2023-06-16 15:29:30 ET
Summary
- Industrial manufacturer Leggett & Platt has a 6% dividend yield and a 4.5% long-term growth rate, offering a potential 10%-11% total return.
- The company's commitment to dividends is strong, but its payout ratio on net earnings and free cash flow has been increasing, approaching a critical level.
- Leggett & Platt may struggle to grow revenues and margins fast enough to outpace obligations, putting the dividend at risk of being cut or suspended.
Investment thesis
With 51 years of dividend increases, Industrial manufacturer Leggett & Platt ( LEG ) has recently earned the coveted title of "dividend king," and the company is a well-known darling of the DGI community. Last month, LEG announced an increase in its quarterly dividend from $0.44 to $0.46 per share, starting with the upcoming July payment. The new projected twelve-month total is $1.84 per share, which rounds up to an attractive 6% dividend yield based on the June 16 closing price of $31.38.
The company's commitment to continue returning cash to shareholders in the form of dividends seems ironclad, with LEG's CFO Jeff Tate even stating during the most recent earnings call that:
" Our ability to be able to fund the dividend is something that we have very good confidence in. We're going to be very minimal and conservative in terms of share repurchases as well as acquisitions during the course of the year."
LEG is far from a fast-growing business and trades at an EV/EBITDA of 10x, which, in my view, doesn't scream undervaluation. The investment case for LEG rests, at this point, primarily on its qualities as an income vehicle and the fact the company's cash flow will continue to support moderate dividend growth in the future. The company's most recent increase of 4.5% seems well aligned with the 5Y average EBITDA and EBIT growth. Leggett & Platt operates, for the most part, in cyclical sectors, and assuming future mid-single-digit EPS and cash flow growth in line with the recent trend could be a decent assumption. LEG's 6% yield and 4.5% long-term growth could produce a potential 10%-11% total return.
Company's overview and segments review
Even if LEG is primarily known for its bedding products, a quick look at its latest annual report shows that this only amounts to less than half of its total turnover. Despite the bedding segment being the largest one, 54% of LEG's sales come from the industrial design and production of specialized products for the automotive and aerospace industries and various furniture, flooring, and textile products.
The variety of products and industries involved as LEG's customers provide some diversification cushion in downturns. However, on the other end, the company has not shown that any of these segments can represent a material growth opportunity. While the bedding product segment sales increased by 4.5% in 2022 vs. 2019, they were lower by 4.1% vs. 2021, and LEG is guiding for a further low-single-digit decline for this segment in 2023. Considering its aerospace exposure, the specialized products business segment experienced the largest pandemic drop, which is understandable. Since then, it has recovered, with 2022 sales up 4.8% vs. 2021, and expected to increase high-single-digit in 2023 as well. However, this segment also posted the most significant drop in EBIT margins, going from 16% in 2019 to only 8.9% in 2022 (the lowest of LEG's divisions from a margins perspective). The more profitable furniture, flooring & textile products segment, which was the division accelerating the most (+3.4% vs. 2021 and +16.8% vs. 2019), is seen down low-single-digit for 2023. The changes in segment mix and the unfavorable turnover trajectory, seen going down 3% at the guidance midpoint vs. 2022, will contribute to LEG's earning only an EBIT margin of 7.5%-8.0% for the current year.
Modeling the numbers
Based on the above historical data and management guidance, I built a 3-year forecast for LEG, which assumes a gradual recovery in sales and margins through the years 2024 and 2025. Considering the big hit in EBIT guided by management for 2023, despite the sales recovery, I expect LEG to face significant challenges in re-establishing gross profit above 20%. In my model, I believe LEG will only support a 19.1% margin by 2025 because the highest-growing segment, specialized products, seems to have the most challenging profitability among the three company divisions. Gross profit should hit the $1 billion mark again, and I expect LEG to continue tightly controlling its SG&A, which will total about 9.7% of revenue, like in 2021 and 2022. The 2025 projection considers LEG to likely reach approximately $500 million in EBIT and $320 million in net income, or about $2.30 per share.
