Leggett & Platt Is About 15% Overpriced

Summary

• I think the market has gotten ahead of itself in regard to Leggett & Platt.
• Although this is a fine company and the increased leverage is not a problem, the shares are trading near a multi-year high valuation.
• I would avoid buying at this time, but I think there is a very profitable options trade available that I elucidate below.

Over the past year, the shares of Leggett & Platt Inc. (NYSE:LEG) are up about 38%, and I thought I'd look in on this so-called dividend aristocrat to see if there's still value here. I'll come right to the point. Although this is an excellent business, with a superb financial history, the shares are overpriced at these levels. I think long-term returns are mostly a function of the price paid, and I think investors would be wise to avoid at these levels, as buying here guarantees disappointing future results in my view. That said, I think there is a way to profit here with a short put "win-win" trade, and I'll outline the specifics of this below.

Financial Snapshot

A quick review of the financial history here reveals that this is actually a growth company, given that revenue has grown at a fairly steady rate of ~CAGR 2.5% since 2014, while net income is up at a remarkable rate of 26% over the same period. The growth is obviously intact, given the first nine months of 2019 compared to the same period a year ago, with revenue up about 13.5% and net income up fully 10.5%.

I've said repeatedly that I'm not able to measure management quality and I rely more on their actions than anything else. Based on their actions alone, I'd say that management is very shareholder-friendly as evidenced by the fact that they've returned just over $1.8 billion to shareholders since 2014 ($771 million of this from buybacks, the balance in the form of ever-growing dividend payments).

Turning quickly to the capital structure, the debt level has obviously increased as a consequence of the Elite Comfort Solutions acquisition. I'm usually not a fan of buying companies that are increasing their debt levels, but I'm less concerned in this case for two reasons. First, the weighted average interest rate of 2.3% is quite low in my view. Second, the average maturities of 6.3 years are long enough into the future that there's nothing to fear from a credit or solvency crisis in my view.

Although I'm not too concerned about increased indebtedness, there are obviously consequences to a more levered capital structure. In particular, it's very unlikely that we can expect much in the way of share buybacks for the foreseeable future as the company will focus on deleveraging. The most recent 10-Q makes this point quite plainly:

Source: Leggett & Platt 3rd quarter 10-Q

Source: Company filings

In sum, I think this is a great company with an excellent tradition of treating shareholders well with ever-growing dividend payments. Although the level of debt has increased, it is manageable in my view, and it seems that management will be de-leveraging aggressively over the next few years.

The Stock

One of the many things I find interesting about investing is the fact that it involves much more than finding a great company like this one and simply buying it. We private investors typically access the future cash flows via stocks that trade in the public markets, and the price change behaviour of stocks can have little to do with the underlying business for long stretches of time. For that reason, we must not only look at the business itself but also the stock which is often a poor proxy for the health of the underlying.

The first question I ask when I look at a stock is whether the price reflects optimism or pessimism on the part of the crowd. If the shares are priced optimistically, I take that as a bad sign because any misstep on the part of the company will cause the shares to be punished. On the other hand, if there's not much hope embedded in the price, at least the shares are less likely to suffer when the inevitable disappointments come. I measure optimism or pessimism in a host of ways. First, I look at a simple ratio of price to some measure of economic value like earnings or cash flow. On that basis, shares of Leggett & Platt are priced near the high end of their historical norms, per the graphic below.

Source: Ycharts

In addition, I also judge the assumptions about growth embedded in the current price. I do this by using the methodology described by Professor Stephen Penman in his excellent book "Accounting for Value." In this book, Penman describes how an investor can use a standard finance formula and using some basic algebra, isolate the "g" (growth) variable to work out what the market must be assuming about a given company. At the moment, the market is assuming that Leggett & Platt will grow at ~6.3% in perpetuity. I consider this to be a bit rich. Based on the above, I wouldn't be willing to buy the shares at these levels. Although I expect dividends to increase, it would take many years of dividend payments to make up for large capital losses.

Options to the Rescue

I confess that I get frustrated when I find a wonderful company like this one that trades at a price that I think is a bit rich. In my view, investors have two options when it comes to this name. They can wait for shares to return to more reasonable levels before buying (boring!) or they can generate some options premiums today. Since patience was never my strong suit, I prefer the latter approach, as I think selling puts on great companies like this creates a "win-win" trade. If the investor sells put options and the shares either flatline or rise in price, the investor simply pockets the premium, which is hardly problematic. If the shares drop in price from here, the investor will be obliged to buy but will do so at a price that has a much better chance of producing a great long term return. In any event, being forced to buy at a much lower price in future is superior to naively buying today in my view.

At the moment, I think the June 2020 puts with a strike of $45 represent the best value here, and they are currently bid-asked at $1.55-1.75. If an investor simply takes the bid here and is subsequently exercised, they will be obliged to buy this great company at a price ~18% below the current level. At that price, the dividend yield rises to 3.7%, and the PE drops to ~17 times. Although it's only been 7 weeks since the shares traded at $45, I think the ECS acquisition has permanently changed the nature of this business, and I think there's a limited chance that these puts will actually be exercised.

Conclusion

I think Leggett & Platt is a fine business, obviously, with a very long tradition of paying ever-growing dividends. This is a growth company in my view, as evidenced by the financial history here. My problem relates to the valuation. The market is too optimistic in my view, and this puts investors on the horns of a dilemma. I think investors who buy today will be disappointed with future returns, as returns are largely a function of price paid. I think the obvious solution to that problem is to sell put options today, as these create a "win-win" trade. If the options expire worthless, the investor wins. If the shares are put to the investor, they win in a sense that they are better off than a buyer at today's price, and I think a net $43.50 represents a much better yield and a much greater chance at decent long-term returns.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.