Description

Summary:

I recommend LZB as a short due to a flawed business model, cookie jar accounting, unrealistic expectations, and a full valuation. There is also the potential that they miss this quarter's earnings because of a reduction in anti-dumping subsidies. I believe this view is very out of consensus, particularly the data points around failing dealers.

Business Overview:

La-Z-Boy manufactures, markets, imports, distributes, and retails upholstery products and wood casegoods furniture products under the La-Z-Boy name in the United States and Canada. It operates in three segments: Upholstery Group, Casegoods Group, and Retail Group. The Upholstery Group segment manufactures and sells upholstered furniture to furniture retailers and proprietary stores. Its products include recliners and motion furniture, sofas, loveseats, chairs, ottomans, sleeper sofas, sectionals, and modulars. The Casegoods Group segment imports, markets, and distributes manufactured or imported wood casegoods furniture to furniture retailers. Its products include tables, chairs, entertainment centers, headboards, dressers, accent pieces, and various coordinated upholstered furniture. The Retail Group segment sells upholstered furniture to end consumers through the retail network. As of April 25, 2009, La-Z-Boy Incorporated had 68 company-owned La-Z-Boy Furniture Galleries stores.

Thesis Details:

•(1)    Flawed Business Model

LZB traditionally sold furniture through independent, regional furniture stores. Those stores have been in secular decline, so to replace that distribution, LZB created the La-z-boy Gallery concept, which is similar to a franchise model (68/310 are company operated), without the royalties. The problem is that these stores are losing money and will close at an accelerating pace over the next few years, causing huge problems for LZB.

The losses can be seen in (1) the segment reporting by LZB which shows losses in retail (without real prospects for improved profitability because management has clearly stated that volumes need to improve 20-25% for retail to breakeven-see comment below) and (2) the consolidated VIEs which show a loss as well. The company consolidates certain stores because of credit extended, loan guarantees, or lease guarantees, but the P&L is backed out right above the net income line making it very clear. The IR representative said the VIE stores are generally better than average because they don't want to extend credit to weak operators-imagine how bad the weak stores are doing. Finally, I spoke to several dealers who said that the only gallery owners that are profitable are the ones that own their building and that most rent their space. As these dealers walk away, LZB must decide whether they should give up the volume or take on the losses. The company generally takes over the store if it is in a large market (recently Seattle) and lets it close if it is a smaller market (recently Rochester). However, the company is "not anxious" to operate more stores according to the IR. I don't think they'll have a choice if they want to keep volumes up and this will cause them to absorb the losses rather than be subsidized by independent operators. In fact, LZB corporate is making the profitability of the independents worse by charging them more for distribution from the new manufacturing facility in Mexico (vs. previously in Utah). The dealers that I spoke to were very unhappy with corporate.

The data below is in the company's 10Ks. One can see that LZB is increasingly reliant on this channel and that the stores in this channel are declining. There is no growth pipeline for dealers or for the company.

FY 2008: No longer broken out.

FY 2007:  Opened 9, Acquired 7, Closed 9

FY 2006:  Opened 21, Closed 18

FY 2005:  Opened 17, Acquired 21, Closed 7

So what are the consequences?

First, they will lose the sales that they garner from the upholstery division (which the company sells to gallery owners at the same price as they do to independents) this will in turn cause their fixed manufacturing costs to be spread over fewer units.  Second, they will take losses on the receivables and any debt/lease guarantees they've provided. I think this will be a punishing combination and surprise the market.

Most recent conference call:

Barry Vogel - Barry Vogel & Associates - Analyst

Kurt, on the retail side, I know you're talking about volume, I know you did have a volume gain sequentially, very slight, and you're still losing $5 million a quarter. I know you've talked about most savings have been realized and you need a certain amount of volume to breakeven and you mentioned before a 25% increase in volume could get you to breakeven. But other than volume, can you lower your quarterly loss in your opinion? Your quarterly losses in retail sequentially in the third and fourth quarter this year?

Kurt Darrow - La-Z-Boy Inc. - President, CEO

I think there's two things to keep in mind, number one, we can, what I mentioned is we can't do it to the same magnitude that we've done the trailing 12 months but we have every intention even on flat volumes to continue to lower the loss but I didn't want to leave that in perception we can cut our way to total profitability. The second thing we've been talking about for the last couple years is you have to look at our business on an integrated retail model and we're making the 10.9% this quarter on the wholesale side of selling to our own retail business and we look at the aggregate of the two in determining the cash generation or cash drain and the long term impact that that would have by carving out the separate retail segment, so I think you've got to look at it in its entirety, you got to look at the alternatives if we didn't have retail stores, how would we get business out of those various communities, how would the position of all of the other costs associated with supporting that happen, so we're going to continue widdle down these losses, increase our volume and we're positive that the integrated retail model is a correct one for our brand.

•(2)    Cookie Jar accounting

The company has benefitted from a lower bad debt provisions this year.

Low Allowance Provision May Be Insufficient - The allowance for doubtful accounts provision declined to the lowest level in six quarters providing a boost to year-over-year earnings. It appears that the level of write-offs declined significantly from the July 2009 quarter, but our analysis is impaired as LZB stopped disclosing the long-term allowance level this quarter. As shown in the table below, the total allowance provision shrank to $2.2 million or 0.7% of revenue in the October 2009 quarter compared to $4.8 million or 1.4% of revenue in the October 2008 quarter. If my checks are correct that dealers are struggling to the point of closing stores, this will be inadequate. Further, charge-offs have exceeded provisions in the last two quarters which emphasizes the point.

The company has also benefitted from a lowering of their pension, LIFO liquidation (fair, but unsustainable), and a reversal of restructuring charges over the last two quarters.

•(3)    Expectations

Under generous assumptions, I do not believe the company will achieve consensus numbers for 2011.

Comments:

• $20m savings starting Q4 FY 2010 (so $15m incremental in 2011). This has been pushed back several times and reduced from $25m originally. I believe it is at risk because they have been delaying implementation.
• $5-6m benefits from casegoods consolidation starting in 2H FY 2010 (mgmt commentary)
• $7-9m costs returning that were temporarily suspended (mgmt commentary)
• Consensus sales pickup with 20% contribution margin (high end of mgmt)
• This compares to consensus estimates for $100m in EBITDA next year.

•(4)    Valuation

Based on consensus estimates for next year, the company is trading at reasonable levels, especially given their conservative capital structure. However, my estimates below show higher multiples, even giving the company the benefit of the doubt and the capital structure is likely to prove deceptive as LZB will be forced to bring more company operated stores and their associated leases on balance sheet (and incomes statement).

•(5)    Catalysts

• Missing Q3 estimates due to lower CDSOA
• Missing Q4 estimates because of delayed Mexico savings
• Missing 2011 estimates because of aggressive consensus estimates, higher bad debt provision, fewer dealers
• Dealer closures and falling sales that miss street expectations (conversations with dealers suggest no pickup in sales)

Summary:

In short, I think this is a brand that is past it's prime and the stock is pricing in aggressive improvements in the operations. Instead, I expect deteriorating fundamentals because of an unsustainable situation (gallery owners operating at significant losses). As stores close, sales and income will fall significantly.

Catalyst