Knoll: Still Worth Riding Out The Headwinds

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About: Knoll, Inc. (KNL), Includes: MLHR, SCS
by: Vince Martin
Summary

There's no shortage of worries when it comes to Knoll, including fears of a cyclical turn and secular pressure in the Office business.

But performance remains strong, strategy and positioning are on point, and valuation is more than reasonable.

There are a number of key factors to consider - but still room for more gains ahead.

There are four broad factors to consider when it comes to furniture and coverings manufacturer Knoll (KNL).

First, recent performance has been excellent. The last four quarters have come in nicely ahead of Street estimates. That includes an impressive Q1 last month in which revenue growth above 12% was seven points better than a three-analyst consensus. That quarter followed a strong 2018, when the company posted 7%+ organic revenue growth. Margins are expanding nicely as well: adjusted gross margin rose 50 bps in 2018, with EBIT margins expanding twice as fast.

Both the Office and Lifestyle segments are contributing in terms of both sales and margins. The late 2017 acquisition of Finland's Muuto looks to be a winner, at least based on early returns. Knoll even threw in a 13% dividend hike last week for good measure.

The second issue, however, is that performance probably should be quite strong at the moment. The corporate tax cut no doubt helped drive demand from commercial clients last year, who likely still drive in the range of two-thirds of Knoll profits. (The Office segment only has generated about 38% of trailing twelve-month segment-level operating income - but the Lifestyle segment includes commercial business as well.) The economy more broadly is quite strong, and unemployment near historic lows: Knoll CEO Andrew Cogan even pointed out to Bloomberg Television in November that businesses were using design as a way to attract much-needed talent.

On top of those cyclical benefits, Knoll benefited from an easy comparison against a difficult 2017. As a result, 2018 performance in particular might not be quite as impressive as it appears at first glance. That in turn colors what look like enormously attractive multiples: KNL trades at a little over 10x 2019 consensus EPS despite expectations for ~10% growth this year, something close to the 1x PEG (price to earnings to growth rate) ratio some value investors target. Of course, at the end of the cycle (presuming that is indeed the case), that type of valuation isn't surprising, or quite as 'cheap' as simple fundamental analysis might suggest.

The third factor is not cyclical, but secular. The long-running worry for Knoll and its other large peers has been the adoption of the "open office" trend and the demise of the individual workstation. As I've noted several times in the past, executives at major office furniture manufacturers (including Knoll CEO Andrew Cogan) have admitted that trend is driving declines in how much customers spend, on average, for their employees. A six-person table costs less than six desks.

But beyond the pressure on revenue per customer, the trend also has minimized the benefit of scale for Knoll, Herman Miller (MLHR), and Steelcase (SCS). A focus on design over size opens the door for smaller firms to compete with the giants, and commentary in the space over the past few years (along with data from industry trade association BIFMA) suggests they have taken some level of market share.

Combined, these issues suggest some level of skepticism toward KNL, and the space. I argued back in 2017 that, between cyclical peak worries and continuing secular concerns (like increasing penetration of telecommuting), the industry is just too tough. I've backtracked somewhat, picking up KNL shares last year; but even now, there's a real risk the sector simply isn't ever going to receive valuations close to that of the market as a whole.

Indeed, of the four majors (also including HNI (HNI)), returns over the past five years have been disappointing. Including dividends, the four stocks on average have returned about 29% total, a ~5.2% CAGR that's less than half the total return of the S&P 500.

That's perhaps not surprising toward the end of the cycle - but it also suggests that upside, particularly from a multiple expansion standpoint, might be limited. More widely-covered cyclicals - think housing stocks or perhaps the largest pure cyclical, Caterpillar (CAT) - aren't seeing much in the way of investor enthusiasm, either; why will the office furniture space be different? Like in the residential furniture sector, to come out ahead investors need to focus intently on valuation and take profits when available.

Those factors all deal with the industry. The final question if an investor is willing to take on the sector's risks becomes which stock to choose. Knoll's recent performance has been solid - but it's not alone. Herman Miller has put together a nice string of results, and gave upside guidance after its fiscal Q3 report in March. Steelcase, a long-disappointing turnaround story, has shown signs of life. All three stocks look similarly cheap: KNL's P/E multiples are lower, but in part due to a more leveraged balance sheet. EV/EBITDA-based valuations that include that debt actually assign KNL a modest premium. At the least, there isn't a clear relative valuation argument to definitively choose one of the group. (I've long been a skeptic toward HNI, owing its to valuation and positioning more toward the lower-end of the market.)

From here, KNL still is the choice, a key reason I'm still long after buying the stock last year. The risks are real, and there are strong cases for MLHR and SCS (which has recovered after an odd post-earnings plunge back in March). But Knoll's management and strategy both look like significant pluses. The company's positioning for where its industries are going - particularly a steadily declining reliance on legacy products and workstations - is underappreciated. And performance has improved notably - even if there's been some outside help. There's enough here, still, to ride out the worries - and potentially the end of the cycle.

Strong Earnings Continue, But...

