Description

Make more money with less stress in Ekornes

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. - Ben Graham

Nobody can know all the facts. Instead, one must rely on shreds of evidence, kernels of truth, and what one suspects to be true but cannot prove. - Seth Klarman

• Ekornes is a cheap, virtually debt free, quality small cap stock. EKO has a long history of profitable operations and is currently trading near 5 year lows because of problems that are probably cyclical in nature. Virtually no future growth is priced in today. Based on historical average earnings and cash flows, the company looks severely undervalued. On my 2015 estimates, the company trades at a P/E of 9.3 and 4.8x EV/EBITDA. Because of its depressed valuation and balance sheet strength, I think the downside is very limited while the upside is quite substantial.

• Variant perception: Where I differ most from consensus is in believing we are very near a moderate sales recovery because of 1. the completed rebuilding of EKO’s distribution channels in the US which crumbled in the aftermath of the financial crisis, 2. sales growth in the Euro area as the Eurozone economy recovers and 3. the launch of several new products in ‘14/’15, the first of which have been extremely well received by retailers and customers and 4. the acquisition of IMG which should also contribute positively.In my opinon, Q3 numbers should be interpreted positively, renewed sales growth looks likely. I should say that that does not imply the much growth in the next quarter, necessarily – but probably within the next year.

• My thesis is that these drivers in combination with a high degree of operational leverage will lead to a recovery in margins and profitability toward historical average levels. This in turn can be expected to lead to increased investor interest and rapid share price appreciation, probably on the order of at least 50% over the next 1-3 years in a base case scenario.Time is our friend as owners of a wonderful business – when we buy at the right price. And while we wait for a repricing of EKO, I estimate an average dividend yield of 7.4%+ for the next two years (I would of course have preferred buybacks here, and I am not ruling it out going forward, but it's not a tradition at EKO). Total expected returns should be about 60%.

• Because of its balance sheet and strong track record, the company could also be a private equity target despite already being extremely well run. Several PE suitors in the Nordic region are known to covet EKO, but so far no agreement has been reached. A buyout is clearly a possibility and recent comparable transactions imply a substantial upside in this case (80%+).

• In summary, Ekornes promises reasonable safety of principal, solid dividend income and the potential for large capital gains. Even Ben Graham would approve.

A long history of profitability

Ekornes ASA is a furniture manufacturer based in Ikkornes, Norway tracing its history back to 1934. The Stressless ® line was first launched in 1974 and the company went public in 1995. It hasn’t reported an operating loss since. Despite its obscure location, Ekornes has managed to build a strong global furniture brand with a premium reputation, visible both in the company’s margins and returns on capital. Its most important markets are the US and Germany, but EKO products are sold all over the world. Its flagship series is the comfortable Stressless ® line of recliners and sofas, which make up about 80% of sales. They also make Svane® high quality mattresses and Collection sofas.

Ekornes has historically been a very profitable and well-run company. The company’s relentless focus on increasing automation and cutting costs has led to EKO historically realizing margins and returns on capital well above that of its industry.  From 2005-2010 its average EBIT margins were 19% versus an industry with  < 10% margins. ROE & ROIC were strong at 26% and 24% on average respectively.

Why does this opportunity exist?

EKO was hit hard by the financial crisis. After the financial crisis years EBIT margins and profitability weakened. 2013 ROE/ROIC fell to only 13/14%, respectively.The main causes were weak sales in the US during and after the recession and the impact of the Euro Crisis. As the company was thus hit with a one-two combination in its most important markets, the subsequent share price weakness is no surprise.  As the US market weakened, many retailers went bankrupt and had to be replaced by new ones. This process has taken time and cost money. Maintaining good relationships with retailers is paramount for EKO, and being supportive through a difficult period for the retailers was considered a must. The Eurozone markets have been depressed for several years and are finally showing signs of improvement, but sales are still volatile. Southern Europe is coming back, while Central Europe is still a problem area.

It did not help that the company’s implementation of a new ERP system messed up sales in Q1+Q2 ‘14, delaying shipments. Some revenues will thus have to be recognized later in the year. 

