Sometimes I don’t get Mr. Market, especially during earnings season. But then again, I also never quite understood how something heavily debatable like the Efficient Market Hypothesis could have won a Nobel Prize. Sure, all information is always available, and overall the market is efficient in a way that the fair value of a company at some point asserts itself. Yet, this is something I would hardly call efficient. To give you an example, about a week ago Haverty Furniture Companies (NYSE:HVT) released their Q3-2021 earnings results, in which they handsomely beat both top and bottom line expectations. The market reacted instantly with the stock being down almost 15% intraday. Like I posted in the comment section, I was an aggressive buyer at that time. The stock then recovered and was up about 6% the next day. Would you call that efficient?
Sure, the real reason for the decline probably lied in the fact that the company guided for prolonged supply chain issues, expecting them to continue well into 2022. But these issues already existed in Q3, yet the company posted record earnings, nonetheless. While I believe the market is being anything but efficient on HVT right now and at current prices an investment into the company is a no-brainer, its stock is one of the most heavily shorted ones on Wallstreet. Therefore, while the dividend growth investment case is pretty straightforward and simple, yet a short thesis requires much more attention to detail, I want to take a closer look at the short case at first.
Haverty is a specialty retailer of residential furniture and accessories. Its founder, J.J. Haverty began the business in 1885 in Atlanta, Georgia with one store and made deliveries using horse-drawn wagons. The company went public as far as in 1929, with back then 19 stores. Meanwhile, the company has grown to 120 stores in 16 states in the Southern and Midwest regions, with none being franchised. The company is still family run so to speak, with Rawson Haverty, Jr., 64, acting as Senior Vice President, Real Estate and Development, and his first cousin Clarence Smith acting as CEO of the company.
Haverty is being an as conservatively run company as far as it can get, it refrains from in-house credit financing of purchases, it has a rock-solid balance sheet, it has been profitable as long as I could track their financials back, and according to its 10-K, HVT has paid a dividend each year since 1935!
Like many brick and mortar retail companies, Haverty’s revenues pre-covid were just slightly on the decline, down from $821.6 million in 2016 to $802.3 million in 2020. Nonetheless, the company managed to increase their free cash flow in that period dramatically, from $36.8 million to a whopping $121.9 million. I am stating actual dollar numbers and not per share, because the company also has reduced their share count gradually, meaning the % increase per share was even higher. (The year 2020 was an outlier year, so numbers might be distorted, but ending in 2019, the picture looks more or less the same.)
Before the pandemic hit, HVT stock was mostly trading in the $20 range, and its FCF/share in the $1-$2 range. Then came COVID, and - one can only describe it like that - things went weird. First, like most companies, the stock declined about 50% and at this point I believe a short entry indeed might have looked appealing, with lockdowns and all the horrific things the world was expecting to happen. But, as it turned out, some parts of retail saw an unprecedented boom shortly thereafter. Like it happened to many competitors, business was thriving after the first COVID wave subsided, leading HVT to post a 2020 EPS of astounding $3.12, up from $1.08 in 2019. And this is where I believe the first short thesis made sense, namely reversion to the mean.
Usually, I am a big proponent of mean reversion. What goes up, must come down at some point and vice versa – simply put. Actually, I took advantage of mean reversion myself by buying into the post-earnings selloff, albeit on a much smaller time frame than the short thesis here would suggest. I indeed believe, from the 3 potentially bearish arguments I present to you, this one could be the one of most relevance, so let’s look at it in more detail.
Like I wrote above, COVID with its lockdowns and social distancing measures created an unprecedented surge in demand for home improvement amongst other things (such as sporting goods for example). This heavily benefited HVT, leading to a triple in both EPS and share price during the last 12 months. Logic implies that these trends, because they are tied to a specific situation (COVID) and not a general change in behaviour, will fade. And with those trends fading, so would the earnings thus the price of Haverty’s stock. Its stock surely did, as of this writing it is down almost 40% from its highs. And according to simple logic, the $20 range would be an appropriate target, simply because the stock has been lingering in this area for quite a while pre-COVID. But, as it is the case with other heavily shorted retails stocks, while Haverty’s stock declined, its earnings just keep growing. This, in my opinion, creates a dangerous situation for those who shorted HVT. To explain further, let’s look at some numbers.
