I've had a decent read on the office furniture space of late. I've argued for Knoll (NYSE:KNL) and predicted rangebound trading for Herman Miller (NASDAQ:MLHR); KNL has outperformed its key peer of late (even with MLHR narrowly reaching post-crisis highs this month) and appreciated nicely since I took a position late last year. Last year, I stayed skeptical of Steelcase (NYSE:SCS) after a huge post-earnings plunge in December; that stock has been the notable laggard among the four publicly traded office furniture stocks in 2016.
But relative to HNI Corporation (NYSE:HNI), I've been way off. In February, I wrote an article (unfortunately) titled "HNI Corporation: $33 Still Is Too Expensive." After a Q2 earnings beat Thursday evening, HNI closed Friday at $52.56, up 58% in exactly five months:
Honestly, I don't entirely get the move. To be sure, HNI has posted a solid first half on the bottom line, which has led to a substantial increase in 2016 guidance. Meanwhile, improving macro sentiment has led multiples in the space as a whole to expand: KNL and MLHR, for instance, have moved from 11-12x forward EPS to 14-15x.
HNI, meanwhile, has seen its valuation expand from about 14x the midpoint of guidance ahead of Q1 to over 18x the raised figure coming out of Q2. Given a better outlook in the mid-term for corporate spend and HNI's exposure to home building, that seems a reasonable response to the increasing optimism toward the U.S. economy of late. But HNI's premium to KNL and MLHR, in particular, has expanded over the same time (by about at turn), and it's still not perfectly clear what has driven HNI's increased guidance or how well the company is positioned within the space going forward. Sales actually have declined rather sharply in both Office and Hearth through the first half, and are guided to decline for the full year.
Back-half comparisons are easier - and that benefit should extend into 2017 - and margin performance has been stellar, clearly coming in well ahead of HNI's own expectations. Another cost savings program is guided to hit the bottom line in full in 2018 (while providing a benefit next year as well), and HNI now is aiming to double its EPS every 3-5 years going forward.
That type of performance certainly would more than justify the current price - but it also appears to require a reasonable acceleration from recent growth and, likely, a consistency that HNI's macro-sensitive end markets don't usually provide. Meanwhile, given HNI's own somewhat erratic guidance of late on a quarterly basis, trusting long-term targets seems a bit of stretch. In the wake of those guidance hikes and the optimistic mid-term outlook, there might be a better fundamental case for HNI at $52 than there was at $33. But from an operational standpoint I'm not quite sure how HNI plans to hit those targets.
The problem when a stock moves sharply against your opinion is that you're then left with two unlikable choices. You can either change sentiment, which raises the risk of being wrong at the bottom and the top; or maintain that opinion, even though the rest of the market is sending a screaming warning that your opinion likely is incorrect. (The easy answer is to stop being wrong the first time, but sadly that's not quite how investing works.)
In the case of HNI, the year-to-date performance certainly has changed my opinion somewhat; with full-year EPS now guided to $2.80-$2.95 against $2.20-$2.60 heading into Q1, fundamentally this looks like a different stock. But where I've struggled with seeing HNI's value is on the top line. HNI shares have appreciated 70%+ after two quarterly reports in which the company posted organic revenue declines, of 5.2% in Q1 and 6.7% in Q2. The Hearth segment hasn't helped, notably in the retail channel: two brutal winters and a spike in propane prices in 2013-2014 no doubt pulled forward sales (excluding acquisitions, HNI Hearth revenue rose 45% in two years) and impacted recent performance.
But HNI's office sales have been poor as well, with organic revenue down over 6% year-to-date. HNI pulled down full-year guidance on the Q4 conference call, projecting a 4 to 7 percent decline in the Office segment and ~flat growth in Hearth. The driver in Office according to HNI was weak macro sentiment, with CEO Stan Askren arguing that HNI's shorter cycle relative to contract-heavy KNL and MLHR gave it better visibility into looming trouble in its space. At the time, Steelcase and HNI were talking up macro troubles, while MLHR and KNL seemed relatively confident (excluding the energy space); that led to a 'chicken or the egg' question: were Steelcase and HNI seeing gloomy end markets because of macro issues, or because they were losing share?
HNI has adjusted its full-year outlook: it's now targeting a 1-4% decline in Office and a low-single-digit decline in Hearth. The latter moves seems driven mostly, if not entirely, by inventory adjustments at dealers and weakness in pellet stoves. And Askren said on the Q2 call that Hearth would stabilize by the middle of next year, with one-time issues (including pellet weakness and the inventory adjustments) likely worked through, allowing the company to benefit from housing starts without an offsetting drag in retrofit sales.
That's good news, particularly given that Hearth is a higher-margin segment (it drove 36% of adjusted operating profit in 2015 off while generating just 23% of revenue). But there's still relatively unexplained weakness in the Office segment. Organic revenue increased 4.3% in 2014, per the 10-K, roughly in line with the 4% market growth cited by industry association BIFMA. But it slowed to 2.2%, with federal government sales providing a headwind. And it's now guided to decline in 2016, with the contract business - the same segment where MLHR and KNL are showing success - guided negative in Q3 and Askren saying on the Q2 call there was little evidence of a near-term return in growth in that channel.
