Description

Summary

Furniture Brands (FBN) is a dominant manufacturer of residential furniture. The company’s improved operating efficiency is being masked by the weak economic environment, and will reveal itself fully over the next five years. The company has reached a critical inflection point that is not yet appreciated by market participants. A host of positive factors are beginning to align for this firm that will result in dramatically improved financial results. These include: significant revenue and earnings drivers, competitive advantages, rapidly improving financial strength, and prodigious free cash flow. Coupled with a modest improvement in the economy over the next 5 years, these ingredients will combine to handsomely reward shareholders of this company. Market cap is about $1.35B. Shares are easily obtained because daily volume is approximately 400,000 shares.

Business

Furniture Brands is the largest manufacturer of residential furniture in the U.S. Brand names include: Thomasville, Broyhill, Lane, Drexel Heritage, Henredon, Maitland-Smith, Hickory Chair, Pearson, Highland House, Creative Interiors, and Founders. The brands are diversified across many price points, most in the middle to upper-end of the market. Most sales are to independent furniture retailers. The company does maintain a modest retail presence of its own. The company is not significantly dependent upon any particular supplier or retailer. The company maintains manufacturing facilities and sources from foreign suppliers, providing flexibility. And, its employees are non-union. The business is not capital intensive, nor is it overly style or trend driven (compared to the apparel industry, for example, where a company can become stuck with a large inventory that is no longer “chic”). Sales are quite cyclical (due to their large ticket and discretionary nature) and tend to lag the housing market.

The CEO, Mickey Holliman, is a career furniture man who has a reputation for being shrewd, but conservative. His grand plan for the firm has been quite successful over the past eight years, building a formidable industry competitor that should exhibit superb results over the next few years.

Competitive Situation

FBN’s largest competitors are Ethan Allen (ETH) and La-Z-Boy (LZB). Projected sales for this year: FBN -- $2.4B, LZB -- $2.3B, ETH -- $900M. Both competitors follow a different model than FBN, having a much larger branded retail presence. That gives them more control over merchandising and final sales, but higher fixed costs. FBN is the much larger than other competitors using its business model. The firm is 8 to 10 times as large as other competitors such as Bassett Furniture (BSET) and Stanley Furniture (STLY). LZB has somewhat greater brand recognition, but is mostly recognized as a recliner brand. ETH is a high-end brand that lacks the extensive breadth of FBN’s offerings. The industry is consolidating, but is still extremely fragmented, with many small regional competitors. FBN’s market share is approximately 10% with room to grow. Most regional firms are dwarfed by FBN’s size, financial strength, depth of product offering, and brand recognition.

The Stars Align

Four substantial factors are beginning to align for this firm.

1. Competitive Advantages

** The company is the biggest and enjoys economies of scale that have yet to reach their full potential because the integration of the highly successful HDM acquisition is not yet complete. The weak economy is also masking operating synergies resulting from the acquisition.

** The firm’s size puts substantial financial resources at its disposal, relative to competitors.

** The broadest product offering in the industry addresses a multitude of style and price points and provides retailers with the most attractive set of offerings in the industry. The diversity provides greater insulation to the cyclical nature of the business.

** FBN’s non-retail model is less capital intensive than strategies involving the development of a retail store base.

** Its “dedicated floor-space model” (similar to that used by some apparel companies) commits a retailer to dedicating space to the company’s product. During difficult economic environments, retailers must continue to stock the company’s product, at the expense of smaller manufacturers. This is one of many market-share drivers for the company.

** The consolidation of the retailing side of the business greatly benefits national players, at the expense of regional firms. Clearly, FBN is the only residential furniture company that can provide its depth of offerings nationwide.

2. Revenue Drivers

** Housing has been strong for years, and the furniture industry follows the housing market. Simply, people buy houses, then they fill them with furniture. The housing market has been extremely strong in recent years and will, eventually, result in much higher furniture sales.

** There is a great deal of pent-up demand for furniture. Furniture sales are, to a certain extent, discretionary. This time around, the business cycle has been unusual. The housing market has remained strong through a weak economic cycle, causing a disconnect between housing and furniture. People have been buying houses, but not furniture. That cannot continue for long. Management believes pent-up demand is “significant” and continues to address this issue in their conference calls. In addition, new houses tend to have much more square footage than their predecessors, requiring more furniture. For those looking for more anecdotal proof of the pent-up demand, ask yourselves how many people you know that have empty rooms in their house. More than ever, we’d bet.

** Demographics are favorable. The baby-boom generation is in their prime furniture-buying years.

** Economic recovery naturally floats all boats in this industry. Eventually, the economy’s winds will be at this industry’s back, rather than its face.

** Market share gains, as a result of the competitive advantages noted above, are driving and will drive this company forward.

** Acquisitions will provide a smaller effect in the future than in the past. Nevertheless, small acquisitions are still likely from time to time.

3. Financial Strength

** FBN emerged in its present form, at the end of 1994, from a debt-laden conglomerate. Debt was very high in the early years, but has been systematically reduced. Along the way, the company managed to make a few acquisitions for cash, making the debt reduction slower than it might have otherwise been. Debt is now at the company’s target of 30% of book capital. No more large acquisitions are likely. So, the plentiful free cash flow (FCF) that this firm generates (even during the rough times, such as now) will enable the company to pay a dividend, repurchase shares, or both. The financial flexibility of the company is as great as it has ever been and will only continue to improve. FCF could be approximately $150M next year, depending upon the timing of capital expenditures and the economic recovery.

4. Earnings Drivers

** Obviously, all the sales drivers above are also earnings drivers. But, there are a number of other factors that will improve margins and earnings per share in the coming years:

** FBN has been closing plants and increasing overseas sourcing for several years. This process improves margins. Unfortunately, that is being masked by the industry trough that exists now. We believe that the firm’s margins will be much higher as a result of this initiative (which continues) at the peak of the next cycle.

** Acquisitions have improved the efficiencies of scale the firm enjoys, also being masked by economic weakness.

** The repayment of debt continues to reduce the firm’s debt service costs.

** Licensing revenues, most falling to the bottom line, should increase as time passes. Thomasville has licensed its name to a manufacturer of high-end kitchen cabinetry sold through Home Depot.

** Share repurchases should have a very large impact on the share base as time passes, improving EPS. The board recently approved a $100M share repurchase program over the next 24 months.

Valuation

The company presently trades at a P/E of 9.1 on next year’s earnings estimate of $2.62 per share. At the next cycle peak, we expect the following numbers from FBN:

Sales-------------$2,900M
Oper Cost---------$2,030M
SGA---------------$ 450M
Depr--------------$ 50M
Int Exp-----------$ 0M

EBT--------------$ 370M
Taxes------------$ 130M

Net Inc----------$ 240M

Because the timing of the next cycle’s peak is uncertain, the share base used to derive EPS is a guesstimate. Assuming a modest reduction in the share base to 52M shares, EPS would = $4.61. At a modest P/E of 12.5, we estimate a conservative value of $57.63, 142% above the present quote. Due to the length of this post, details of the valuation assumptions will be discussed via messages.

Catalyst

The convergence of a number positive factors will drive EPS much higher over the next several years.