2023-12-04 17:09:39 ET
Summary
- La-Z-Boy is a global leader in the furniture market but its ability to compound earnings on equity appears limited based on this analysis.
- Q2 fiscal '24 numbers show La-Z-Boy Inc trading at 11x next year's earnings and 1.4x book value.
- The furniture business is a challenging one in general due to lack of differentiation, tight margins, and capital tied up in NWC.
Investment outlook
Following a mixed set of Q2 fiscal '24 numbers, La-Z-Boy Incorporated ( LZB ) has crept onto our signals as a potential buy trading at 11x next year's earnings and 1.4x book value. Q2 revenues were down 16% YoY on earnings of $0.74/share, both ahead of consensus.
Iconic brands such as LZB often possess consumer advantages, but the furniture business is a difficult one, considering:
(i). It is near impossible to differentiate on product or price,
(ii). Margins are therefore tight. Businesses rely on capital/asset turnover,
(iii). Capital is mostly tied up in NWC (receivables + inventory) + fixed assets,
(iv). Those with production/cost leadership advantages seem to outshine.
Investment findings suggest LZB is a global leader in the furniture market. It enjoys production advantages that produce a high ratio of sales to capital employed in the business. Earnings + FCF of the business are therefore most sensitive to changes in this.
Q2 earnings were impacted by this wind-back in unit turnover, compressing sales + profits down the P&L. Management are now eyeing Q2 fiscal '23 sales of $515–$535mm on operating margins of ~8%. Investors are also treated to a 2.3% forward dividend yield paying 11x earnings at the time of writing.
Despite the economic goodwill in "La-Z Boy", repeated sales history, and predictable cash flows, my judgment is LZB's ability to compound the rate of earnings produced on equity is limited for several reasons, to be discussed here today:
- Sales + earnings growth (inc. Q2 earnings),
- Compounding returns on investor capital,
- FCF per share,
- Starting valuations.
The company's Q2 numbers were reasonably strong and the market's response afterwards suggests it projects a stronger period of business for the company.
Taking a long-term view, the picture is less clear. A deeper analysis of the company's value drivers reveals a reduced ability to unlock shareholder wealth, in my opinion. This report will examine LZB's investment outlook through this lens using sound economic assumptions. Net-net, I rate LZB a hold for the reasons outlined in this report.
Figure 1.
Critical facts to investment thesis
1. Q2 FY'24 numbers, sales + earnings growth
Investment returns over the coming 1–3 years are highly sensitive to sales + earnings growth. Multiples expansion occurs alongside these factors. The question is whether LZB can compound its intrinsic value over this time.
The facts pattern on growth includes the following points:
- Consensus projects 3-4% avg. earnings growth out to '25, on 11x earnings at earnings of $2.94/share, plus sales growth of 3-4%
- The market's required return, at these stipulations, + a 12% discount rate, is 4% and ranging from 4–9% under various assumptions
- In my opinion, the company's rate of earnings on equity is reasonable enough to support these growth rates.
The company's Q2 FY'24 numbers are insightful context to the points above. My observations are as follows.
Dividends up 10%: The company increased its quarterly dividend by 10% from $0.18/share to $0.20/share ($0.80/share annualized), payable December 18th this year. This is ~3% forward yield at the time of writing. It paid out $8mm in dividends during the quarter, alongside $10mm in stock buybacks for a total of $18mm returned to shareholders (nearly ~$75mm annualized).
Sales and growth: Top-line sales were down 16% YoY to $511mm. Revenues were down as unit volumes contracted in terms of backlog deliveries. In contrast, delivered sales for Q2 FY2024 were booked at $511mm, a 14% increase from the most recent non-pandemic second quarter. It pulled this to adj. operating income of $41mm, down 34% YoY on earnings of $0.74/share.
Cash flows and CapEx: The company generated $31mm in OCF, up 84% YoY, and tallying $57mm the YTD (Q1–Q2, respectively). CapEx of $13mm was directed towards retail store openings, remodels, and facility upgrades. It also returned $18mm in cash to shareholders, $8mm of which was in dividends.
Divisional takeouts:
- Retail segment sales were down 15% YoY to $214mm, operating margin of 13%, down 300bps,
-
The wholesale segment did $365mm of business, down 18% YoY on operating margins of 7.7%, down 100bps YoY.
- The Joybird business did $32mm in sales also down 15%.
In my view, the investment outlook looking 1-3 years out is skewed to buying LZB for investment income vs. capital gains. Earnings are projected to grow at the long-term GDP rate into '25 and my judgement is stock returns could hug this rate of growth.