In summary, this opportunity exists because investors are fed up with reports of weak top-line growth and declining profitability, and because the company is underfollowed/underanalyzed and boring.

It’s currently covered by only 2 local sell-side analysts, both of whom are competent, but none of them work for a top 5 firm in terms of equity trading market share. Only one of them (Preben Rasch-Olsen at Carnegie) seems to think a sales recovery is near. The liquidity in the shares is also limited, about 15 000 shares per day. Consequently, this is not the sort of stock most analysts make a top priority – it makes them little or no money and their time is likely better spent on other pursuits.

To top it all off, there have been some temporary management issues: the former CEO Oeyvind Toerlen quit in december 2012 after a strategic disagreement with the board and was only replaced two weeks ago after what has generally been considered an unacceptably long search period. However, there is no reason to suspect that EKO currently has a weak management team. The new CEO has extensive industry experience from Stokke ASA and a good reputation. The other members of senior management have been with the company for years and seem both competent, able and honest. Their track record in terms of capital allocation and cost control is strong and proof of their skill. Management and board’s remuneration is modest (almost ridiculously low by American standards) and aligned with shareholder interests: bonuses for senior management (paid in cash only) are dependent on EBIT margin meeting certain levels. The higher the EBIT margin, the higher the bonus. The risk of dilution through option issuance to management etc is nil. Though I wish management owned more stock, they have proven to be diciplined allocators of capital and have acted in a shareholder friendly manner historically.

In my opinion, there is no reason to believe that EKO’s problems are structural or irreversible. Quite the opposite. I think we are in the latter stages of a cyclical downturn for EKO and that things are showing early signs of improvement – more on this in the next section.

An uptick in sales is near

In the first two quarters of 2014, EKO experienced weak markets in central europe in particular, as well as  problems due to the implementation of a new ERP system. This led to delays in shipping and revenue recognition. I think the situastion is now improving. Export numbers provide one clue:

Government export numbers are historically positively correlated with EKO sales growth outside Norway. Exports to North America and Europe combined had a 0.63 correlation with sales growth at EKO in the same year from 2001-2010 and 0.54 from 2000-2013). Every year except 2011 with an increase in furniture exports yoy from Norway has seen positive sales growth yoy at Ekornes. Furthermore, EKO has since 2000 had sales growth yoy 10/14 times while the change in exports has only been positive 6/14 times, indicating that EKO also outperforms its Norwegian competition abroad. 2014 numbers include data up to and including september.

SSB’s numbers alos show exports to some important countries have been markedly stronger year on year in 2014, e.g. exports to the US. Because of the high fixed cost base and operational leverage embedded in EKOs business model, even moderate sales growth and increased capacity utilization should soon translate into stronger margins and increasing ROE/ROIC. As this becomes visible to investors, the stock should be repriced.

What are the fundamental reasons I believe EKO will return to sales growth fairly soon?

As I stated above, I think the government statistics number should be viewed as a leading indicator for EKOs sales this year – EKO is probably on the verge of moderate sales growth. Given the current undervaluation of Ekornes, the mentioned sales growth does not have to be very large to justify a much higher stock price. However, a data point is just a data point unless there is a reasonable explanation for why this might be an important clue. I believe there is. The four fundamental drivers of my sales growth inflection point hypothesis are as follows:

1. The rebuilding of sales channels in the important US market will become visible on the top line over the coming quarters. This has been a costly effort, as only 25% of its US retailers were part of EKOs distribution network five years ago. I believe the number of US resellers is now expanding again. Furniture is not a market that is at great risk of technological disruption the way I see it. It seems reasonable to assume that a return to normalized growth rates in the underlying market is likely, which would imply a long term sales growth CAGR of 3.3% (based on the CAGR seen from 1992-2013). Furniture sales in the US are still well below the levels seen before the financial crisis.Without estimating future growth in detail, it seems likely to me that these levels will be surpassed as time passes and the economy improves. I just can’t say when. In EKO’s Q3 report, there were indeed signs improvement in the US business. For Q3, new order receipts from the US and Canada were up 11% yoy.  