That performance is where my general skepticism toward HNI has come from - and it's possible I'm simply being too stubborn. HNI continues to drive significant margin expansion, which has more than offset relative Office weakness. The supplies-driven channel (basically the lower half of the space) is expected to rebound in the back half, with implied guidance for Q3 and Q4 suggesting an overall modest increase in North American office revenue. With margins increasing and another $0.50+ benefit from restructuring on the way over the next two years, maybe modest increases and even below-market growth are enough. But as a general rule, it's difficult to create sustainable earnings growth when three-quarters of revenues are stagnant - in what seems to be a much better industry-wide situation than HNI itself thought just five months ago.
Margins And Guidance
HNI's guidance of late has been almost bizarre: in my experience, I can't remember a company moving full-year projections so much and so often in such a short time. Here's the history:
- Q3 conference call, October 22. HNI projects sales to be up or down low single digits, and EPS of $2.60-$2.85. No segment color is given.
- Q4 conference call, February 11. Q4 EPS hits implied guidance, Office sales hit their range, Hearth revenues miss relatively significantly. 2016 consolidated revenue guidance now guided low- to mid-single digits. Office sales are guided to -4% to -7%; Hearth roughly flat. Due to "the weak economic environment and high degree of uncertainty," HNI lowers and expands its range to $2.20-$2.60. Not coincidentally, shares touch $30, their lowest levels in two years.
- Q1 conference call, April 22. Q1 sales figures are a bit better than expected; Hearth's 2% decline fits the range, but a 4.9% decrease in Office sales is toward the better end of -4% to -8% guidance, as is the consolidated sales total. But EPS crushes guidance and estimates, with non-GAAP EPS of $0.31 well ahead of the company's projection of $0.16-$0.21. When asked why the beat was so big, Askren credits "productivity improvement [and] operational improvement" as far more important than better market conditions. HNI pushes guidance back up to $2.40-$2.70, which implies a very modest increase to Q2-Q4 projections (just over 1% in terms of EPS).
- Press release, June 10. Ahead of a presentation at industry conference NeoCon, HNI increases Q2 guidance to $0.62-$0.67, up from $0.54-$0.59. Full-year guidance is raised to $2.70-$2.90. Given an implied Q2 increase of $0.08 at the midpoint, the guidance thus suggests EPS expectations in the back half have been raised by $0.17, a 9% increase. But HNI also pulls Q2 sales guidance downward, to a decline of 6-8% from a previously targeted 4-7%. In the presentation itself, HNI then announces a target of doubling EPS every 3-5 years, a target that I do not believe the company ever had announced in the past.
- Q2 conference call, July 22. HNI manages to beat the lowered sales guidance it had issued less three weeks before the end of the quarter, with a consolidated decline of 5.6% sitting nicely in the original range. EPS comes in above the updated range, at $0.68. HNI raises EPS guidance again six weeks after doing so in June; the updated full-year figure of $2.80-$2.95 implies an additional 3% boost in back-half EPS. Consolidated revenue is now guided to -1% to -3%, slightly better than the reduced levels coming out of Q4, but below post-Q3 projections. Office is projected to fall 1-4%, and Hearth at 0 to -3%; office's outperformance appears due to the supplies-driven channel, while contract was weak in Q2 (and guided weak in Q3) and Hearth's modest reduction appears likely due to collapsing pellet stove demand. When asked in the Q&A why the EPS guidance was raised, Askren again cites "continued strong execution [and] operational performance" while citing little change in the overall market.
The question is: is this a good thing? The issue I've long had is that it's not entirely clear what HNI is doing, which isn't helped by the fact that HNI itself can't seem to project the impact of what it's doing. The moving guidance is coming mostly from margins, not sales. For instance, the 1-4% decline in Office, against expectations of a 4-7% decline post-Q4, represents a 300 bps delta. HNI's typical contribution margin of 25% in the segment then implies a ~$0.19 per share full-year benefit after-tax from higher-than-expected Office revenue.
But full-year EPS guidance has increased $0.475 (at the midpoint), and certainly weaker-than-expected sales in higher-margin Hearth have offset some of the relative improvement in Office. More broadly, by Askren's own admission, market conditions really haven't changed all that much, save for apparent sentiment improvements between February and April (which, of course, were echoed in the equity markets). It's bullish, I suppose, that HNI keeps raising guidance of late, but it's also somewhat unsettling that the company had to move its targets relatively dramatically four times in the span of nine months. That's particularly true given that the catalysts behind the increases, specifically, appear to be HNI's own internal initiatives, not external factors in what admittedly can be a very lumpy market.