Source: Seeking Alpha
For the sake of simplicity, I want to focus on EV/EBIT to make my first point. The company’s EV/EBIT currently stands at 5.2x, far below its 5-year average of 17.03x. To be more specific, TTM Haverty’s EBIT stands at $112.8 million, up from $29.4 million in 2019. Lots of room to the downside, one might think. But is it? With the company earning record amounts of profits and buying back shares, a 2019 EBIT multiplied with Haverty’s 5-year EV/EBIT handle would imply an enterprise value of roughly $500million, or a share price of about $27.5. That doesn’t really sound like a favorable target price for a short investment, with “upside” of only 15% from its closing price of $32.32, as of 11/5/2021. Besides, the stock already saw these levels for a short time after releasing its latest earnings, and also this is really the best-case scenario for a short, with revenues and earnings obviously NOT falling off the cliff currently. Plus, every positive earnings report from now on will only reduce the profit potential for a short trade.
But that is not all. One has to factor in borrowing costs (which I will generously exclude due to our low-rate environment) and dividends. Let’s do a simple math, with the assumption a very smart and lucky person managed to go short at $50 in June 2021. While the investment is being up about 40% currently, a short would have to pay $0.25 every quarter just to wait for that best case target in terms of mean reversion to materialize. This is hardly what I would call a sound risk/reward ratio anymore, meaning that I feel very safe to call a bottom at $27.5 for the mean reversion thesis, and I want to reiterate, this assumes that suddenly HVT’s numbers would fall back to its 2019 levels, which I view as highly unlikely.
But, reversion to the mean is only one aspect, what about the death of retail?
Another imminent threat – although it has been called a threat now for many years. I must admit, I am a heavy and loyal Amazon (AMZN) customer myself, heck, sometimes I even order my groceries online these days.
As you can see above, the rise of e-commerce truly looks unstoppable. During the lockdown-part of the pandemic it saw a huge jump and is now reverting to the mean again (pun intended), which is still an impressive upwards trajectory.
In real numbers it sounds even more dramatic. Brick and mortar retail experienced an unprecedented decline during 2020, with 12,200 stores closing across the U.S. that year alone, headed by J.C. Penney, GameStop (GME) and The Gap (GPS).
Notice though, that HVT hasn’t closed a single store, in fact just the opposite. As CEO Clarence Smith said in the last earnings call:
We expect to end 2021 with 121 stores, 1 store over last year. In 2022, we have plans to open 5 stores, netting 3. We're evaluating numerous opportunities for locations, which we can serve in our distribution footprint. We've been pleased with our strategy of converting existing retail space to Haverty stores.
Source: Q3 2021 earnings call
This makes perfectly sense for two reasons. First, with many retail stores closing, leases become more affordable, thus making expansion potentially more attractive. Secondly, and I should disclose this is just a personal opinion, while companies like Wayfair (W) surely are taking market share away here and there, I believe good old furniture stores are here to stay. While accessories might be easily ordered and returned, have you ever returned a couch or a cupboard to an online retailer comfortably? I guess not. Also, most people just want and need to make physical contact with furniture before deciding to buy it. Not even virtual reality could provide that.
Summing up, while the slow death of most retail-branches indeed seems inevitable, I strongly believe the furniture business will be one of the few exceptions. It certainly is now.
To be fair, this issue affects not only brick and mortar but all retail and many more industries. But boiling it down to HVT, there are still a few noteworthy observations to be made.
While Haverty’s upholstery products are being mostly produced domestically, the company imports the vast majority of its case goods from Asia, mostly from Vietnam. Needless to say, Covid-related factory closures resulted in a shortage of supply. And then there is the sharp rise in container rates. As President Steven Burdette said:
Container capacity, container rates and port congestion continue to be areas of concern. We expect these issues to continue well into 2022. Our container prices on the spot market continued to increase during the quarter.
Source: Source: Q3 2021 earnings call
I believe this statement is exactly what sent HVT stock tumbling just after the earnings report.
But just after this paragraph, Mr. Burdette continued:
We remain optimistic for the fourth quarter. Our teams are doing a wonderful job communicating with our customers regarding any delays with their products. While there will be a slowdown in import receipts from Vietnam, we are expecting improved shipping times from our domestic suppliers and improvements in shipments from our bedding suppliers to help offset some of these delays.