2. Slow improvement in European markets is also likely over time as the effects of the European crisis continue to abate. Although I will admit that seems to take longer than I had expected. Right now, it looks like Germany is the biggest problem, it is a very important market for EKO. It is a positive though that EKO says they feel their relative competitive position is strengthening, it is just a very weak market.

3. The launch of several new products starting in the fall of 2014 should boost sales. Products with a more contemporary look (which can be produced without substantial new capex expenditure), the first two lines of which have been extremely well received by resellers and customers (Metro ® and City ®) should help increase sales growth going forward. EKO plans to increase production capacity in its chairs segment by 6% yoy in 2014 after the positive reception in the market. Talking to sales people at EKO retailers in Norway, the company’s claims were confirmed, the new lines are selling well. The employees I talked to had noticed that many buyers were people who already owned EKO furniture. 

Additionally, the acquisition of IMG should contribute positively. 2014 revenues for IMG will be about 320m NOK, and I estimate 352 for 2015.

How are product development decisions made at EKO? What are the capex needs?

New models are on the way, with a more contemporary look. I think this modernization of the design expression at EKO is a positive. While I realize that not everyone likes minimalist furniture, EKO has been known to make products that are not considered among the most aesthetically pleasing by people with so-called good taste. And the look of some of their products belongs firmly in the eighties. They still make plenty of products that I would never consider putting in my living room, no matter how comfortable they are (if you have never tried a Stressless ® chair, you should. They’re UNBELIEVABLY comfortable).

I think it is important though, to understand that EKO makes popular furniture. It is made for a mass market, and evidently, many like the EKO look. 

While writing up EKO, it became important for me to get comfortable with how product development decisions were made at EKO. Did they put out this (in my view) largely antiquated look out of habit, was it because they are forced to because the production equipment can only make a certain look, or was it for commercial reasons? If a different look required substantial capex investment, that could be a big problem.

I felt this was a very important thing to understand so forgive me for getting into this in some depth – the whole business is predicated upon correctly anticipating what look and feel their customers will pay up for. Misses can be very costly.

I contacted two former employees of the company. One worked in the design department, and the other in a management position. When I asked them about how the product development descisions were made, it became clear that EKO is making these decisions based purely based on expected returns (i.e. produce the look the customer wants, but do it only if it can be done efficiently with a short payback period on the investment required. When models start selling less, make changes).

They center their products around a small number of standardized modules and designs, using robotics extensively, which enables them to produce very high quality products more cheaply than competitors in the same segment of the market. This is where I believe EKO really stand out versus the competition, and where both cost advantages and EKO’s reputation for quality comes from.

Over time, EKO can change the look of their product lines as they feel customer tastes are changing, and even though their production processes are highly automated, there is flexibility in the systems such that big investments are not required to create a fresh look on new lines.

I was able to confirm that this understanding is correct since the company plans to launch several new products over the next year in spite of not having made large capex investments beyond the norm recently (we can expect capex in line with D&A for the foreseeable future). I expected around 110-130m NOK for 2014 / going forward based on info from the company’s outgoing CFO (Robert Svendsen is also in charge of investor relations to save money, apparently. Gotta love that), but now I think that might actually be on the high side. For the sake of conservatism, I've kept it at the higher level in my model. The IMG acquisition comes on top of this, of course.

Ekornes’ moats

Looking at historical returns on capital and margins, one is forced to consider that EKO might have some sort of economic moat. The company enjoys high gross margins year after year and much higher margins and returns on capital than peers despite primarily operating in a decidedly high cost country (Norway). I think the most relevant listed peers are La-Z-Boy and Natuzzi SPA. EKO consistently crushes them on both margins and profitability. I think this indicates that EKO has a durable moat. I believe EKO’s moat stems from its efficient, low cost production / high degree of automation and and its skill in managing distributor relationships – Ekornes reputedly creates the highest margins for retailers. Additionally, there is probably some brand value here enabling EKO to sell at a price premium to competitors relative to its cost of production: many years of high and systematic ad spend and a reputation for quality and comfort has made the Ekornes and Stressless ® brands very well known in EKO’s markets of interest.

