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2019-11-11 22:01:15

Steelcase (SCS) has performed nicely in 2019, gaining 21%. Fiscal second-quarter earnings in late September helped the cause: SCS shares are up over 7% from their close the day of the after-hours release.

But in both cases, the gains don't look like nearly enough. The 21% gain YTD obviously benefits from the lows at which cyclicals like SCS traded at the end of 2018. Steelcase stock actually has underperformed the S&P 500 this year.

More importantly, the company's two main peers, Knoll (KNL) and Herman Miller (MLHR), both have broken out:

Data by YCharts

SCS actually has underperformed KNL since its earnings release, despite posting impressive results in what I argued in August was a key quarter for the bull case. It's given back some of its post-earnings gains while peers have moved higher.

There are some reasons, perhaps, for the market's relative reluctance to push the stock higher. Steelcase has been consistently inconsistent for several years now. (In fact, an investor could argue that's been the case for its 21 years on the public markets. SCS actually still trades below its IPO price. Total returns, per YCharts data, have been 13%, or about 0.6% annualized.) Third-quarter guidance appears to have been a touch soft relative to consensus. And there are reasons for caution toward the entire office furniture space.

Still, in the context of the market, the sector, and Steelcase's performance, it's not hard to imagine a scenario where SCS easily is a $20+ stock. It's equally easy to imagine that scenario playing out in the next 6-12 months. At this valuation (on both a relative and absolute basis), SCS looks like one of the best cyclicals in the market. And it increasingly looks like the best pick in the industry, a title I've long bestowed on KNL, which I remain long. With SCS below $18, I'll be thinking long and hard about swapping SCS for KNL, and I'd recommend investors do the same.

A Strong Q2 Report

In the Q2 release, Steelcase CEO Jim Keane called the quarter one of our strongest quarters in the past 20 years, and it's tough to argue with that description. Admittedly, that quote says something about the company's performance over the past two decades, during which time revenue has grown by roughly 10%, but history aside Q2 was impressive.

Revenue rose 14% year-over-year, above the high end of the company's guidance, with organic growth at 9%. There was some help from slippage out of Q1, which management after that quarter attributed to construction labor shortages. But Steelcase also had a tough comparison (8% organic growth in Q2FY19) and it's helpful simply that the Q1 explanation was on point. To be blunt, this is a company that hasn't always met its promises or seemed to be on top of industry trends, and so a quarter that went ahead of an accurate plan helps the bull case.

Gross margin expanded 40 bps, as pricing increases taken in past quarters are holding and input costs (notably steel) are normalizing. Operating expenses leveraged 30 bps despite investments in the business (and with some modest help, per the Q2 call, from delayed project spending). EBIT as a result increased 26% and EPS, due to one-time benefits in the year-prior period, rose 22%.

To be sure, the industry seems to be in excellent shape at the moment. Herman Miller's adjusted EPS too increased 22% in its fiscal Q1. Knoll drove revenue growth of 8.8% in its third quarter (which ended a month after Herman Miller's first quarter and five-plus weeks after Steelcase's Q2).

But Steelcase said on its Q2 call that revenue growth outpaced that of the industry, using data from industry organization BIFMA. And the gains at the three major players, along with less-impressive but still solid results from lower-end HNI Corporation (HNI), seem like a notable reversal of a recent trend.

Smaller designers had made inroads even amid major clients amid the shift to more unique, flexible workspaces, with notable share gains in so-called ancillary products. Steelcase, Knoll, and Herman Miller seem to finally have responded through both acquisitions (such as Steelcase's purchase of smartworking manufacturer Orangebox) and portfolio improvements.

Keane has said repeatedly in recent quarters that his company finally had filled in its product gaps and that it was ready to go on offense. The impressive Q2 numbers, which follow a strong Q1, provide fundamental support that he was right.

The Relative Case for SCS Stock

It's worth repeating: there's clearly some help here from the industry and from the broader economy. BIFMA data cited by Steelcase on the call reflects 9% shipment growth, a huge figure for the industry. Tight labor markets, in Keane's telling, are driving employers to upgrade workspaces to increase productivity. Multiples of ~14x on a P/E basis (using updated guidance pointing investors to the high end of $1.20-$1.35 in EPS for FY20) and just under 8x Adjusted EBITDA (based on TTM figures from the Q2 earnings presentation) might seem somewhat reasonable given that pair of cyclical tailwinds.

