2024-01-19 23:14:45 ET
Summary
- Flexsteel manufactures and sells furniture, and has had quite a turbulent long-term earnings history.
- The company reported very strong Q2 results along with a great FY2024/FY2025 outlook. In addition, Flexsteel presented high ambitions for future growth.
- Although the long-term earnings history cast shadows on the high ambitions, the stock seems to have a great risk-to-reward as the valuation has significant upside to my conservative base scenario.
Flexsteel Industries ( FLXS ) manufactures and imports furniture to over 2700 retail stores and ecommerce channels across the United States. The company sells under three core brands; Flexsteel, Charisma, and Homestyles. In addition, the company has a number of sub-brands for specialized offerings. Most of Flexsteel’s sales come from independent retailers, but the company has plans to expand the other sales channels for growth.
Flexsteel’s earnings profile has been quite turbulent, reflected in a fluctuating and mostly poor price action in the company’s stock. The company doesn’t invest very heavily into growth, and currently pays out a dividend with a yield of 2.45% .
Turbulence in Long-Term Financials
Overall, Flexsteel has achieved very modest growth – from FY2003 to current trailing figures as of Q1/FY2024, the company has a CAGR of 1.5%. The sales trend has seen periods of growth and declines, and most notably, Flexsteel’s revenues decreased by -27.7% in FY2023 as demand plummeted from a Covid pandemic high into a level that’s pressured by decreased customer spending.
Prior to the pandemic, Flexsteel had multiple years of quite stable margins from FY2010 to FY2018 with an average EBIT margin of 6.2%. In FY2019, the company’s earnings plummeted into negative figures, and have largely fluctuated as the Covid pandemic has caused significant turbulence in the industry. Currently, Flexsteel’s trailing EBIT margin stands at 2.4%, well below pre-pandemic levels.
Strong Preliminary Q2 & Guidance
On the 11 th of January, Flexsteel reported its preliminary Q2/FY2024 results from October to December. The company flexes a sales growth of 7.5% in a challenging macroeconomic environment, and a great margin performance. The company’s EBIT margin increased from 4.0% to 4.6% year-over-year. The performance is very impressive as the furnishing industry is currently struggling – for example, Bassett’s revenues are expected to drop by -25.1% in a period from September to November year-over-year, Hooker Furnishings’ by -6.1% in a period from November to January, and Ethan Allen Interiors’ by -11.8% in the same period as Flexsteel.
On top of the strong result in Q2, Flexsteel seems to be confident in further improvements, as the company provided a very strong financial outlook for the future. With the middle point of the Q3 and Q4 outlook, Flexsteel’s revenues would grow by 3.6% in FY2024. The company would also have an operating income of $17.7 million, representing a margin of 4.3% for the year. The guided operating income is over double from a figure of $7.8 million in FY2023.
Further, Flexsteel expects the momentum to continue into FY2025 with the guidance of a 2% to 6% revenue growth and an operating margin of 5.5% to 6.5%, highlighting a performance in more normalized market conditions. Flexsteel’s management reflects the strong improvements to improved productivity, cost savings, pricing discipline, and an improved product portfolio management – the great financials are a factor of multiple initiatives, which all seem to be working well for the company.
The stock jumped by 29% on the following day from the press release and has continued to rise afterwards. With Flexsteel’s long-term struggles, the Q2 figures and especially the strong guidance give hope for an improved operational level, making the stock jump highly justified in my opinion.
Significant Long-Term Ambitions
Going further from the FY2025 guidance, Flexsteel has significant earnings growth plans as told in the January investor presentation . The company had long-term net sales of $750 million including acquisitions and an operating margin of 8%. While the revenue target could be met quite easily with acquisitions, the operating margin of 8% seems very ambitious – in Flexsteel’s history from FY2003 to the current date, the margin hasn’t been achieved in a single year. The target is also well above the FY2025 outlook, and seems to factor in great longer-term operational improvements.