All three companies have struggled to grow the top line over the last few years, suggesting that EKO’s sales growth problem is industry wide and not company specific. Trough 2010, EKO was outperforming on the top line. Over the long term, EKO is the better at growing sales as well, as witnessed in the relative 10 yr sales CAGR. LZB’s slight outperformance over the last 5 years is likely due to their low eurozone exposure (the majority of LZB’s sales are in the US/Canada). These numbers overall do not suggest that EKOs moat is eroding, which is of course a worry when margins and profitability decline. 

Instead, I think this is strong evidence in support of my thesis that EKOs current problems are largely cyclical in nature and due to a weak furniture market in general. Curiously, LZB trades at levels way above EKO despite weaker LT sales growth and lackluster profitability (consensus: 17.5x P/E for ‘15). 

Valuation –what is EKO worth?

At this point one could be tempted to move directly to trying to model exactly how this renewed sales growth might play out, detailing the impact on earnings for the coming quarters and years. However, I think it’s an important principle to think defense first, and I care deeply about track records and very little for detailed projections, as a famous investor has been known to say from time to time. Thus, I think a reasonable starting point for a valuation of EKO is establishing what historical earnings and free cash flows have been on average and using this to see what growth is implied in today’s stock price. I want to examine the potential downside first. If that is minimal, I move on to the upside potential.

What normalized free cash flow yield am I buying today, assuming the past is a reasonable guide to the future? It turns out that assuming no growth, a 10% discount rate and subtracting 10m of net debt on the balance sheet at year-end, EKO is worth 73 NOK. (Adjusted for the IMG transaction, net cash at year end would probably be 400 mNOK). This is encouraging. I love growth, but hate paying for it. The fact that very little growth is priced in provides a nice margin of safety in my opinion.

Now I feel I may allow myself to enter the more speculative phase of the valuation process and assign some value to growth:

Now it’s time to ask: what could go right? How will the modest sales growth I think is likely going forward impact earnings and cash flows? I add 352 mNOK on the top line from IMG, and assume a return to 3% annual sales growth in 2014 for the rest of EKO. I then assume a overall 5% sales growth from 2015 through 2017. This is not a big stretch – from 2004 to 2010, sales CAGR was 4.1%. The long term guidance from management is still an annual sales growth of 5-10%. Emerging from a cyclical trough could mean a much higher growth rate than that in the short run. In 2010, EKO’s sales grew by 11% yoy, for example. Anyway: after this I pencil in 3% sales growth (below the industry CAGR since 1992 and EKO’s sales CAGR since the turn of the century of 4%). This should lead to rapid EPS growth.

Base case: what happens to earnings at EKO as sales growth improves? 

The answer is: earnings improve dramatically as operating margins move toward historical averages. 

Applying the historical avg multiple of 12 to 11.5 NOK in EPS in 2017, yields a fair value of 138 NOK.

That seems very reasonable for a profitable, debt free company even if sales growth is fairly slow in absolute terms. Cross checking this with a DCF, I find that with a 9% discount rate, the value of EKO should be 121 NOK. I’ll use 10% for a larger margin of safety and my DCF value becomes 98 NOK. 

Return on capital will improve sharply and revert to the historical mean

Keeping the «Invested capital» term constant (for illustration purposes this will do), ROIC should move from 16% in 2014 to around 24% in 2016 (equal to the historical average up until 2010). The reason for showing this explicitly is to hammer my point home: moderate sales growth completely transforms EKO as an investment case. The market will have to take notice once EKO posts returns like this (note: figures don't correspond exactly with current BS).

Applying the historical avg multiple of 12 to 11.5 NOK in EPS in 2017, yields a fair value of 138 NOK.

That seems very reasonable for a profitable, debt free company even if sales growth is fairly slow in absolute terms. Cross checking this with a DCF, I find that with a 9% discount rate, the value of EKO should be 121 NOK. I’ll use 10% for a larger margin of safety and my DCF value becomes 98 NOK.

The average of the earnings multiple value and the DCF value is my base case fair value scenario: 119 NOK.

