Description
Investment Summary
Steelcase has several things going for it: the company remains the global market share leader in its industry with strong customer relationships, demand is starting to improve from very depressed levels, the balance sheet has been strengthened, management continues to rationalize its cost base and improve efficiency, and the company should continue generating free cash flow. As with any investment, there are real risks, including slow responses to new competitive challenges (i.e. the way management took way too long to adopt lean manufacturing), commodity cost pressures, and the risk that demand stagnates or slumps if the economy slows down more.
Net/net, however, I think Steelcase offers attractive total return opportunities and represents an attractive investment in a company that is just beginning to turn around after a multiple-year slump.
Situation Overview
Steelcase is the North America and global market share leader, yet operational laggard, in business and industrial furniture (BIF), an industry that is emerging from the worst downturn in 34 years. While the stock has bounced off its $8 low in 2002/2003, I believe it can move substantially higher as the company continues to implement lean manufacturing procedures and participates in a recovery in corporate capital spending.
Thanks to continued efforts to rein in costs and improving demand, Steelcase just posted its first full year of profitability since F02 (fiscal years end in Feburary), with a net margin of 0.7% (ex-restructuring charges). While such a low margin is hardly reason to rejoice when competitors Herman Miller (MLHR) and HNI Corp (HNI) post net margins of 4%-6%, it’s an improvement from the losses of the prior two years.
These results have been possibly, despite a peak-to-trough 35% drop in revenue since F01, because the company has dramatically reduced its cost structure and (belatedly) adopted lean manufacturing processes. On a square foot basis, the company has brought manufacturing square footage down to 7.6MM sq feet from 12.9MM. The company continues to reduce its infrastructure even as demand improves – they’re taking out another 2.6MM sq feet over the next two years – indicating they were probably too slow in downsizing, but appear to finally be fully embracing the use of efficient operations to regain reasonable profitability.
The recent trend in improved profitability could accelerate if demand improves, which appears to be happening. After seeing revenue declines of -24%, -17%, and -7%, respectively, in F02, F03, and F04, the company experienced revenue growth of 11% in F05 (6% excluding consolidated dealers and foreign exchange). And the revenue growth increased every quarter, reaching 23% in the latest quarter (17% ex-dealers and FX).
Despite (and in some cases because) of the major restructuring steps taken over the past three years, Steelcase has improved its financial structure over the past four years. The company’s cash flow has been strong as it reduced working capital, had minimal capital expenditures, and sold off most of its lease receivables. As of February ’01, Steelcase had net debt of $504MM ($34MM cash and $537MM in debt) on $1.6B in shareholders equity. As of February this year, the company had a net cash position of $22MM ($348MM cash, $326MM debt) on $1.2B in equity.
Valuation
My base case valuation assumption is that the stock could reach at least $18 (a modest 30% three-year return, excluding the 1.7% dividend), equating to 15x earning earnings of $1.20 share. That earnings number could be achieved with revenues of $3.25B (about 7.5% compound annual growth) and 5.5% net margins (lower than the 5.6% - 8.1% achieved in 1998-2000 and not too much above the currently-depressed 5% margin average of competitors MLHR and HNI). In all honesty, though, I’d be disappointed if the stock only reached $18 in three years.
My imagination isn’t stretched too far envisioning earnings of $1.50/share, which could happen if net margins hit 6.5% (still below the 8% achieved in 1998 and 1999) and sales rise an annualized 10% to $3.5B (which is just a hair above fiscal 2000’s $3.4B and 12% below 2001’s $4.0B). If the company executes that well, the multiple would likely be a bit higher. I don’t want to get too crazy, so let’s give it 16x, which would imply a price of $24, 74% higher than the current $13.80. And the modest 1.7% annual dividend add a bit more.
Company Description
Steelcase is North America’s leading business and institutional furniture providers, offering a wide array of products and services that integrate furniture, architecture, and technology. The company had 19% of the North American marketplace in 2003. The company has lost a couple of points of market share over the past two years due to the tremendous drop in orders from large companies, SCS’ strongest niche, as well as strong competition from HNI and MLHR. Nonetheless, the share still is larger than the 14% and 12% of the two respected competitors. The company’s installed base, an important driver of follow-on orders because of incompatibility between different systems – is estimated to be twice that of the next largest installed base of MLHR.
Segment Breakout
North America (55% of fiscal revenue, profit breakout not meaningful due to near breakeven performance): encompasses manufacturing and sales for the US and Canada for core brands, primarily Steelcase and Turnstone (a brand targeted at the middle-market segment). Most of the company’s products are sold through a large group of independent dealers, with the largest dealer representing 2.8% of the company’s revenue and the top five representing 9.5% of sales.
Steelcase Design Partnership (12% of revenue, a division that has maintained profitability over past two years): Focuses on higher-end design furniture for lobby and reception areas, conference rooms, private offices, heath care, and learning environments. Independently-operated companies include Brayton International, The Designtex Group, Office Details, Inc, Metropolitan Furniture Corp., and Vectra.
