La-Z-Boy LZB
October 25, 2005 - 5:23pm EST by
2005 2006
Price: 11.27 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 584 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Who hasn't heard of La-Z-Boy? LZB has the best-known furniture brand among consumers and has done a good deal in the past two years to structure its business with a rational mix of imported pieces and parts and USA manufacturing. Yet the stock sports the following multiples:

P/B = 1.2x
P/TB = 1.4x
EV/Adj EBITDA (TTM) = 7.7x
EV/Average Adj EBITDA FY 03 through 05 = 5.5x

Again looking at FY 03 through 05 averages, adjusted EBITDA less maintenance capex of $25M = $121M per year, which compares very nicely with current enterprise value of close to $800M.

The company pays a 4% dividend and has a 6M share repurchase authorization. In FY 03 the company repurchased about 4.5M shares or 7.5% of total outstanding. I think '03 margins and cash flows could be replicated in the near future, and I believe management continues to take a shareholder-friendly view on return of capital.

What is weighing on the stock?

* Recently forced to reduce forecast for Q2 ending October 29, 2005
- Guiding to loss of $0.17 - $0.21 including a $0.09 - $0.10 restructuring charge for the closing of one plant, versus prior guidance of $0.17 - $0.21 profit.
- Guidance was modified due to two factors:
1) There is a North American shortage of polyurethane foam stuffing used in LZB's upholstery division; LZB and other furniture makers are on allocation. LZB's allocations have been increasing weekly and the company expects to be back to a normal allocation by December. In addition, there are 45-60 days of inventory in the supply chain that will be worked down during this period. The net effect is that sales that the great majority of sales missed in the second quarter are not lost but are pushed into future quarters.
2) Consumer demand is softer than anticipated. LZB reports that they are increasingly finding that customer demand for furniture is driven more by consumer confidence levels and less by new housing stock (which was a traditional measure used to forecast demand). As home buyers stretch budgets to buy larger starter homes, they have deferred purchases of furniture needed to fill these homes. The demand issue should resolve in the longer-run as new homeowners get the resources to furnish their homes. However, it is true we could be waiting a while for the consumer confidence issue to resolve. (I'll leave the macro betting to the reader.)

* Challenges relating to increasing import competition in the North American marketplace
- As a result of inefficient domestic manufacturing, operating margins in the casegoods segment were just 0.7% in the fiscal year ended April 2004 and just 1.2% in the fiscal year ended April 2005
- The good news: LZB has closed 20 out of 23 domestic casegoods plants and is on target for 75% import content in casegoods by the end of the current fiscal year. The three remaining casegoods plants handle 1) hospitality (hotel) orders, which the company believes are more economical to source domestically due to the bulk delivery demands of customers; 2) kids furniture, which is more economical to source domestically due to its high ratio of shipping cost to sales price; 3) solid wood bedroom furniture, a segment in which the company is not yet satisfied with quality of Asian product. For all practical purposes, the casegoods restructuring is completed. In Q1 the company reported 4.1% operating margins in its casegood segment, and it expects continued strength in margins.
- I believe the company is managing the import threat in a very rational manner in its larger upholstery segment (more below)

* Raw material prices have squeezed margins. Rises in prices of steel, plywood, and most recently foam have impacted LZB margins as the company has not immediately passed these costs through to customers.

Why LZB should trade up to at least $15/share despite it all

* Foam problems are short-term. While the second fiscal quarter and third fiscal quarter are likely to experience some fall-out from the poly-foam shortage, the situation is already resolving. Few sales are likely to be lost, but deliveries will be delayed into future quarters. Some margin will be lost in the short-run, but I believe the long-run implications are very minimal. Thus a near-term buying opportunity is created.

* Raw material margin squeeze likely to be short-term. Again, I'll leave the macros to you. However, it seems likely to me that at some point within a few quarters raw material prices will moderate and/or be passed through to customers as inflation we all see in commodities and energy works its way through to consumer prices. There is an adverse "stagflation" scenario for LZB possible in the near-term you might want to wait for if that's your macro view; but in the long-run there is no reason I see LZB should not survive and thrive.

* LZB's upholstered furniture segment, which represents about 3/4 of LZB sales, is resistant to import threat. This is a more difficult proposition to get comfortable with. As I see it, customers will continue to want to choose fabrics for their furniture. In addition, customers will continue to want 2-4 week delivery of custom upholstered furniture. These characteristics of upholstered furniture argue for local just-in-time assembly of custom furniture to meet specific customer orders, rather than build-to-stock and warehousing of a limited number of furniture SKUs. The model does not preclude import of furniture parts; indeed, LZB has moved aggressively to incorporate imported cut-and-sewn fabric kits into its U.S.-based assembly operations. LZB is actively looking at what other pieces and parts may become economical to import. In addition, LZB is redesigning products where possible to minimize use of high cost raw materials. I'm fairly confident that current management will import such parts as become economical. If necessary, I believe U.S. opeations could be shut down over time with only moderate write-offs.

* LZB is turning around its retail operations. The company has addressed the problem of underperforming stores in key markets by buying-out dealer partners, relocating and updating stores, and changing store managements. In the first quarter, retail segment operating income was -$5M. I believe management is on the path to reversing these losses and in the long-run, the retail unit should be capable of 3-5% positive operating margins, which would mean a net quarterly add of $7-8M operating income versus the Q1 result.

* LZB has successfully updated their brand with a new line of attractive product offerings (anecdotally confirmed by my wife who is indeed in the target demographic for LZB marketing)

* The LZB franchise including its massive, diverse distribution system, its #1 position in reclining-chairs, its 10% market share of the wholesale residential furniture market in the U.S., its 15% market share of the upholstered furniture market in the U.S., and its position as the best-known furniture brand in the U.S. and a top consumer brand overall, plus its fairly consistent free cash flow generation + current catalysts make it an attractive buy-out candidate for a private equity investor and/or Asian furniture maker looking to add brand credibility in the U.S.

* Finally, valuation on the upside (very rough numbers):
Upholstery sales run-rate: $1.5B x 8-10% op margin = $120M - $150M
Casegoods sales run-rate: $.5B x 4-6% op margin = $20M - $30M
Retail sales run-rate: $.2B x 3-5% op margin = $6M - $10M
Less corporate & other @ $20M
Operating income potential: $126M - $170M
Interest of $12M => Pretax income: $114M - $158M
Taxes @ 38% => Net income: $71M - $98M
Shares @ 52M => $1.37 - $1.88 EPS potential
Reasonable 14x P/E multiple => Share price $19 - $26

Discounting to $15 seems reasonable for the time & risk of a model like this actually coming to pass. $11 seems quite cheap.

Disclaimer: The write-up represents my own personal opinions. This is not a recommendation to buy or sell. My firm or I may buy or sell LZB at any time in the future.

Second disclaimer: I'll say up front that my research on this stock is a work in progress. I look forward to your thoughts and comments.


See write-up for details. In short:
* Reversal of near-term poly foam supply troubles
* Upholstery margins will improve: 1) raw material costs will eventually plateau, sink, or be passed through; and 2) management will continue to take actions required to return upholstery to 8-10% operating margins
* Troubled retail markets will be turned around, reducing the current retail drag on operating income
* Possible interest by private equity or foreign acquirers
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