2023-11-20 04:57:51 ET
Summary
- HNI Corporation's revenue growth is expected to benefit from strength in its small and medium-sized customer business and potential recovery in its contract business.
- Residential business is also seeing sequential improvement and we should see a sharp recovery once the interest rate cycle turns.
- The company's margins should continue to benefit from cost-saving and productivity improvement initiatives, as well as synergy benefits from the Kimball International acquisition.
Investment Thesis
I last covered HNI Corporation ( HNI ) in December last year. While I was a bit worried at that time about the potential slowdown in the Workplace as well as the Residential segment and the impact of volume deleveraging from this slowdown on margins, the markets ended up being more resilient than initially feared and the company’s excellent execution on cost saving and productivity initiatives helped margins. The company’s revenues and margins also benefited from the recent acquisition of Kimball International.
Looking forward, HNI’s revenue growth should benefit from continued strength in its small and medium-sized ((SMB)) customer business and potential recovery in its contract business which should drive revenue growth in its Workplace Furnishings segment in the coming quarters. The workplace business should also benefit from potential revenue synergies from Kimball International integration moving forward. While there is some pressure on the company’s Residential Building Products business due to a slowdown in new construction and remodel/retrofit markets, the company has seen a sequential improvement in the segment’s order rate indicating a positive outlook for the coming quarters. In addition, this business should also see gains from favorable demand-supply dynamics in the housing market which should fuel the revenue growth in the medium to long-term.
On the margin front, the company’s margins should continue to benefit from its cost-savings and productivity improvement initiatives and portfolio simplification actions. Further, synergy benefits from Kimball integration combined with volume leverage as the sales recover should help the company to post solid margins in the coming quarters. The stock looks attractive when compared to its historical averages. This, coupled with good growth prospects makes HNI stock a good buy.
Revenue Analysis and Outlook
After seeing good growth in FY21 and FY22 helped by the recovery in workplace furnishings as offices started opening and strong residential markets, the company’s organic sales growth was impacted by slower than expected return to office as well as slowdown in residential markets in the recent quarters. However, the company’s total sales turned positive again in the third quarter helped by Kimball's acquisition and relatively easier comparisons in the workplace segment.
In the third quarter of 2023, the Workplace Finishings segment’s net sales increased 43.1% Y/Y to $536.8 million mainly due to a $158 million contribution from the acquisition of Kimball International in the Q2 2023, partially offset by a $2.7 million impact from the divestiture of Lamex office furniture business in the Q3 2022. The segment’s organic sales grew 1.7% Y/Y driven by effective price realization which more than offset the decline in volume due to macroeconomic headwinds across most customer segments in the legacy HNI workplace businesses.
In the Residential Building Products segment, net sales declined 21.8% Y/Y to $174.8 million due to lower volumes in both the new construction and existing home channels brought on by a decline in housing starts and reduced home remodeling activity as a result of higher interest rates and general macroeconomic uncertainty. These negatives were somewhat offset by the higher price realization in the quarter.
On a Consolidated basis, net sales grew 18.8% Y/Y to $711.6 million led by strong inorganic growth in the Workplace Finishings segment, partially offset by the weakness in the Residential Building Products segment. However, the organic sales declined 7.1% Y/Y due to lower volume in both the legacy HNI businesses and the Residential Building Products business.
Looking forward, the company’s revenue outlook is positive.
In the company’s Workplace Furnishings segment, its exposure to SMB clients is helping its revenue growth. SMB clients account for over half of the company’s Workplace Furnishings sales and have seen strong growth. According to management , small and mid-sized firms have accounted for nearly 100% of net post-pandemic hiring. The shift in population to smaller secondary metros where office visits are nearly back to pre-pandemic levels has also benefited SMB sales. The demand from SMB customers is expected to remain strong and HNI’s good exposure to this market should help its sales.
On the contract side, while the customer orders have been down Y/Y in recent quarters, I believe they are likely to see a turnaround in the near term. Due to a slower-than-expected return-to-office trend and a shift towards a hybrid work culture, a lot of large corporates are rationalizing their footprint and shifting to new smaller offices in the coming quarters. This shift to new office spaces and adapting their spaces for the hybrid work environment is expected to drive the need for new furnitures. Below is a relevant excerpt from management commentary about this trend from the last earnings call ,
“Looking forward, we see dynamics which support an increase in furniture buying events. I'll remind you that furniture events are the primary driver of demand in our industry. Replacing office furniture is an episodic event, generally driven by an office move or need to refresh an environment for employee recruitment and retention.