International (23% of revenue): Represents results for the sales and marketing of the Steelcase and Werndl brands outside the US and Canada; holds the leading market share in Europe.
Other (10% of revenue): Includes Financial Services (the company sold most of its leases in prior years, but still has some assets rolling off and other ongoing activities); PolyVision, which designs and manufactures “visual communications” like static and electronic whiteboards; and IDEO, which provides product design and innovation services.
About 6.5% of the company’s US employees are covered by collective bargaining agreements.
Industry Overview
According to BIFMA, the Business and Industrial Furniture Manufacturers Association, the US Office Furniture Market was about $10.6B in 2004, up 5.4% – the first annual increase since 2000. During the downturn of 2001-2003, the industry declined 32%, the steepest drop seen since 1971 (the first year for which data is available). This plunge was caused by the severe belt tightening by Corporate America following the enormous industry growth in the 1990s, which was fueled in part by the loose spending habits towards the end of the dot-com boom.
In the 30 years prior to 2001, the industry experienced only five years of decline, all of which surrounded the 1974 and 1991 recessions (with none of those being as sharp as the recent drop). Although I haven’t seen specific supporting statistics, most analysts agree that the demand from large companies, where Steelcase is more dominant, dropped more sharply than that for the middle market – where job growth has been stronger.
Imports are only a modest issue for the industry at this point. In 2004, they represented 19% of the US industry value, compared to 6% in 1990 and 14% in 2000. Obviously, their importance is increasing, but they shouldn’t destroy the industry over the next few years. At the higher end of the market spectrum, service costs of installation and design make up a good portion of the overall sale, decreasing the benefit of an import, and customers often want faster turnaround than is currently available. Canada is the source of about 45% of imports, a slight decrease from the 60% in the late 1990s as China and other countries make some inroads.
According to a BB&T analyst report, Steelcase is the BIF market leader with 19% market share, compared to 14% for HNI, 12% for Herman Miller, 11% for Haworth, and 8% for Knoll. Steelcase’s market share appears to have been fairly constant over the past few years, although it has dropped a bit over the past two years as the mid-market, where Steelcase has less market presence, has outperformed the overall industry.
Over the past 15 years, Steelcase’s market share has declined slightly (it was 21% in 1986) as the market shares of its competitors has increased due to consolidation and organic growth. In 1986, the top 5 companies accounted for 41% of the market, while in 2003 that figure was 63%. One of the reasons Steelcase appears to have fallen behind its competitors is that it maintained a vertically integrated (and expensive) manufacturing operations while its chief competitors adopted lean procedures.
Lean Manufacturing Finally Happening
Steelcase’s largest competitors, HNI Corp. (a/k/a Hon) and Herman Miller, began adopting lean manufacturing processes in the 1990s, which gave them an enormous competitive advantage over Steelcase – and helped those companies maintain or regain margins quickly after demand plummeted over the past few years.
Forced by the industry downturn and market realities, Steelcase began restructuring its manufacturing operations and processes in 2001. Since that time, it has brought its US manufacturing square footage down to 7.6MM from 12.9MM and has begun outsourcing a small portion of its parts. In addition to less overhead, improved processes should enable the company to reduce its inventory-related working capital as turns improve.
Earlier this week, the company announced plans to cut production space down to 5MM sq. feet over the next two years by phasing out one of its manufacturing campuses in Grand Rapids. Management believes that lean manufacturing processes will allow for the delivery of more volume than in 2000, when revenues were $3.4B (vs. last year’s $2.6B).
Overall, management has responded slowly to changing industry dynamics, but they seem to finally be taking the right steps to bring its cost structure in line with competitors.
Financial Review
Earnings Model
Management’s three year target is to get operating margins up to about 10%, which incorporates gross margins of 35% and operating expenses at or below 25%. Assuming a reasonable demand environment and continued cost control, these objectives seem reasonable. The company’s tax rate is expected to be 37%-38%, yielding a targeted net margin of 6.2%-6.3% (interest expense and other should basically be a wash).
During F98 and F99, Steelcase was able to achieve gross margins above 35% and operating margins of 11%. Then competitors became more aggressive on pricing as their efficiency improved, reducing Steelcase’s gross margins during the strong demand years of F00 and F01. This downward trend continued through F04, when gross margins fell to 28.0% (excluding restructuring charges). In F05, gross margins (ex-restructuring) increased slightly to 28.9% as strengthening demand and improved operations were somewhat offset by higher steel prices (which were not completely offset by a steel surcharge).
Operating expenses, which in the late ‘90s were kept below 25%, inched up as management let costs spiral. This problem was exacerbated by the sales plunge from F02-F04, with operating expenses rising to 29.4% of sales in F03. The expense ratio dropped to 27.6% in F05, thanks to the sales improvement and spending restraint. In absolute dollars, operating expenses were $722MM last year, down from over $1B in F01.