The bear case: no sales recovery and relatively stagnant earnings: 68 NOK

EKO seems to be a safe bet – it has minimal debt and a history of profitable operations. This is a case of low risk, but high uncertainty – an interesting combination. Assuming I am wrong and no material sales growth occurs i the near future, I estimate a realistic 2017 downside case at 8x the average EPS of 7.9 NOK for the last five years (which is lower than the 10 yr average at 8.4 NOK) plus total dividends of 5.50 NOK. I cut the current dividend payment to 2.75 NOK for the next two years because the payout ratio is on the high side based on current earnings alone, this will perhaps become an issue if I’m wrong about the sales growth. 2.75 should be doable in any case. That yields a downside valuation of 68 NOK. The worst case here is stagnation and a dividend cut. I should stress that I’m talking about fundamental downside and risk of permanent loss of capital, not where the stock price might go in the short run.

The bull case: a buyout

In a recent transaction, Triton Partners bought Scandinavian Business Seating (SBS) from the Swedish listed private equity firm Ratos (RATOB SS Equity) at EV/sales 1.9x.

http://www.triton-partners.com/news/triton-signed-agreement-to-acquire-scandinavian-business-seating/

http://www.ratos.se/en/Press/Press-releases/2014/Ratos-sells-SB-Seating-to-Triton/

Applying 1.9x EV/sales to EKO (my 2015 estimate) yields 155 NOK. This presentation on SBS from 2011 is interesting: https://www.ratos.se/Global/02_Innehaven/SB%20Seating/110310_SBS_ThH_LIR_ENG.pdf?epslanguage=en

In 14 comparable transactions done in the US in 2012/13 according to HarrisWilliams Co* the median EV/EBITDA multiple was 9.5. While I don’t believe a buyout is the most likely scenario, I think that if it does happen the pricing is likely strong, considering both the quality of the business and that the Ekornes family has previously been rumored to be in negotiations with private equity interests but not pulled the trigger (they own enough stock to stop a deal at about 13% in total).

One recent transaction of particular interest is the purchase of Stokke AS, a premium furniture maker most known for the iconic «Tripp-Trapp chair» by the South korean business man Jung-Ju Kim. His stated goal is to buy strong European consumer brands with big and relatively untapped sales potential in Asia. This transaction shows that premium brand furniture makers are attractive M&A targets. Stokke is based in Sunnmøre, Norway just like Ekornes. It had a pretax margin of 18.6% in 2013, around the historical average levels for EKO. It has a strong brand globally and a history of profitability. So does EKO. The purchase price has not been disclosed publicly, but several new sources including Bloomberg reports the price around 3 billion NOK. EBITDA was around 200m NOK in 2013, so Stokke fetched about 15x that. However, sales growth at Stokke had been around 10-12% per year in 2011 and 2012, so any price comparison should take this into account, obviously. But even applying a 30-40% discount to that EBITDA multiple would yield a price for EKO of about 9-10.5x EBITDA.

If we assume 9x my 2015 EBITDA estimate, that implies 148 NOK. I'm going with 148 as my estimate for a buyout scenario.

Expected returns

Take the probability of loss times the amount of possible loss from the probability of gain times the possible gain. That’s what we’re trying to do.

Warren Buffett

My base case scenario implies an upside of about 50% trough capital gains to my base case target price of 119 NOK plus two dividend payments of 6.2% and 8.6% for a total upside of about 65% (assuming no reinvestment of dividends). I think there’s a 60% chance that this scenario unfolds. My bull case is a buyout at 148 NOK. I estimate the probability of this ocurring at 25% since several comparable transactions have been done recently and rumors abound concerning EKO and PE interests. My 3 yr downside case is 68 NOK. I think there’s a 15% chance of this happening. This investment obviously has a nice asymmetric reward/risk profile. These are subjective and utterly imprecise probabilities of course and and should be taken with more than a grain of salt.

My probability weighted expected return becomes: ((0.60 * 0.65) + (0.25* 0.95)) + (0.15 * -0.14) = 60%

Assuming a 3 year investment horizon, that’s an expected CAGR of 17% after probability weighting (which can make many a potential 50c dollar look less appealing). That’s extremely attractive in my view, and passes my personal annualized return hurdle with flying colors. I should think a 17% CAGR from a near debt free, solid company would seem interesting even for the most discriminating investor.

