Description

THESIS SUMMARY: Flexsteel Industries (FLXS) is a debt-free furniture manufacturer with a large portfolio of owned real estate whose shares have been punished for recent business underperformance amid macroeconomic headwinds and large, non-recurring expenses. The stock now trades at ~60 percent of TBV, despite impending asset sales which should generate cash proceeds equivalent to roughly half of its current enterprise value. Additionally, company-wide expense reductions associated with its restructuring plan will help normalize margins in line with historical profitability. Other positive signals include meaningful insider buying and the fact that the CEO has opted to amend his compensation terms to receive his 2019 cash bonus of ~$400k in Flexsteel stock and stock options. I see the shares trading somewhere between $20.81-$23.41 per share, an upside return between 36-52 percent over its current price of $15.36 per share.

COMPANY BACKGROUND

Flexsteel distributes its furniture products throughout the U.S. and Canada through its sales force and independent reps to customers for use in the home, hotels, healthcare facilities, recreation vehicles, boats, and offices. Flexsteel owns and leases several manufacturing and distribution facilities across Arkansas, California, Georgia, Iowa, Mississippi, Mexico, and Vietnam. The Company’s furniture products utilize domestically manufactured parts as well as imported parts, allowing for product offerings across a wide price range. Flexsteel’s furniture incorporates its patented "Blue Steel Spring" seating platform. Flexsteel believes that this patent gives it a competitive edge as it is relatively uncommon for furniture companies to hold design-related patents.

SALES IMPACTED BY TARIFFS AND WEAKENED DEMAND

Between FY 2010-2018, Flexsteel prospered with total sales growth of ~50 percent while maintaining positive annual operating income margins between 4.7 and 7.9 percent. By late 2016, shortly after reporting record sales of ~$500.1M, the stock price had grown ~10x peak-to-trough from its mid-year 2009 price. Flexsteel set its highest quarterly sales record in fiscal Q2 2018.

FY 2019 was a very different story however, as total sales declined 9.3 percent and operating income was negative $43.2M, the biggest operating loss in a decade. The Company attributed the sales decline primarily to weaker demand for retail furniture combined with negative impacts from the trade war tariffs between the US and China. Given that 42 percent of Flexsteel's furniture sold in the first half of 2019 was imported from China, the Company has a material exposure to the import tariffs. To date, Flexsteel has passed these increased costs on to customers through price increases, which has reduced demand and will continue to be a sales headwind until some sort of resolution is achieved. Management is reportedly working with suppliers for price concessions and trying to shift the supply chain to other countries to bring their pricing back to normalized levels.

RECENT LOSSES NOT AS BAD AS THEY APPEAR

Shareholders have seen a ~55 percent share price decline over the last year due to Flexsteel’s poor financial performance. While the deteriorating top-line is a cause for concern, it's important to recognize that Flexsteel's operating losses are not a new normal for the company, rather they are the result of extraordinary and one-time occurrences during FY 2019, including:

- $21.3M for enterprise resource planning ("ERP") system impairment*
- $10.0M for restructuring expenses (more discussion on the restructuring plan below)
- $7.7M in inventory impairment (related to the exit of the two product lines)
- $2.6M for a valuation allowance on foreign VAT
- $2.5M from the termination of a defined benefit plan
- $2.0M in CEO transition costs
- $500k in litigation settlement costs.

Adding these costs back to its FY 2019’s income statement puts Flexsteel back into the black with an operating income of ~$4.0M. Note that this is still much lower profitability than has historically been reported, and Flexsteel is working on executing a restructuring plan to bring back historical profit levels (described below).

*Some Background on the ERP Mishap - The ERP system impairment accounted for almost half of the total charges listed above, but shouldn’t be an ongoing problem for the Company. This project was initiated by the prior executive team in order to replace and retire two legacy business information systems, but when it went live in early 2018 there was a significant disruption resulting in greater customer returns, allowances and promotional costs on products sold to e-commerce customers, as well as service level penalties causing a significant volume contraction. Management assessed the ERP system work completed to date in FY 2019 and determined that a large amount of the capitalized ERP asset was unrecoverable which resulted in $21.3M non-cash impairment charges for the year. The Company hired a Chief Information Officer in February 2019 who will guide ERP implementation going forward. Since then Management has developed plans to implement a reduced-scope version of the ERP system that will satisfy Flexsteel’s business requirements.

THE RESTRUCTURING PLAN

Asset Sales - In May 2019 Flexsteel announced the implementation of certain restructuring initiatives, primarily the closure and sale of various manufacturing facilities and other expense reduction efforts. Flexsteel expects to generate between $45M and $55M in proceeds from asset sales (roughly half the Company’s enterprise value) and in fact already reached an agreement to sell its Riverside facility to a buyer for ~$20.5M, with the transaction expected to close on August 26, 2019. Asset sale proceeds bolster the Company’s already fortress-like balance sheet and offer many options, including a longer runway for turnaround.