With gross margins lower than operating expenses through F04, Steelcase operated at a loss for the past few years. The company eked out a 1.2% operating profit in F05 thanks to rising demand and benefits from the movement toward lean manufacturing processes, reasonable improvement from the operating loss of -0.9% in F04.
The 35% gross margin objective doesn’t seem too outlandish considering competitor HNI is already working at a 36% level and MLHR is at 32% for the first nine months of F05, when the industry is just coming out of a serious downturn. At the same time, the operating expense objective looks achievable as well. If the company constrained operating expense growth to 4% annually over the next three years, they would achieve the sub-25% expense ratio on annual sales growth of 7.5% or more.
Steelcase management will need to continue improving manufacturing efficiency, but its objectives appear reasonable, particularly considering that the company should actually have scale advantage vis-à-vis competitors.
Balance Sheet and Cash Flow Statement Overview
Despite reported losses, Steelcase has actually had decent cash flow over the past three years, as the company sold most of its leasing business, sold excess assets, reduced working capital, and kept a tight rein on capital expenditures. This discipline enabled the company to move from a net debt position of $504MM at the end of F01 to a net cash position of $22MM ($348MM cash, $326MM debt) at the end of F05.
The company’s selling of leasing assets and property is the primary reason for this cash generation. But it was also helped by management’s keeping capital expenditures down to only $92MM over the past two years compared to D&A of $269MM. Such low CAPX spending is below the normal maintenance level, but management believes CAPX projections of $75MM-$100MM/year are reasonable.
Random 10-K Items
Benefit Plan Obligations: The company had $275MM in liabilities related to benefit plans as of Feb 27, 2004, comprised of $191MM retiree health benefits, $37MM accrued for defined benefit plans, $31MM deferred comp, and $15MM due to defined contribution plans. Partially offsetting this liability is company-owned life insurance with a cash surrender value of $177.9MM. The actual pension plan is relatively small at $83MM with $43MM in assets and fairly conservative assumptions (5.75% interest rate, 7.25% expected return, 3% salary progression).
Stock/Option compensation – Steelcase adopted SFAS 123 in March 2003. During the subsequent year, it only issued restricted stock (265K shares and units) and no options. Information on fiscal 2005 is not yet available. Prior to adopting SFAS 123, the company’s footnoted option expense was 0.07-0.08/share per year, based on 3MM – 4MM options/year.
Ownership
At 4/28/04, the company had 50.6MM Class A shares and 97.6MM Class B (non-traded) shares with 10 votes each. Directors and officers own 7% of Class A stock and 20% of Class B supervoting shares. I assume “insider” ownership of B shares is near 100% since they can only be held by “Permitted Tranferees.” You can get a full list of ownership in the proxy, but the duplication of control makes understanding actual ownership a little difficult.
Essentially, you have to be willing to be a true minority owner if you invest in Steelcase. Such a leap of faith is somewhat of a challenge given management’s sluggish response to industry changes over the past few years. But it does look like management is finally adjusting to these realities and making appropriate adjustments. In addition, the management and company culture seem designed to truly embrace and appreciate employees, which in the long term is often beneficial to a company.
Management
Robert C Pew III, a former Steelcase executive, has been Chairman since June 2003 and is the son of the Chairman Emeritus.
James P Hackett has been President, CEO, and Director since December 1994
CFO James P Keane, a former McKinsey consultant, has been with the company since 1997 and in his current position since April 2001
Frank Merlotti, President of Steelcase North America, has been in that role since September 2002. He was CEO of Steelcase Design Group subsidiary Metropolitan Furniture from 1991-1999
Robert Block, the president of Steelcase International, joined the company in 1998 and has been in his current role since October 2000.
Michael Love, a former President of the Vecta subsidiary, has headed up the Steelcase Design Partnership since May 2000
Biggest Risks
- Insulated management team makes poor decisions and doesn’t respond quickly enough to competitive dynamics (a problem in the past that’s hopefully been corrected, but you never know)
- Company doesn’t finish executing on its restructuring plans allowing competition to gain market share through their lower costs and more efficient operations
- Economic slowdown weakens recovery in corporate capital spending.
- Commodity price increases are not offset by surcharges (so far costs appear to be being passed through with a slight delay, but that is because the demand environment is improving)
- Outsourcing and efficiency plans by Corporate America reduces demand for office furniture
- Someone figures out a way to effectively import higher-end products and still meet customer installation and delivery demands
Catalyst
- Continued earnings recovery from biggest industry slump in 34 years
- Improved cost structure as company continues to adopt lean manufacturing
- Appreciation of solid cash flow, strengthened balance sheet, and improving earnings estimates
- Investor shift away toward industrial names, one of the few sectors emerging from truly recessionary conditions, and away from sectors that haven’t experienced a real downturn over the past several years (i.e. consumer and finance)