Flexsteel plans to achieve the improved financials with sales growth and continuous cost savings. The company sees growth opportunities in expanding the offering’s penetration beyond primary living areas, targeting younger customers and an overall improved brand awareness, and growing alternate sales channels. The significant margin expansion is targeted through increased sales providing operating leverage, higher margins on new products, and further cost savings.
While the Q2 results came in very strong, I don’t take the ambitious earnings growth plans for granted yet. With Flexsteel’s turbulent long-term earnings history, I believe that the company needs to prove more for the goals to be priced in. Still, the goals are highly interesting to investors, and provide significant potential future upside.
Stock Price has a Window of Opportunity
The stock price has rallied after Flexsteel’s strong Q2 preliminary results and the company’s announcement of earnings growth plans. Still, the stock seems very undervalued with a P/E multiple of 8.2 with the middle point of Flexsteel’s FY2025 outlook.
To demonstrate the undervaluation, I constructed a discounted cash flow model. In the DCF model, I factor in a scenario where Flexsteel achieves the outlook for FY2025 but has struggles in achieving the long-term growth plans. After FY2025, I estimate the growth to stay moderate at 2.5% in FY2026, and to slow down into the company’s historical long-term growth rate of just 1.5% in steps. For the EBIT margin, I estimate some deterioration from the FY2025 outlook’s middle point guidance of 6.0% - along with the poor sales growth, I estimate the margin to fall moderately to 5.5%. The company has quite a low maintenance CapEx and minimal investment needs with my growth estimates, making the cash flow conversion relatively good.
With the mentioned estimates along with a cost of capital of 9.69%, the DCF model estimates Flexsteel’s fair value at $37.34, around 43% above the stock price at the time of writing. The stock has significant upside to a scenario where Flexsteel’s long-term ambitions are far from being met; the market still prices in a very high amount of doubt. While I understand the doubt after just one quarter of very strong financials, I already believe that higher earnings should be priced in than the market seems to anticipate. My estimates estimate an average annual FCF of $18.9 million, around half of Flexsteel’s long-term ambition of $40 million.
The used weighed average cost of capital is derived from a capital asset pricing model:
In Q1/FY2024, Flexsteel had $0.6 million in interest expenses due to the company’s remaining line of credit borrowings. As the company plans to pay off its interest-bearing debts in the next couple of quarters, though, I don’t estimate Flexsteel to have any debt as a form of financing in the long term. For the risk-free rate on the cost of equity side, I use the United States’ 10-year bond yield of 4.08% . The equity risk premium of 4.60% is Professor Aswath Damodaran’s latest estimate for the United States, made on the 5 th of January.
Yahoo Finance estimates Flexsteel’s beta at a figure of 0.51 . I don’t believe that the beta is very representative of Flexsteel’s sustainable risk level, so instead I use the average of Flexsteel and three other furnishing companies’ betas – Flexsteel’s beta of 0.51, Bassett’s beta of 1.65 , Hooker Furnishings’ beta of 1.09 , and Ethan Allen Interiors’ beta of 1.20 create an average of 1.11, which I use in the CAPM. Finally, I add a small liquidity premium of 0.5%, crafting a cost of equity and WACC of 9.69%.
Takeaway
Flexsteel reported very strong preliminary Q2 results, and outstandingly good FY2024 & FY2025 outlooks. In addition, the company reported high long-term earnings growth ambitions, leading the stock to skyrocket. While Flexsteel’s long-term earnings history is quite turbulent, and doesn’t fully support Flexsteel’s ambitions, I believe that the market still prices in a too high amount of doubt – in my baseline scenario where Flexsteel falls back into a pre-pandemic performance, the stock still has a very high amount of upside. The stock seems to have a good amount of room to continue the rally. Although the investment case could be strong enough for a strong buy rating, I only have a buy rating for the time being as the investment case is likely to have volatility with upcoming quarters.
For further details see:
Flexsteel Industries: A Window Of Opportunity