2. Stable earnings on equity
The company routinely earns 8–10% return on its investor equity, with a range of 7-11% ROE over the last 3 years on a rolling TTM basis. The company's stable earnings relative to capital enables it to spin off cash to shareholders via FCF and dividends.
There is no statistical leverage, thus net margins + capital turnover drive investor returns, and have been stable since 2021.
Figure 2.
Conversely, incremental rates of business return haven't kept up to this speed. This squares off with the economics off the business. Opportunities for LZB to redeploy cash are scarce, despite its reasonable ROE + FCF. Instead, returns rely on capital turnover + pricing to grow sales.
LZB has been compounding earnings at an incremental rate of <1% on equity since 2021. At the same time, reinvesting anywhere from 10%–45% of earnings at these mixed rates of return. Compounding the company's intrinsic value at the function of its ROE and reinvestment rates sports a $40 implied intrinsic value at the time of writing (Figure 3).
A more detailed analysis includes the following:
- LZB also retained $5.22/share of investor earnings over this time, returning $0.50/share in incremental earnings on this, 9.5% return on capital.
- The market return in the same time was negative $7.81/share.
- Hence, for every $1 of retained earnings, the company produced a loss of $1.50 in market valuation.
The notion of 1) soft earnings relative to net capital, and 2) market losses on reinvested earnings, implies LZB's ability to compound shareholder wealth is limited in my opinion.
Figure 3.
Critically, the firm has spun off ~$26 in FCF per share since 2020 (TTM values), below where it currently trades at $35 (Figure 3a). My estimates suggest it may be overstretched at this market value, that corresponds to 12x forward earnings and a PEG of 1.11x. Moving forward, my assumptions are for the company to throw off ~$1/share in FCF out to mid 2024, supporting a neutral view.
The notion on compounding FCF is critical to my investment thesis in on LZB. Whilst cumulatively, the numbers add up, there is neither 1) growth in FCF/share or 2) attractive yields—5.1% trailing yield.
For capital appreciation, in my opinion, one would prefer to see a few improvements to the fundamental economics of LZB's underlying assets:
- The company throwing off more cash to shareholders each period on aggregate (for a higher FCF yield, i.e., more value),
- Growth in FCF per share.
The absence of these two points is critical. Dividends aside, we aren't actually attributable to the owner earnings our marketable securities produce (vs. a wholly owned business, for instance). So we can't recognize them on our portfolio's 'income statement'.
The market also does a mighty fine job of accurately prescribing fair value to companies over time, however. Growth in earnings + FCF/share is discounted by the market with higher market valuations, and vice versa. Accounting rules also provide we can book our holdings at market value (carrying value). Hence:
(1). Whilst we can't record the FCFs/earnings on our 'income statement';
(2). These are then recorded as capitalized earnings via the updated market values, and reflected as an increase (decrease) in net worth on our balance sheet.
Therefore, I reiterate my view that LZB's ability to compound shareholder wealth appears limited unless critical factors begin to change. This supports a neutral posture.
Figure 3a.
3. Starting valuations
A more thoughtful analysis on how these returns transpose to investors links starting valuations to investment return.
Forward growth rates imply 3-4% out to '25 as mentioned, and for this could earn 10–12% on equity should all go according to plan (Figure 4).
Critically, the stock sells at 1.4x net asset value, implying:
- That investors value LZB at 1.4x $22.53/share in shareholder equity to buy LZB today, and receive 8–12% return on equity (2.94/22.53).
- The forward ROE for the investor slips to 8.5% if paying 1.4x (2.94 / (1.4x22.53) = 8.5% ).
- This is still a reasonable return in my opinion and implies a market value of $43-$44 at consensus growth rates out to 2026, 22% value gap.
Figure 4.
LZB is also priced at 9.7x trailing earnings and the incremental ROE was negative 3.4% last quarter. At the same 9.7x multiple, the company is now worth $34/share, no change from its current market value.
Therefore, on earnings power and asset factors, the valuation debate is balanced in my opinion.
Discussion summary
LZB opens the interesting debate of excellent brand / product vs. excellent investment. There is no negotiating the company's furniture offerings, anyone who has sat in one will attest to this.
However, the firm lacks the full composite of critical investment facts required to get me over the line here. The question of opportunity cost therefore presents itself in owning the company.
(1). No demonstration of earnings power, including 1–3 year projections,
(2). Earning modest returns on equity with no debt,
(3). Simple operating model,
(4). Reasonably priced,
(5). Stable + persistent FCF per share.
I would throw in the 10% growth in quarterly dividend as a standout here as well. For the prospects of capital appreciation, my recommendation is to seek more selective opportunities elsewhere. Net-net, rate hold.
For further details see:
La-Z-Boy: Recent Growth Not Supported By Returns On Underlying Assets