Expense Reduction - Along with cost savings from a smaller footprint of facilities, other expense reductions include their recent exit of two unprofitable product lines (commercial office furniture and customer-designed hospitality furniture) which together represented about seven percent of annual sales. Additionally, Management has stated that they are pursuing negotiated discounts with suppliers and other SG&A reduction efforts. The target is to generate $27M to $32M in annual run-rate cost-savings by FY 2021 to achieve an EBIT margin of 7+ percent for Flexsteel. The total expenses associated with the restructuring plan are estimated to be $48M to $53M, with $36M to $40M of that amount in cash. As of June 30, 2019, Flexsteel has incurred $17.7M of restructuring expenses.

SHARE PRICE UNDERVALUATION AND TARGET

Tangible Net Asset Valuation - FLXS shares have historically traded at or above book value. Today the shares trade at ~0.6x book value and TBV, which is materially lower than many of Flexsteel's closest competitors’ TBV multiples, including Bassett Furniture Industries, Inc. (BSET) at ~0.8x, Hooker Furniture Corporation (HOFT) at ~1.1x, Ethan Allen Interiors Inc. (ETH) at ~1.4x, and La-Z-Boy Inc. at ~2.9x. If Flexsteel's restructuring plan successfully achieves its objectives then we can reasonably expect a smaller discount. A conservative range in this scenario of 0.8x to 0.9x TBV indicates a price target range between $20.81 and $23.41 per FLXS share. This implies a return between 36 and 52 percent over the current price of $15.36.

Normalized EBITDA Valuation – In estimating a normalized EBITDA for Flexsteel, we must take into account both the difficult macro environment and the post-restructuring return profile. Given the YoY sales decline of 9.3 percent in FY 2019 from weaker demand and tariffs, investors can project a conservative case scenario where net sales decline a further 30 percent before stabilizing. This implies annual sales of $310.5M (which would be lower absolute sales dollars and a larger decline than what occurred during the global financial crisis). If Flexsteel achieves normalized 6 percent EBIT margin (less than Management's 7+ percent margin target), then Flexsteel would be generating ~$18.6M in annual EBIT and ~$24.1M in EBITDA (estimating D&A to be at the midpoint of management's go-forward capex guidance of $5-$6M annually). This means that Flexsteel trades at 4x enterprise value to normalized EBITDA, much lower than its historical EV/EBITDA multiples in the high single-digit range. Note that the target range of $20.81-$23.41 per share mentioned above implies an EV/normalized EBITDA multiple between 5.9x-6.7x, closer to Flexsteel's historical valuation range.

Insider Buying - Another signal of undervaluation for FLXS shares is that insider purchases that collectively amounted to ~$157k in August 2019 by the CEO, CFO, CIO and VP of Manufacturing. Additionally, the Company filed a disclosure to investors reporting that the CEO had opted to convert his ~$400k cash bonus for FY 2019 into Flexsteel stock and options.

CATALYSTS

- Execution of the sale of the Riverside, CA facility for $20.5M which closes August 26, 2019
- Real estate sales that should generate between $45M and $55M in total proceeds
- The normalization of earnings as ERP, restructuring and other non-recurring expenses taper off
- Improved profitability from expense reductions driven by the restructuring plan
- Improved shareholder transparency and communications with the recent reinstatement of quarterly earnings calls, resulting in increased investor awareness

RISKS

- Tariffs may continue to be a headwind until a solution presents itself (whether through political means or by shifting Flexsteel’s supply chain to other countries)
- Poor execution of restructuring initiatives may result in longer turnaround or other challenges
- Increased cost of raw materials (which have historically been passed on to customers) may impact Flexsteel’s performance, in recent years the increased prices of polyurethane, polyfoam, plywood, and to a lesser extent, steel have had an impact on Flexsteel’s business.
- With the yield curve inversion indicating an upcoming recession, the share price may be subject to greater volatility as negative news headlines influence investors to sell off consumer stocks. With FLXS shares trading at just ~60 percent of TBV, the market seems to already incorporate a largely pessimistic economic outlook.
- There is risk to Flexsteel’s dividend if business fundamentals continue to deteriorate. However shareholders would likely benefit if these cash payouts were redirected to either operational improvements or stock buybacks. Note that Flexsteel has paid cash dividends every year since 1938.
- Other risks associated with being a small-cap stock, such as liquidity which may be a greater concern for some investors.

CONCLUSION

Shareholder overreaction has made Flexsteel’s stock a bargain, especially in light of the restructuring-related catalysts of asset dispositions and expense reductions. The stock represents an attractive value investment opportunity with a margin of safety derived from its low price relative to both its unencumbered tangible net asset value and normalized earnings power.

Catalyst

- Execution of the sale of the Riverside, CA facility for $20.5M which closes August 26, 2019
- Real estate sales that should generate between $45M and $55M in total proceeds
- The normalization of earnings as ERP, restructuring and other non-recurring expenses taper off
- Improved profitability from expense reductions driven by the restructuring plan
- Improved shareholder transparency and communications with the recent reinstatement of quarterly earnings calls, resulting in increased investor awareness