Tuesday, June 26, 2012

Hooker Furniture and the minutia of inventory

Hooker Furniture (HOFT) is not really an interesting business, they make and sell furniture.  The company isn't necessarily that cheap either it's selling slightly below book value and has a P/E of 22.  So why am I looking at this company?  For two reasons, the first is I want to build up a knowledge of companies that I might be interested in buying if they get cheaper, and secondly I think Hooker has a fascinating investment angle some readers might appreciate.

Quick Investment Thesis

-Market cap of $121m with $47m in cash and no debt
-Selling for slightly less than book value (4% less)
-EV/FCF of 2.62
-Dividend of 3.5%

Background

Hooker Furniture is as its name implies a furniture manufacturer located in Virginia.  They were founded in the 1920s and their products target a upper-medium price point.  The company claims toto innovate in the entertainment and home office segments where they are perceived to be a market leader.  They rolled out a new line recently that's targeted towards younger consumers with lower prices.

The company sources most of their furniture (roughly 75%) from China and Vietnam, the rest is made in the US.  The company releases over 1,000 new products each year and rolls off old models quickly.  If you're ever wondering why you can't fine replacement pillows for your two year old couch this might be part of the answer, the manufacturer wants you to buy a new couch!

The company breaks their products down into two divisions casegoods and upholstery.  Casegoods are things like a TV entertainment centers and desks.  Upholstery consists of items such as chairs and couches.  Casegoods make up 66% of sales with upholstery making up the rest (34%).

Sales are made through independent furniture stores nationwide including all of the Berkshire owned stores including Nebraska Furniture Mart and Star Furniture.  Hooker operates their own 95,000 sq ft showroom in High Point North Carolina.  I did a search on their website and found Hooker products in four well known furniture stores within five miles of my house.

Is it cheap?

The big question when looking at Hooker Furniture is how to value them?  Should we value them on a book value basis, a P/E or cash flow basis?  On a classic earnings basis Hooker isn't cheap at all, they have a P/E of 22.  If you take out the net cash they still have a P/E of 14, better but not spectacular.

Looking at the company from a book value perspective they aren't that cheap either.  At first glance the company is selling at a 4% discount to book value but inventory is understated because Hooker uses LIFO accounting.  Adding back in the LIFO reserve results in an adjusted book value of $144.15m.  Using the new adjusted book value Hooker is currently trading at a 15% discount which while nice isn't really enough to get me interested in the company.

The company's balance sheet is pristine, they have $40m in cash or $3.73 p/s and no debt.

Where things start to look interesting are on the cash flow statement.  The company reported just $5m for net income for 2012 yet had $32m in cash from operations and $28.2m in free cash flow.  As mentioned in the quick thesis the EV/FCF multiple is 2.62 which is the number that made my head turn.  I first wondered if this was sustainable, and second what had happened in the past.

If we dig into the details of cash from operations we find that "Inventories" under "Changes in Assets and Liabilities" contributed $23m towards operating cash flow.  So what is this inventories?  There are two possibilities, the first is these are inventory items that were sold in a different period and cash was finally received this year.  That might capture some, but the larger reason is found is explained by LIFO.  LIFO means "last in first out", meaning inventory purchased recently is captured in the cost of goods sold while depreciated inventory is what's reflected on the balance sheet.  Remember how I mentioned the company pushes out 1,000 new products a year, and they refresh their products twice a year?  This means if you have some bedroom furniture sitting in the warehouse for one year it's now three models behind, in accounting terms worthless.  Here's the catch, on a cash basis Hooker can probably still get full price.  Liquidating this old inventory results in ample cash flow yet almost no accounting profits.

I didn't initially intend to dive into the minutia of inventory accounting but as I researched I realized it was fundamental to understanding Hooker.  I also know that I have a large contingent of non-US readers who might be unfamiliar with what exactly LIFO is, hopefully my digression was useful.

Inventory liquidation isn't a sustainable strategy, over the last three years the company has had two years of liquidation and one year of rebuilding.  Inventory contributed $23m to operating cash flow this year but sucked up $21m last year.  Two years ago inventory liquidation contributed $24m in cash, similar to this past year.

One last point on inventory before moving on.  I wondered how quick their inventory was moving so I calculated their inventory turnover which came to 3.7.  I don't know how this compares to other furniture companies but it's reasonably high, the company is clearing out their inventory almost four times a year.