Going forward, the predictive acceleration of lease expirations and the need for companies to adapt their spaces for hybrid work, support an increase in these events. Hybrid work has become the new normal. According to a recent Gallup survey, more than half of all remote-capable employees are now working in hybrid environments, with that number expected to move to 60% in coming quarters. And office lease rollover activity is expected to more than double next year and remain elevated through 2028. These factors taken together support an increase in furniture buying events.”
So, the continued strength in the SMB business as well as stabilization and potential recovery in the Contract business should help accelerate organic growth in the Workplace Furnishings segment of HNI in the coming quarters.
In addition, there is good potential for revenue synergies from Kimball International integration as Kimball has a good presence in high-growth secondary geographies which can help HNI increase its presence there.
On the residential side, while the company is seeing a slowdown in both new construction and remodel/retrofit activity with the third quarter total orders down 18% Y/Y, the order rate improved sequentially versus the first half of the year when it was down 29% Y/Y. Similarly, revenue decline in the residential segment was ~21.8% Y/Y in Q3 FY23 versus ~30.1% Y/Y in Q2 FY23. For the fourth quarter management has guided for residential building products revenues to be down high single digit to low teens indicating further sequential improvement. As the company starts lapping easier comparisons from Q1 FY24 onwards, I expect a return to growth in this segment as well.
Also, while the high-interest rate environment has impacted the sales in the residential business so far, the demand-supply dynamics in this business remain attractive thanks to over a decade of underbuilding of new homes post the great housing recession of 2008. The interest rate cycle is near its peak and once it starts reversing, I expect a sharp recovery in this end-market benefiting HNI’s residential business in the medium to long run.
Margin Analysis and Outlook
In Q3 2023, the company’s adjusted operating margin improved 240 bps Y/Y to 9.2% driven by positive price/cost dynamics due to inflation-related price increases, improved net productivity, and the favorable impact of the Kimball International acquisition which more than offset the adverse impact of lower organic volume and higher variable compensation.
On a segment basis, the Workplace Furnishings segment’s adjusted operating margin expanded 750 bps Y/Y while the Residential Building Products segment’s adjusted operating margin was flat Y/Y as the impact of lower volumes fully offset the favorable price/cost, improved net productivity, and lower variable compensation.
Looking forward, I am optimistic about the company’s margin growth prospects. The company is doing a good job in terms of its cost savings and productivity improvement programs. Last year, the company announced a $30 mn corporate-wide cost-saving program and it has already surpassed that target with a run-rate saving of ~$50 mn across the corporation by the end of the third quarter. Management is expecting $5 mn to $10 mn incremental benefits in its residential segment next year and given its track record, I expect savings to come at the upper end of the target range. The company has also done a good job in terms of portfolio simplification including exiting the loss-making Poppin business which had an annual operating loss of ~$20 mn, divesting the company’s China business, and rationalizing its eCommerce offering which should help margins in the coming quarters. Further, there should be upside from synergy benefits from Kimball integration and volume leverage once the sales start recovering.
Valuation and Conclusion
HNI is currently trading at 13.95x FY24 consensus EPS estimates of $2.81 and 12.21x FY25 consensus EPS estimates of $3.21, which is at a discount versus the company’s average forward P/E of 16.69x over the last 5 years.
I believe the company has good near-term and long-term growth prospects benefiting from strong growth in the SMB business, potential recovery in the Contract business, synergies from Kimball integration, stabilizing demand trends in the residential business, and favorable supply-demand dynamics in the housing market. Further, I believe the interest rate cycle is near its peak. Once the interest rate cycle reverses, the company’s residential business should see a sharp recovery accelerating the company’s revenue growth. The company has done a good job in terms of improving margins and I expect continued benefits from its cost savings and productivity improvement initiatives, portfolio simplification efforts, and volume leverage. The company’s good revenue and margin growth prospects and a lower-than-historical valuation make me optimistic about the stock and hence, I am moving to a buy rating.
For further details see:
HNI Corporation: Good Execution And End-Markets Bottoming Should Drive Outperformance