Description

Culp is a high-quality upholstery fabric company that generates a significant amount of free cash flow and owns a gem (mattress ticking) that is relatively immune to imports, and is worth more than the enterprise value of the entire company. The company pre-announced recently that it would miss FQ4 earnings (ending in April) and that sent the stock down about 20% in one day. Earnings will now be $.24-.27 / share vs. $.31-.35/share previously estimated. This has pushed the stock to an extremely attractive valuation - a market cap of $87million and enterprise value of $129 million. The company is generating roughly $12 million per year in free-cash flow before working capital changes and I feel that we will have see a major catalyst soon in the unlocking of the value of the ticking business. In addition the company is doing a superb job of adjusting their traditional upholstery business to the realities of the import threats.

Culp got started in 1972 as a converter of upholstery and has transformed into one of the three largest furniture upholstery manufacturers and the world’s largest producer of mattress ticking. Importantly, the upholstery business has faced significant competition from imports, which will clearly continue in the future. However, while most of their competitors are now bankrupt, Culp is managing through this onslaught surprisingly well - closing a significant amount of U.S manufacturing, opening an upholstery finishing plant in China, shifting the company to a free-cash flow generating model, bringing down net-debt from a dangerous level of over $136 million in April 2000 to around $37million (by my estimates) in April 2004 from internally generated cash, and bringing up gross margins in the upholstery business to a record high recently.

The way to think about this company is to break it up into 2 segments (1) upholstery – 2/3rds of sales and (2) mattress ticking – about 1/3rd of total sales.

Below is a breakout of the income and free-cash flow of each of the businesses. Keep in mind that the results of the businesses are volatile so I’m normalizing them a bit to show what they look like today on a go-forward basis. The company discloses only the sales and gross income by division – but I’ve worked through the EBIT, cap-ex, and depreciation by segment and run the numbers by management – so I’m confident that I’m reasonably close on each of the line-items.


Ticking Upholstery Total

Sales 109 202 311

EBIT 11 4.5 15.5

Net Interest (6.3)

Pretax 11 4.5 9.2

After-tax 7.5 3 6.3

Depreciation 4.5 9.4 13.9

Cap-ex (2) (6) (8)
(note: includes vendor financed cap-ex)

Free Cash Flow 10 6.4 12.2


Fully diluted shares outstanding is 11.859



Mattress Ticking

Ticking is the patterned outer fabric covering of a mattress. Culp is very low cost and is the largest mattress ticking company in the world with an approximate 25-30% share of the U.S. market. Ticking customers are largely the “four S’s” of mattresses – Sealy, Simmons, Serta, and Spring Air who, collectively, represent over 2/3rds of the mattress industry.

Mattress and ticking are JIT businesses that have short-delivery lead times making them less exposed to imports. While we, as consumers, are willing to wait 6 months or more for a couch – we want our mattress the day or day after we order it. The mattress companies have distribution centers all around the country to ensure that retailers get next-day or same-day delivery. Culp, too, must respond quickly to orders – and 70% of sales are delivered in one day or less. It’s very difficult for the mattress companies to anticipate the patterns that will need to be ordered and delivered immediately. As a result, both mattresses and mattress ticking have been resistant to imports. In fact, imports only represent about 3% of mattresses today. I assume that this is what attracted the private equity firms to the business – KKR recently announced the purchase of Sealy and Thomas H. Lee owns (and is now bringing public again) Simmons.

In late 2002 the ticking industry faced a problem – mattress companies began moving from two-sided ticking to one-sided. One-sided ticking uses about a third less ticking than two-sided– so Culp’s volumes suffered and sales in ticking were down 5.5% in fiscal 2003 (ending in April) for the company. While this hurt, Culp did better than the overall industry by gaining a decent amount of share during the transition. The good news is that this shift is now largely behind the company as the mattress industry is today about 80% one-sided. As a result, Culp ticking started growing between 4.5-7% year/year in the 3 quarters ending in January and grew about 10% year/year in the April quarter (pre-announced but not yet reported).

I feel that this business will continue to grow well going forward. The mattress industry grows a bit over 6% per year and Culp will likely continue to gain share of ticking. The next largest competitor here is a division of Burlington Industries at around $90-95 million in sales. Burlington seems to be having trouble with its ticking business as it is higher cost and has been trying to sell it – with apparently no takers. Culp took a close look but felt the operation was too high cost. I feel that Burlington is likely to continue losing share to Culp. Also, further growth could come from the company entering Asia to sell to mattress companies over there.

The valuation that this business would get as a stand-alone company is compelling. In the most recent quarter (April) it had annualized revenue of $109 million and had EBIT margins of about 10% or $11million annually. The division has depreciation of $4.5million and capital expenditures of $2 million annually over the next few years. I figure free-cash flow is about $10 million per year (assumes about $7.5 million after-tax earnings plus $4.5million in depreciation minus $2million in capital expenditures). I estimate that this business would sell at a free cash flow yield of 6-7% if it was a stand-alone company given its resistance to imports and strong growth characteristics. That would give the segment a valuation of $142-$167million.