Considering this forecast, the current dividend of $1.84 seems barely covered, with a 91% payout ratio based on the cumulative 3-year EPS, even without further increases from the present level. A common rebuttal by bulls is that the dividend continues to be well-covered by cash flow instead. The company expects to produce between $450 and $500 million in operating cash flow while only devoting $100 million to CAPEX. Assuming FCF at the midpoint of $375 million, the payout stands at 71%, which is relatively high and above recent years, but manageable. Still, investors should begin to wonder whether the company is jeopardizing its prospects to support it. The $100 million CAPEX spend for 2022 is only about 50% of LEG's D&A costs. Last year, the company also recorded $107 million in CAPEX and $66 million in 2020. The (2020-2022) three-year average of $91 million is significantly below the previous (2017-2019) three-year average of $154 million.
By averaging the 2020-2022 operating cash flow, LEG earned about $440 million annually and spent $220 million on dividends. If the company had continued with its prior level of investment, dividends would have represented an even higher payout of 77%. In the not-so-long run, the company will face the dilemma of picking up investments again and stretching its payout ratio very thin or continuing to underinvest in the business and cutting down its growth.
Another problem is that operating cash flow is not growing already, excluding the possibility that things will improve over time. LEG's cash flow, while robust, has effectively remained unchanged for the past ten years. The 2013 operating cash flow was already $416.9 million, against $441.4 million in 2022. That's a paltry 0.6% CAGR, which does not come close to the 4.5% CAGR in dividends during the same timeframe. Things get a little better by comparing the 2023 forecasted $500 million figure (high end of the guidance) vs. $381 million in 2014, but even so, the 3.0% CAGR is below the dividend increase CAGR.
Risks
While I do not believe the dividend is in immediate danger, it is evident that LEG's payout ratio on net earnings and free cash flow has been increasing for quite some time. The financial burden from the dividends is approaching a critical level. I cannot see LEG revenues (or margins) growing fast enough to outpace obligations and get things back on track.
Because of LEG's underinvestment in the last decade and its high FCF payout ratio, I don't think investments will allow cash flow to grow at a CAGR higher than 1%-2% in the future, which would also be a slowdown from past EBIT increase of 4%-5%, and below the 4.5% required to sustain the current dividend growth. However, the company could prove me wrong, as it has been in a tight spot before (2013-2014) and has been able to pull itself out thanks to a significant improvement in economic conditions in 2015.
My forecast estimates that LEG will close its FY23 and FY24 relatively unscathed by a global slowdown, with 2023 being the trough in the cycle. While 2023 will be a soft year, with both sales and margins contracting, the subsequent figures only make sense factoring in a mild recession, not a severe one. In a worst-case scenario, the dip could be far more pronounced and further down the road, putting the dividend at significant risk of being cut or suspended. The resulting exit of individual dividend investors and dividend-oriented passive and active funds could knock LEG's share price down to new lows well below the current level.
The verdict
Based on my forecast, the company appears to be trading at 15x FY24 EPS and 13.5x FY25 EPS. Although LEG's most recent five-year average is slightly higher at about 16.5x, I don't believe the company will close that gap in the short or medium term. Home furnishing companies such as Mohawk Industries ( MHK ) trade substantially cheaper already based on earnings multiples alone. And with limited growth, even a 13x-15x EPS multiple could be rather generous.
LEG does not appear to be overvalued, but I still believe it will likely underperform from here. Even though I have been scouting for new additions to my high-yielding DGI portfolio, I am not considering LEG an attractive prospect at this time.
While I believe that the executives' statements regarding dividend safety are genuine, the stock market is full of cases of dividend cuts administered right after reassurances to investors. Leggett & Platt is trapped within the "dividend kings" club. Even if it would be wise to reallocate capital towards growth urgently, the company is afraid that doing so would alienate its investor base. I am not enthusiastic about an income investment with shaky foundations. For these reasons, in my view, investors should seek better opportunities elsewhere.
For further details see:
Leggett & Platt: The High Costs Of Being A King