Looking at the headline numbers for the last few quarters, it certainly appears that Knoll is on track:

Quarter Revenue Growth Organic Revenue Growth Adjusted EBIT Margins
Q1 2018 15.5% 10%* +10 bps
Q2 2018 20.3% 12.5% +110 bps
Q3 2018 12.5% 4.8% +160 bps
Q4 2018 12.2% 3.7% +100 bps
Q1 2019 12.2% 11%* +80 bps

* - author estimate based on management commentary

And the numbers do tell at least some of the story here. Q1 was exceptionally solid, as noted, with sales coming in well ahead of expectations. CEO Cogan noted on the Q1 conference call that backlog actually built during the quarter, a reversal of the normal seasonal trend. And he added that the core Office business has been growing at double the rate of the industry (as measured by BIFMA data).

Meanwhile, the slowdown in second-half 2018 organic growth isn't particularly surprising, given first-half numbers benefited from an exceedingly easy comparison. (It's still not entirely clear why first-half 2017 results were so poor, but they were largely an industry-wide problem perhaps driven by uncertainty ahead of tax reform being resolved.) Muuto was an acquired with an eye toward introducing it to the North American market and expanding its role on the workplace side; that plan seems to be working, per recent commentary.

Two price increases have helped both revenue and margins, offsetting some of last year's inflation in steel and other inputs. CFO Charles Rayfield predicted on the Q1 call that inflation had likely reached a peak, suggesting some help to margins for the rest of the year. Tariffs are a minor risk, with Cogan's comments to TheStreet last year suggesting a few million dollars in incremental costs with the new 25% levy. But Knoll managed through the initial hikes, and deflation elsewhere should mitigate some of that pressure.

The fundamentals are solid, no doubt. But, again, they probably should be good. The industry on the whole is strong. Herman Miller has posted 7% organic growth in the first three quarters of its FY19 (ending May), albeit with just a 3.1% organic increase in its North American office business. On the same basis, Steelcase drove 9% organic growth in its fiscal 2019 (ending February 22) both on a consolidated basis and in the America. There no doubt was some pent-up demand in 2018 (and likely into 2019), help from tax reform, and economic tailwinds behind the business.

And the comparisons matter, too:

Knoll, 2016 versus 2018

Metric 2016 2018 Change
Organic Net Sales ($M) 1,164.3 1,216.7 +4.5%
Adjusted Gross Margin 38.3% 37.0% -130 bps
Adjusted Operating Profit ($M) 136.3 132.4 -2.9%
Adjusted Operating Margin 11.7% 10.2% -150 bps

The profit and margin figures include the Muuto acquisition, which should be accretive on both fronts. Organic adjusted EBIT dollar growth over the two years probably is negative -10% or worse. 2016 was a huge year, admittedly, with a perfect combination of low input costs and strong demand: Knoll's adjusted EBIT margins expanded 140 bps against 2015, with Q4 levels the highest in "many, many years", per Cogan on the Q4 2016 call.

Still, the multi-year growth profile here is flattish - toward the end of the cycle. Office operating profit of $50 million-plus last year was still almost 10% below 2015 levels. As a result, there's certainly a sense that KNL and its peers have become "show me" stories. The market bid up the group toward the end of 2016 - only to see sales, and share prices, fall sharply at the beginning of 2017. Investors don't want to make that mistake again.

Knoll's Positioning and Valuation

All that said, the cyclical concerns are priced in to at least some extent. And the strong Q1 results - when the comparison was notably tougher - certainly help the case here; from here, KNL should have seen a much bigger bounce. (The stock is up less than 3% from pre-earnings levels.) Margins still have some room to expand for the full year, even if 2016 levels might represent a peak. Trailing twelve-month non-GAAP EPS is $1.88, and likely heading toward $2 this year. Knoll already has paid off some of the Muuto debt, dropping its leverage ratio to 2.58x from 3.12x, and further progress in cutting interest expense can add a few pennies to EPS.

Meanwhile, in terms of the cyclical worries, Knoll looks increasingly well-positioned, as I detailed last year. Exactly 20% of 2018 revenue came from residential, per the Q4 earnings slides, with the figure dropping slightly to 18.9% in Q1. Owing to higher margins in the Lifestyle segment (20%+), likely over a quarter of profit comes from residential - a figure that could rise as Muuto sales to the market grow. That business is high-end, and maybe luxury, whether coming from KnollStudio (the portfolio of products from well-known designers), Edelman Leather, HOLLY HUNT, or Vladimir Kagan.

Assuming double-digit EBITDA multiples for that business - easily achievable given margins and what investors are paying for luxury brands elsewhere - KNL's consolidated 8x+ EV/EBITDA multiple suggests multiples in the range of 7x EBITDA and ~9x net income for the office side. That presence helps on the commercial side as well, as the lines between the two markets blend into the so-called 'resimercial' trend.

As a result, valuation is at worst acceptable. And I continue to believe in Knoll as a company. The company continues to succeed with M&A: HOLLY HUNT was a winner, DatesWeiser has become profitable, and Muuto is on track. And those additions have created a portfolio with a range of offerings as trends shift:

source: Knoll April 2018 presentation

I'm not sure KNL is going to see multiples expand even to the 9x+ EBITDA and mid-teen P/E levels seen in recent years. But valuation is good enough, and the qualitative case looks attractive. Q1 results help the near-term case, and a 3%+ dividend yield adds another pillar. There may be some choppiness - KNL dipped sharply amid the Q4 rout - and this isn't a case where there's a near-term path to huge returns. But this remains a case of owning an attractive business at a reasonable valuation - and for now, that's enough.

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.