Source: Source: Q3 2021 earnings call
It is also important to note that all these problems already existed in Q3, yet the company managed to post record sales and profits during this quarter, nonetheless. Also, the company highlighted in the recent earnings call that its inventory is at its best shape it has been in over a year
Finally, and again I want to emphasize that this is only a personal observation, I am more and more getting the feeling that empty shelves and long delivery times lead to a what I call “hunter effect”. Let’s call it a fear of missing out. The emptier the shelves get, the more the incentive to gather what is left, before those products become out of stock, too.
While supply chain issues are without question a point of concern and deserve monitoring, I would conclude that I haven’t seen many companies navigating through these problems as elegantly as Haverty has been lately.
During the analysis of a potential new investment, I believe it is paramount to first consider the possible downside, before thinking about upside potential. For reasons mentioned above, I strongly believe HVT’s downside lies at $27.5, if the company were indeed to quickly fall back to its 2019 earnings.
As for possible upside, let us look at some numbers.
Source: table created by Author using data from Seeking Alpha
Excluding the last 2 years, assuming they have indeed been outliers, the company grew its FCF at a CAGR of 16.4%. EPS is a bit lumpier, but overall has an even higher CAGR. Taking into account the statements in the recent earnings call by CEO Clarence Smith, that he is confident to growing the company’s sales and maintaining strong double-digit operating profits in the years ahead, together with Haverty expanding its store count next year, I think it is safe to say that an investment in HVT offers mid double-digit growth potential in the years ahead, even if the stock would fall back to my worst case target price of $27.5.
Like I wrote above, Haverty has paid a dividend since 1935, the dividend looks extremely safe with a current payout ratio of only 20.92% and on a long term basis almost always below 50%. The 5-year dividend growth rate sits at 17.48% currently, which is almost exactly in line with the company’s pre-COVID free cash flow CAGR of 16.4%. My base case therefore implies a safe and long-term dividend growth rate in the double-digits, which at a current yield of just above 3% in my opinion makes for a great investment.
Now, for a best-case scenario, let us assume that the post-COVID spike in earnings was not just a fad, which I believe could very well be possible, and Haverty would be able to maintain double digit growth from these elevated levels. The market in my opinion would need to rerate the company’s multiples back to its pre-COVID range pretty quickly. HVT’s 5-year average PE multiple sits at about 15x, which is in line with its sector. So, applying this to the company’s TTM EPS of 4.91 this implies a share price of $73.65, more than 100% upside from HVT’s current share price. This more or less concurs with the current analysts’ price target of $64.
Also, while I am not the biggest advocate of predicting short squeezes, with a short interest of more than 19% at the time of writing this article, it is certainly within the realm of possibility that this could happen at some point to HVT’s stock.
Summing up, while I personally view HVT as an ideal DGI investment, I also believe it also offers a highly asymmetric bet. While I don’t see downside lower than $27.5, which is only 15% away from a share price of $32.32 at the time of this writing, I see upside of more than 100% if the company’s earnings keep coming in as they currently are.
Don’t get me wrong, in contrast to most people, I sincerely admire shorts. In my opinion they are the heroes of our industry. They usually take high risks, accept unfavorable risk/reward ratios (limited upside, unlimited downside) and they often discover frauds – or at least irregularities. But in this case, after going through all the potential short theses, I strongly advise considering exiting this (so far, winning) trade. Even if the company’s earnings revert to its long term mean, there exists minimal downside in terms of share price, and with every dividend payment and good earnings report this downside narrows even further.
For long investors on the other hand, I believe Haverty is indeed a wonderful company at a wonderful price. Unfortunately, I cannot ask him myself, but I think HVT is a stock that both young and old Warren Buffett would love. Young Buffett would be thrilled by the, for such a conservative company atypical, asymmetric bet an investment offers, and old Buffett on the other hand would just love the predictable business with its stable and fast-growing dividend.
Personally, while I have to admit that patience is not my greatest virtue, I would advise a very simple strategy, which I will apply for my own investment here, too. I believe the company is well-run enough to simply look at the dividend, and not the moods of Mr. Market. This means, I am a buyer at a yield above 3%, and a seller at a yield below 2%. After all, while making for a good night’s sleep, I think this strategy also offers the most favorable returns, with low turnover and minimal room for error.
Edit: After writing of this article, HVT announced a special dividend of $2.00 and an increase of its stock buyback program. This makes the investment case even more compelling and the short squeeze theory more probable.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of HVT either through stock ownership, options, or other derivatives. 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.