But, again, both Knoll and Herman Miller are benefiting from those tailwinds, too. And both stocks have significantly outpaced SCS so far this year, while relative performance in recent weeks suggests minimal help to SCS shares from a Q2 report that, simply put, mattered. For several years now, Steelcase has had a bull case on paper, but quite often has disappointed in practice. The company now has built a multi-quarter trend (going back to a solid, if not quite perfect, FY19) of delivering, but it seems to be treated almost as the 'same old Steelcase'.

And it's worth noting that some pillars of the bull case remain. SCS, despite what was often disappointing performance in the U.S. relative to its rivals, often has received a valuation premium to MLHR in particular owing to its potential in EMEA. That business has operated in the red for years now, and an ongoing turnaround effort repeatedly has stumbled. But Keane reiterated guidance for full-year profitability in that business after the first-half loss narrowed to $4.7 million from $7.7 million the year before. If Steelcase can get that business to a targeted mid-single-digit margin (on top of more than 100 bps in margin improvement in FY20), that alone drives at least $0.20 in incremental EPS, a mid-teen tailwind on a percentage basis.

Steelcase also has a solid presence in Asia. Per past commentary, that includes relationships with domestic companies in China and Hong Kong, not just local units of Western companies. Those two markets unsurprisingly saw some challenges in Q2, but management called out strong performance in the quarter in India, an obvious growth market long-term.

Despite those strong points, SCS no longer is receiving a premium to its peers:

StockP/EEV/EBITDAPeriod EndingSCS13.8x7.9xAug-19KNL13.7x9.3xSep-19MLHR15.3x10.4xAug-19

all figures adjusted, from the respective companies' reports and presentations

And so it's not hard to see a relative case for SCS at the moment. Certainly, all three companies are performing well — Herman Miller, for instance is guiding for 16% growth at the midpoint of its Q2 EPS guidance — but Steelcase has been mostly left out of the YTD rally. It has room for improvement in EMEA, growth potential in Asia, and perhaps some opportunity for catch-up gains if it truly has the ability to go toe-to-toe with Herman Miller and Knoll domestically.

In the context of peer valuations, there's then a case for 14-15x $1.40-$1.50 in FY21 EPS (consensus is at $1.47, ~10% y/y growth), which would the stock to $21. That's about 20% total returns including the 3.2% dividend. (I'd expect a dividend hike next year as well.) 8.5x EBITDA, still a discount to peers, and 10% growth from TTM numbers to FY21 levels gets the stock to $22.

Whatever the exact price target, the case for SCS stock here is relatively simple. The status quo well could drive 20% or higher returns over the next 12 months. If Steelcase keeps executing and the industry stays healthy, the valuation gap should narrow, and SCS will drive strong returns on both an absolute and a relative basis.

What Goes Wrong

The core concerns here are those 'ifs'. Again, maybe this time is different for Steelcase, but investors would be forgiven for wanting a little more proof that the company finally is back on track. EMEA profitability is a step in the right direction, but that's still a business doing $600 million-plus in annual revenue while generating what seem likely to be sub-1% operating margins this year. UK demand unsurprisingly is weak at the moment, and growth on the Continent isn't exactly inspiring at the moment. Asia has risks. It would be surprising if Steelcase's improvements reversed in the second half, but it wouldn't be stunning.

There's also a broader fear about the industry. Yes, industry growth is torrid at the moment. But it seems likely that there are some benefits not only from low unemployment, but from catch-up spending relative to past years. Between the 2016 U.S. presidential election and tax reform, there were reasons for companies to hold off on spending, which was disappointing relative to what one might expect amid the last few years of an 11-year economic recovery. As a result, the entire space plunged in 2017 after soaring following that election.

It's not hard to wonder if there isn't another speed bump ahead. The 2020 presidential election looms, and if a progressive candidate wins the Democratic nomination (or even gains momentum toward that point), that could lead some U.S. executives to again hold off on spending amid uncertainty around potential tax changes relative to capital expenses. A Democratic win could also, at least according to some observers, lead stocks to plunge, and though I'm more skeptical on that front than most cyclical names like office furniture manufacturers would be at risk even in a more muted market decline.

But here, too, SCS seems less exposed because of its performance of late. The stock is trading around resistance that has held since 2016. KNL is at its highest levels in nearly three years (and right about where it reversed at the beginning of 2017). MLHR is at an all-time high. Those stocks have broken out. SCS hasn't.

And it increasingly looks like it should at some point. Valuation is reasonable, and execution is much-improved. Steelcase probably needs some cyclical help, or at least the absence of a cyclical reversal. But for investors willing to take that bet, there seem to be few better choices out there.

Disclosure: I am/we are long KNL. 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.

Additional disclosure: This week I may exit my position in KNL and/or add shares in SCS.

seekingalpha.com Vince Martin
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