SWOT

Strengths

• Brand – high awareness both in the Nordics and abroad
• Product development skill (know how)
• Low cost, efficient producer
• Trademarks and patents (Stressless, Plus, Comfort-Zone, Ergo-adapt etc)
• Well managed distribution network
• Industry with high barriers to entry – specialized machinery, differentiated products, expensive shop fixtures and development of retailer relationships are required

Weaknesses

• High labor costs in Norway
• Currency sensitivity requires continous hedging
• Only present in high end niche today (may be a strength in relation to brand long term?)
• Lack of ability to raise prices above inflation. This is a business with cost advantages from an efficient process and a good brand, but that does not translate into pricing power. This has always been a problem, but is even more of a problem in a downturn for furniture in general.

Opportunities

• Leading player in the German market (highest per capita furniture spend in Europe)
• Renewed sales growth in the US likely after rebuilding distribution channels
• Asian markets have room for substantial growth
• New products launching in 2014/15

Threats

• Copycats and patent infringers
• Lower priced competitors (e.g. Zerostress)
• Low growth market pressures pricing extra hard currently
• Raw materials price increases
• New cyclical downturn in world economy

Pre-mortem: If something went wrong, what was it?

Deteriorating macro picture in leads to continued weakness in Europe and North America

Sales growth remains subdued and margins are pressured. Lower priced competitors grab market share.

Mitigant: Industry is not likely to be at a cyclical peak. Otherwise, this is (as always) a real risk.

Increased currency volatility leads to large losses

Ekornes has a large exposure to among other currencies the USD and the Euro.

Mitigant: Company has a long term currency hedging policy in place. Still an issue.

Rising costs beyond EKO’s control

Increasing raw materials prices (leather, wood, textiles, chemicals) could pressure profitability

Mitigant: None

Piracy and brand dilution

Copycats in low cost countries selling cheap imitations diluting the Ekornes brand strength. IMG furniture will dilute the EKO brand.

Mitigant: Aggressively protecting patents and trademarks. Additionally, the cost of labour in Asian countries is on the rise relatively speaking – the Asian cost advantage is shrinking. IMG furniture will not be sold in the same channels as EKO.

Widespread changes in distribution – balance of power shifting more toward the retailers

Consolidation among retailers reducing EKO’s ability to cherry pick retailers and control pricing.

Mitigant: Key markets remain relatively fragmented except in Central Europe, where there has been little pressure on EKOs sales margins from the retailers despite this consolidation scenario occurring. EKO is supportive in terms of promotional activity and delivers products on which retailers are able to realize high margins relative to competing products.

Conclusions and investment recommendation

EKO is reasonably priced based on normalized free cash flows/earnings and has a virtually unlevered balance sheet. This provides downside protection. In terms of upside, the company is probably close to turning a corner in terms of sales growth, which should lead to increased investor interest and share price appreciation as increasing capacity utilization, a higher EBIT margin and return on capital follows. My probability weighted estimated return is a 17% CAGR over the next three years.

Should a buyout materialize, it could mean an even bigger upside.

My thesis does not rely on refinancing, detailed or aggressive growth projections or hinge on unusual accounting anomalies or any specific hard catalyst. All that is required for this hypothesis to work is a partial mean reversion in terms of sales growth. As such, it is unlikely to be especially eye-catching. However, I do expect it to be extremely profitable.

This is simply time arbitrage – investing in a consistently profitable, unlevered company which is temporarily undervalued primarily due to cyclical factors will usually produce a good result, and I expect this situation to be no different.

Paraphrasing Howard Marks: good opportunities tend to occur when people forget that most things are cyclical. EKO is a high quality company, and does not come cheap when sales are clearly trending up. It must and should be bought in a downturn.

I recommend buying EKO (and one of their chairs) and then reclining. Stress less. Make more money.

Appendix

Multiples

Historical data

Balance sheet as reported Q3 2014

Reasonably updated shareholder list

Catalyst

Introduction of new models + cyclical recovery in key markets = moderate sales growth

Buy-out a possibility