (including a Holly Hunt showroom in London) as well. Margin expansion there seems closer to its end than in Office: Cogan said 15% over a full year would make Knoll "happy," and that level only is about 60 bps ahead of 2015 levels, and ~40 bps ahead of trailing twelve-month figures. But Studio looks stable, at least, and at ~40% of overall profits provides a nice base with growth opportunities going forward - even if that growth seems relatively modest.
On the other hand, the Coverings segment had a dismal quarter, with revenue falling 10.4% year over year and operating margin compressing 200 bps. KnollTextiles and Edelman remain weak; the latter business continues to struggle with weakness in private aviation.
Cogan had said on the Q1 call that Edelman had stabilized; Q2 appears to show that call was premature. Jet shipments continue to plunge, with a stronger dollar and oil weakness part of the cause, and that could augur continued difficulties for that business. On the Q2 call, Cogan again predicted the segment would stabilize, citing new leadership in Textiles and easier comparisons for Edelman.
My one key concern in the quarter is whether Cogan again is a bit early. If oil price weakness indeed is a cause, that impact may linger as some think (indeed, it already has, looking at suppliers to the industry or even companies indirectly impacted). Coverings is a smaller part of Knoll, but still an important segment, driving ~20% of trailing twelve-month operating profit. Its margins - still 20.7% in Q2 - are the highest in the company as well. For Knoll to get profits up another level after strong recent growth, it will need that business to at least stabilize, allowing Office improvements to hit the bottom line and get EPS over $2.
I had modeled KNL's 2016 EPS at $1.67 coming out of Q1, up ~10% year over year, and that's where consensus sat heading into Q2 as well. That includes a substantial EPS impact to Q1, where FX impacts on intercompany balances took down EPS $0.03 after a $0.09 gain the year before.
That impact was essentially nil in Q2, allowing the operating profit improvement to shine through. Even so, EPS is up over 11% through the first six months, and that target would require sub-9% growth in the back half. Knoll has a tough Q4 comparison, but a very easy Q3 (particularly on the top line), and both Office and Studio look set up well for the coming quarter.
I'd modeled 6% growth in Office; that looks far too pessimistic, as does 2% growth and a 13% operating margin in Studio. Coverings projections need to come down, with sales down nearly 7% year-to-date, and margins below 22%, but there's enough gains from the other two segments to more than offset that. At this point, I'd look for the following:
- Office: 8% growth (sub-4% back half, given Q4 comparison and potentially choppy Q3), 10% margin.
- Studio: 5% growth (~3% back half, given Holly Hunt slowdown), 14% margin.
- Coverings: -5% decline (modest decline in back half, from easier comparisons), 21.5% margin.
That gets to about $1.75 even including the non-cash FX charge from Q1, and puts KNL's forward multiple at 14.4x. That's right in line with MLHR (whose fiscal year ends five months later) and 4 turns behind HNI (for reasons I still don't entirely understand). I'd rather have KNL than either stock at the same multiple, and there's enough growth left in 2017 for KNL to seriously challenge $2 in EPS. (~50 bps margin expansion, driven solely by Office continuing to plan, plus mid single-digit revenue growth). Knoll is under its leverage targets at the moment. It's looking at potential acquisitions or it could move toward a share repurchase, which in this case, I'd welcome.
I still think current fair value here is in the upper $20s, which, admittedly, isn't outstanding upside in a macro-sensitive space. But beyond the numbers, I have faith in the company, and in the stock. Management is solid, and execution for the most part has been outstanding of late: It's pretty much impossible to choose anyone but Knoll as the leader in the space at the moment, at least among the four publicly traded majors.
Knoll's diversification among segments and its more value-added business gives it more cushion (in my opinion) against macro volatility, and more protection against the commoditization of the lower- to mid-range segments in which HNI and Steelcase are struggling at the moment. Q2 only strengthened my attitude on this front. Honestly, I'm surprised to see that investors didn't agree.
Disclosure: I am/we are long KNL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.