The larger question is to what extent these improvements are sustainable. The $35-$40 million in estimated savings by 2018 provide a roughly $0.50+ benefit, with a few pennies being seen in Q4, ~$0.25 in 2017, and the balance in 2018. That alone drives high-single-digit EPS growth over the next two years. But HNI also has very beneficial input cost levels at the moment; steel prices are climbing at the moment, which could pressure margins. HNI hasn't broken out in filings or on calls the beneficial impact from commodity costs, but it seems likely to be material given commentary from peers in the space.
To be honest, the gains seem a bit confusing. HNI's margins are improving because its operations are improving - but Askren also has been CEO since 2003, so there's the question of why HNI has so much room to improve margins. The company itself clearly is outperforming its own expectations, which from a high level raises the question of how much room will be left. HNI is driving huge margin gains - 340 bps in non-GAAP gross margin in Q2, for instance - even while dealing with volume deleverage - but it's not sure ahead of time how much impact these apparently highly material operational changes will have.
I'm still skeptical that these margin improvements can last much longer without some sort of operational leverage. In one sense, that's OK. Even assuming flat profits from the business, the cost savings program would get 2018 EPS to about $3.38, putting the current 2018 P/E multiple at about 15.6x. That's not terribly high if one argues that HNI's Hearth business - which lacks the secular headwinds of telecommuting and 'open office' plans that face the office furniture industry - merits a premium to peers. Even at $53, with cost taken out this year and more to come, all HNI really needs is further revenue growth at a blended 25-30% contribution margin to drive upside going forward.
But when is that growth coming? Q3 offers the first easy comparison for HNI in Office, where sales have declined for four consecutive quarters. Yet sales are guided ~flat (-2% to 2%) excluding an acquisition, and Hearth is guided up modestly positive. Some gains from Hearth beginning in 2H 2017 would help, but I still think current valuation needs some sort of boost from Office. HNI's own plans suggest the same conclusion:
HNI NeoCon presentation
The double comes against FY15 non-GAAP EPS of $2.58, implying HNI sees a path to $5 in EPS by the end of the decade. The "Other Businesses" primarily includes retrofit hearth and a small amount of the office segment; both of those are declining at the moment. The target for Hearth New Construction implies continued strength in housing, with new single-family starts rising over 50% from current levels. Notably, North America Office Furniture growth is targeted to drive about $0.875 in incremental EPS at the midpoint. At a 35% tax rate and a 25% contribution margin, that requires an additional ~$240 million in revenue - about 15% growth.
Over four years (which would put HNI at the long end of its 3-5 year target for $5+), that implies a 3%+ CAGR in the business - which grew 2%+ in 2015 and is guided to ~-4% (on an organic basis) in 2016. HNI thus is targeting a substantial acceleration in sales - and, clearly, multiple years of cooperation from a macro standpoint.
Admittedly, I've been wrong so far, but I'm highly skeptical of these targets. (Presumably, the market is too, or else the current ~18x multiple to 2016 EPS likely would be higher.) At the least, HNI needs to get Office sales going to even near the $5 level - and if it doesn't, I'm not sure shares look terribly cheap.
Obviously, I've come around to HNI a little bit in the wake of its first-half performance; assuming the company has changed its cost structure permanently (and there's not enough reason to think otherwise), then its margin profile is such that even relatively flat growth going forward seems likely to imply reasonably low downside from current levels. Any macro downturn obviously is going to impact HNI - sales fell over 30% year-over-year in 2009 for instance - but the same is true of KNL, MLHR, SCS, and myriad other cyclicals.
Giving credit for basically zero growth going forward and the benefit of the new restructuring initiative, HNI's fair value probably still is around $44, discounting back a 15x multiple (more in line with its historical levels and still a premium to peers) to those 2018 profits. I've argued in the past that restructuring charges possibly need to be added back to EPS, given that HNI will have taken charges in eleven of the thirteen years spanning 2006 and 2018, with a total cost averaging $0.22 per year after-tax. Even making that adjustment, fair value still stays above $40 - even if HNI doesn't grow at all through 2018.
From an upside standpoint, even doubling EPS doesn't seem likely to necessarily double HNI's share price, given the current semi-elevated multiple; but $5+ could support a share price easily over $80, implying 60%+ upside from current levels. Thus, I can see a risk/reward calculation here in favor of HNI - and betting on management of late has proven profitable, as it's HNI that has been the clear outperformer over the past few years.
But that $5 target simply seems so optimistic from here; it requires HNI not just to continue its "operational improvements", but for the macro situation to stay beneficial and for the company to start taking back some of the share it appears to have lost over the past few quarters. I'd be more confident in HNI's long-term targets if it better understood its own short-term targets, and it's simply not going to be possible to "operationally improve" earnings up over a multi-year stretch against limited sales leverage or outright deleveraging.
Again, I've been wrong of late, and I may be a tiny brick in the 'wall of worry' that HNI will keep climbing. HNI deserves credit for the margin expansion it's driven year-to-date, and if a solid macro climate and the end of pellet weakness do combine, there could be more upside. But in that scenario, there will be upside for peers as well, and the stories there are based more on share gains and revenue strength than unspecified operational improvements. Maybe I'm still wrong, but I find those stories more promising going forward.
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.