We believe Knoll (NYSE:KNL) should trade at an EV/Sales multiple of 0.6 to 0.8 times. With shares currently trading at a 0.7 sales multiple, the company is trading within our valuation range.
The amount of debt Knoll carries on its balance sheet might put them at a competitive disadvantage to competitors with healthier balance sheets, especially since the contract furniture business is consolidating through acquisitions.
We don’t see enough compelling reasons to invest in Knoll at this moment.
Quick Overview
Knoll is a global manufacturer of commercial and residential furniture, accessories, lighting, and textiles. The biggest portion of revenues comes from selling furniture to the workplace environment. This is where management sees the biggest opportunity for sales growth by expanding unpenetrated categories and ancillary markets. The company is also expanding its residential markets, leveraging their experience with products that could cross over in what they call “resimercial’.
Knoll reaches its customers through a network of independent dealers and distributors, showrooms, home design shops, and online. They work with a direct sales force to bring awareness of their brand to the market.
Accordingly, the company reports operating results under two segments: Office and Lifestyle.
Office is the biggest segment of the company accounting for 62% of total sales. This segment could be considered to be Knoll’s legacy product offerings. The strategy to increase revenues relies on expanding its product portfolio, driven mainly by acquisitions. This market has transformed in the last decade with how workplaces are been designed. Open spaces are replacing cubicles. This means their clients are replacing individual workstations with ancillary furniture like lounge chairs, sofas, stools, and end tables.
Their lifestyle segment focuses on bringing the residentially-inspired workplaces to market.
Recent trends
Like we mentioned before, there is a seismic shift in how workplaces are now being designed. With more offices opting for open spaces, the increase in ancillary furniture is increasing. What used to be 80% system furniture and 20% ancillary in the workplace is now changing to where new offices are being designed with 50% of ancillary furniture in mind. There are some pros and cons to this seismic shift in consumer behavior.
The traditional boundaries between residential and workplace furniture are blurring, and with that, comes new challenges:
Contract brands are now “competing” with retail brands that don’t “play by the same rules” in terms of quality, construction and warranty, among other things. – huffpost.com
The new challenge is more competition. The retail market is more competitive than the commercial market. There are more choices for clients to choose from, which could take market share away from Knoll. More choices also mean more value-conscious buyers.
There is also a shift in the role of the independent dealer. With more products to offer, dealers now need to become specialists in more product lines. This is acknowledged in Knoll’s annual report:
Dealers help people to understand workplace needs and planning capabilities, and Knoll is providing more of the training and education that helps them add value and increase their profits when they sell Knoll. – 10K
It is going to be interesting how that relationship evolves. For the moment, we see increasing costs for dealers in terms of logistics. If we think of a cubicle, a picture comes to mind of a standardized size and design. However, ancillary furniture comes in different sizes and materials. That becomes a new challenge for dealers to ship in a cost-effective way. Will Knoll absorb such costs?
A positive for the changing trend is that we see, for example, ancillary furniture as having a shorter replacement cycle. That could be due to wear or refreshing the look of the office.
There have been a number of acquisitions not only by Knoll but other competitors as well. Acquisitions help expand the product portfolio. In August of last year, Knoll acquired a company called Fully, a direct-to-consumer office furniture brand. The acquisition provides its Office segment a variety of new offerings while broadening its reach into the consumer market through e-commerce. In 2018, the company completed the acquisition of Scandinavian company Muuto for $300M, making it one of the biggest acquisitions for Knoll. This acquisition added more depth into their “resimercial” portfolio, cementing Knoll’s strategy to become a go-to source for this new trend.
Financial Overview
The company finished its fiscal 2019 with revenues up by 9.7% to $1.4B from $1.3B in 2018. The increase in revenues was attributed to solid growth from their acquisitions, especially Muuto. Gross profit increased by 14% and operating profit by 12.6% for the year. As a percent of revenue, both gross and operating income margins expanded by 114 and 30 basis points, respectively.
From a capital structure point of view, the company has a lot of leverage in their balance sheet. Knoll’s debt to market cap ratio stands at 95%, its debt to EBITDA ratio at 2.5x, and their interest coverage ratio at 4.7x. The company ended the year with $8.5M in cash and $256M in available liquidity under their revolver facility. The total debt on the balance sheet was $428M, with $381M due on 2024. The credit agreement requires Knoll to comply with two financial covenants: total debt to consolidated EBITDA ratio of 4 to 1, which steps down to 3.75 to 1 in June 2020, and an interest coverage ratio of 3 to 1. We see sufficient liquidity at hand for Knoll to cover their next three years of contractual obligations totaling $199M and enough room under their debt covenants.
The company updated investors through a press release at the end of March, discussing their actions taken due to the coronavirus. In the press release, the company mentions having $120M on cash, and not surprisingly, they withdrew their guidance for the year. However, they didn’t mention anything about the dividend, which, at recent prices, yields a 7.22% return. Still, there is reason to believe that the dividend might be cut soon to preserve liquidity.
Valuation
Knoll is selling at cheap multiples. It currently trades at a forward EV/Sales multiple of 0.7 times. Their P/E multiple also points to a cheap stock at only 6.2 times earnings. However, due to the high leverage and historical results, we believe a fair multiple to pay for shares in Knoll is somewhere between 0.6 and 0.8 times EV/Sales. That puts them in between our valuation range.
We based our valuation multiple based on Knoll’s tangible return on capital, an after-tax operating margin, a reinvestment rate, and a long-term growth rate. All of these assumptions are based on a “normalized” environment (what we think Knoll could achieve if conditions were back to normal). That also means avoiding using high margins due to a cycle top.
Knoll’s return on tangible capital has averaged 15% for the last 10 years. The company has also reinvested around 15% of after-tax operating profits back into their business during the same time period. If these results can continue into the future, then we believe Knoll can grow at a 2.2% rate.
Our low-end EV/Sales multiple of 0.6 assumes after-tax operating margins of 4%, last achieved in 2013. The high-end of the valuation multiple assumes Knoll can sustain an 8.5% after-tax operating margin, historically, within their 10-year average.
Analysts’ are expecting zero revenue growth for the next two years. That would put them at current levels of $1.4B. If we value the company using an EV/Sales multiple of 0.6 to 0.8, we estimate Knoll’s intrinsic value per share in a range of $8 to $14 per share. At a recent price of $9.21, we don’t see a compelling investment case.
Takeaway
The amount of leverage at the company and the timing of the coronavirus, its effect, and future repercussions on the economy make this a very risky investment. The amount of leverage is going to put a hold on the company’s strategy of growing through acquisitions. They won’t have too much room to maneuver if operating results are affected to the point in which they are against their debt covenants.
That could damage their market share position, as competitors like Herman Miller (MLHR), which are in a better financial position with little debt on their balance sheet, could take the opportunity to grab share.
At an estimated value per share somewhere in the $8 to $14 range, and with recent prices trading at $9.21, shares are trading at a fair valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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