This business could be sold to either a strategic or a financial buyer. Culp has made sure to separate the ticking manufacturing from upholstery in order to show that it can run at these numbers as a stand-alone business, which tells me that they would be willing to sell it. My feeling is that the company will move to unlock the value of this business in some way fairly soon.



Upholstery

Upholstery can be broken up further into
(a) Culp Decorative Fabrics (CDF) and (b) Culp Velvet Prints (CVP). CDF makes traditional furniture upholstery (every major fabric except leather and suede) and CVP is the largest velvet upholstery operation in the world – with very little competition any longer.
Both businesses have been feeling the pressure from imported leather and suede from China and from traditional upholstery imports.
Management has shown that they recognize the realities of this market and has responded extremely well to this threat:

- They’ve restructured each of the divisions
- Closed 8 of the 18 manufacturing plants in the U.S.
- Cut about 30% of their workforce
- Changed the corporate focus (and incentives) to a free-cash flow generating model
- Drove down net debt from $138 million to $37 million

The results of the restructuring have been dramatic. Gross margins have gone from 9.7% to over 18% in the most recent two quarters – their highest ever.

Also, it’s important to understand the model that they are moving towards. This model reflects the realities of the new world and takes advantage of Culp’s strengths:

(1) Part of the business will evolve into a “sourcing” model where Culp will design product, source from low-cost countries and convert and sell to U.S manufacturers of furniture. Most U.S. furniture companies don’t want to go around Asia in order to source product. Culp is able to provide U.S. design (which entails their tremendous experience understanding trends etc.) coupled with low cost product from the cheapest areas of the world. This business already represents 8 ½ % of total sales and is doubling on a yr/yr basis. This will become a very large part of their business going forward. Culp has the best reputation in the industry of offering first-rate customer service, which entails design (knowing what will sell and on what pieces of furniture) and on-time delivery of product. Culp will be able to continue to offer this service with low cost sourcing.


(2) China finishing: Culp just completed the building of a finishing plant in China that will provide the company with a low-cost manufacturing base. This will be a major part of the Culp story long-term. Importantly, the plant just started shipping product last month and has been designed into Universal’s (division of Lacquercraft) imported collection. This is a major development as this is largest furniture line ever exported from Asia to the U.S. and it appears that Culp’s product that is made in China will account for about 40% of the upholstery in the line.


(3) Finally, upholstery for lower-end furniture will likely stay in the U.S. as shipping costs offset labor savings. Also, velvet is much more difficult to make and will likely remain here as well. So the company will continue to have some U.S. manufacturing going forward. From conversations with management, however, it is very likely that more will be shut down. Approximately 1/3rd of PP&E could be shut down at some point in the near future (PP&E is about $79 million currently). The good thing is that they own the plants and will have very little cash outlays related to shutting them down.


One thing that is very clear when talking to management is that they will do whatever is necessary to survive and thrive in the new environment. They will shut down whatever plants need to be closed and their past actions prove this. The management team understands the realities of imports as well as any I’ve come across and is not afraid to respond accordingly.

The valuation of this business is more difficult to get my arms around as there are a lot of moving parts. EBIT is running at about $4.5million annually. Depreciation is $9.4 million annually so EBITDA is about $14million. I assume capital expenditures are about $6million in this business (company says that it will be lower) – so they’re generating about $3.7million in free-cash flow. I would assume that given the uncertainties in this business that it is fair that it would sell at about a 10% FCF yield stand-alone for a valuation of $64million. Quaker Fabrics is the closest comparable in terms of product – but they don’t generate much free-cash flow. Quaker’s EV/ Sales is about 51%. The $64 million valuation for Culp’s business would represent an EV / Sales of about 32% - which is extremely conservative in my opinion.






Summary Valuation

As described in the segment breakout in more detail:

Ticking: FCF of $10million at a 6.5% FCF yield (taking average of 6-7%) = $154 million

Upholstery: FCF of $6.4 million at a 10% FCF yield = $64 million

So: EV of $218million less net debt of $37 million = $181 intrinsic market cap
or $15.27 / share (fully diluted shares of 11.859)

Note: The $37 million in net debt is a bit lower than the most reported number because I’ve assumed some cash flow generation in the April quarter. I think I’m pretty close on the number.

Catalyst

My working assumption is that the company will find a way to unlock the value of the mattress ticking business and use it to significantly enhance shareholder value. If they were to sell if for less than I’m assuming – let’s say for $125 million – then they would bring in $100 million after-tax from the sale. They could use this cash to buy back a ton of shares, pay a huge one-time dividend, or even take the rest of the company private.
Another option is to do a tax-free spin-off of ticking. Either way, I feel the value of the company is worth up to double the current price.