Is there a margin of safety?

This is a tough question, at this price I would say no.  The company doesn't exhibit strong earnings power, and they aren't selling at enough of a book value discount to warrant a purchase.

There's something else that caught my eye that concerns me with Hooker Furniture.  The company prides themselves on their dividend payouts.  Over fiscal 2012 the company paid out $4.3m in dividends against $5.067m in net income.  Another way to put it is the company has a 85% payout ratio.  Payouts this high can be concerning because they often don't leave the company enough money to reinvest, especially for a business that's capital intensive such as furniture.

Net income plus depreciation in 2012 doesn't cover the dividend and capital expenditure costs which concerns me.  The difference is only $500k which isn't much, and there is plenty of cash to cover it, but eating the cash to pay a dividend isn't a good policy.

The two yellow flags for me on Hooker Furniture are the facts that the company is generating excess cash flow from liquidating old inventory, and without a slew of non-cash charges and inventory liquidation the company can't cover their dividend and reinvest without dipping into the kitty.

So at the current price with the yellow flags there isn't a margin of safety.  Could these two items be a non-issue?  Sure at 50% of book value I would have a much different perspective on Hooker Furniture.

Summary

Hooker Furniture is the type of company that often appears on value screens, they are average, often not very cheap, but not expensive either.  Hooker Furniture is not the type of company I would buy for my son and stick in his brokerage account to compound for the next few decades.  But an average business doesn't have to be avoided as an investment, the investor just needs to take care to ensure they're buying at a very favorable price with ample downside protection.  At the current price I don't believe those factors are in place, but at some future date they might be.

Talk to Nate about Hooker Furniture

Disclosure: No position


4 comments:

  1. Check out Stanley Furniture. It has no interest bearing debt and has a cash position of ~$52M with a market cap of $57M. The cash position isn't currently reflected on the balance sheet, because ~$40M of CDSOA-payments were recieved after FY12Q1 (this also means that screeners aren't able to pickup the numbers yet!). The management stated in the previous conference call that this money belongs to the shareholders but it's still unclear how it will be distributed. Insiders hold a large chunk of the company, so I'm personally hoping for a special dividend. It should also be noted, that there is still ongoing litigation about CDSOA-payments so the cash isn't probably distributed until it's over (management estimation is at the end of 2012, read more from my blog).

    The management has been focused on restructuring the business during the housing crisis and very little has been done to market the company. This has of course depressed sales in the past but the restructuring is now largely finished and the company can start to ramp-up advertisement and marketing efforts. Management is currently estimating that it requires $30M in sales per quarter to break-even. This level is very close so cash-burn is no longer a huge deal (especially with the cash position!).

    I've emailed the Stanley's CFO in the past and he has been very quick to respond to my questions. I've posted the emails (with his permission) to my blog. The blog is in Finnish but the emails are in english, so one should find the email parts pretty easilly! ;) http://mietteitasijoittamisesta.wordpress.com/?s=STLY

    In the current state, investing in STLY is practically investing in cash and as an added bonus, you get the business for almost free. Independent director T. Scott McIlhenny Jr. recently bought almost $50k worth of stock @ $4.5 stock price.

    - vdell

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  2. Sorry for the slow response. Thanks for the comment, I checked out your blog. Somehow I missed where you said it was in Finnish and spent 15m trying to guess what language it was. I eventually googled specific words and Finnish came up, if I just read better…

    I was able to translate it and understand your main point, STLY seems interesting, I'm going to look into them further and hopefully have a chance to do a post. Thanks for the comment and the information, this looks like a nice little bargain!

    Nate

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  3. There was a breakdown of the company's ROIC about a year before the financial crisis. Related to the housing bubble popping? The current price seems to assume that the ROE will rise back up to around 8% or so. Normally a 4% ROE would warrant a value of 50% of book value.

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    1. Most likely, before the bubble popped I believe they had higher margins and probably turned inventory quicker. They're working to change their furniture lineup which to me seems like they're searching for the formula for success again. The housing boom has moved on, and unfortunately Hooker was left in the dust. They need to reorient for the future which is people buying less and less expensive furniture.

      I think it's expensive now, at 50% of BV I'd be interested although there is the dividend coverage issue.

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