Steelcase Inc.: No Margin Of Safety (NYSE:SCS)

With a lot of confusion about how the pandemic is going to evolve the workplace setting, it is not surprising to see shares in Steelcase Inc. (SCS), struggle as the broad market completely recovered from the trough set in March.

The global market share leader in office furniture is struggling as the majority of office workers are still working from home. In countries where concerns about a second wave of infections continue, management has noted a weak order book.

To prepare for a lower revenue environment, the company has already taken steps to right-size its business. The company announced a restructuring to bring down costs by reducing its workforce.

The view of management is that we are transitioning towards a “hybrid” workplace, where “many more people will work from home from time to time.” This sentiment is also shared by Herman Miller’s (MLHR) management, which views the market moving towards a “hub and spoke” model for office work, where employees are given the choice to work remotely but having a central office where they could meet.

Today, however, it feels Steelcase’s business model is out of touch with the current reality. The company has historically used authorized local dealers to sell furniture in bulk to office buildings. With employees working from home, that channel is disrupted.

For Steelcase, the percentage of total sales derived from its direct-to-consumer channels is minimal. Additionally, if management decides to increase their DTC penetration, we believe they are going to face tough competition in the likes of Amazon (AMZN), Wayfair (W), Overstock (OSTK), IKEA, and big-box-retailers. These retailers also offer products at lower price points, making it hard for Steelcase to compete profitably.

From a valuation perspective, the company is trading at a forward P/E multiple of 15x. The market is putting a premium to Steelcase compared to its peer group, with Herman Miller and Knoll (KNL) trading at forward earnings of 10x and 14x, respectively. Is the premium justified? We don’t think so. Before COVID, the company was lagging its peer group on sales growth with a 3-year CAGR of 1.46% compared to 2.62% for MLHR and 6.25% for KNL. Steelcase also had the lowest profit margins.

The lack of a margin of safety, an uncertain outlook, and more pressure coming in Q3, we believe SCS’s premium valuation doesn’t offer investors a good risk/reward scenario. We have a neutral view on the company.

Weak Q2 and expected sequential sales decline in Q3

Steelcase reported second quarter sales of $819M, down 18% on a year-over-year basis, but ahead of the consensus by $36M. The company also reported non-GAAP EPS of $0.55, beating analyst’s expectations by $0.18.

Steelcase was able to report better than expected earnings due to their cost-containment measures, which consisted mainly of salary reductions and keeping discretionary costs relatively flat, against a sequential increase in sales. That said, the temporary salary reductions are coming back in Q3, with management guiding for $180M to $185M in operating expenses, or a sequential increase of approximately $10M at the mid-point. Offsetting operating expenses would be the expected savings of $40M annually from the salaried workforce reduction as part of their restructuring program.

The company’s better-than-expected top line was also the result of working through their accumulated backlog of customer orders at the beginning of the quarter, which exceeded their prior year by 11%.

However, as the company works through its backlog, that momentum is going to slow down due to a soft market. The company ended its second quarter with a year-over-year decline of 31% in new orders.

As a result, management expects sales for Q3 between a range of $690M to $725M, or a sequential decline of approximately $100M to $125M in constant currency compared to their second quarter. Gross margins are also expected to be pressured as management sees more business coming from the government sector and less from education.

Cloudy Outlook

At this point, not even management at Steelcase knows how the competitive landscape is going to evolve. One thing they are certain about is that it has changed, and some changes might be permanent. For example, they are certain that more people are going to work from home from time to time.

However, to add to the confusion, there are some strong indicators coming out of their Chinese market that points to a healthy recovery. For example, management notes that their orders in China are back to prior-year levels:

Today, about 8 months after it started, our orders in China are back to prior year levels. So in China, when the recovery came, it came quickly, and that’s because there was pent-up demand. Projects have been delayed, and everyone is trying to catch up. – Q2 call

If China can be used as the template of the recovery, then it suggests that within a controlled environment, the underlying economy tries to bounce back, making it positive for Steelcase. The company is seeing the same effect in Germany, where the virus was better controlled, with orders showing a “nice recovery.”

That said, the above scenarios also highlight the unpredictability of the situation, driven by the correlation between the number of infections:

In countries where concerns about a second wave continue, our orders remain weak. – Q2 call

The low amount of sales coming from its direct-to-consumer channel is a weak spot for Steelcase and we believe the company might have lost sales to competitors:

I can’t quantify it, but I would say that compared to our total business, it has historically been a relatively small part of our business. And even with the growth, it’s still relatively small. – Q2 call

For example, MLHR reported an increase of 40% in orders within their retail segment during Q1 (which coincides with Steelcase’s Q2, both 3-month periods ending in August). We also know corporations were giving stipends or reimbursements to employees for home office furniture. Management at Steelcase made it clear they are competing to get share:

Sometimes it can be the company providing that furniture directly to those employees. Sometimes, it can be in the form of a stipend. And in those cases, it might be directed at, okay, so it might be a case where the employees get the stipend, and they can spend the money as they wish. And so we’re competing for that business. – Q2 call

Currently, we believe MLHR is in a better competitive position as they have cross-selling opportunities and a chance to increase brand awareness via their DTC channel. Meanwhile, Steelcase is still heavily dependent on its dealer network for acquiring new business.

The Bottom Line

Trading at a forward P/E multiple of 15x, Steelcase is trading at a premium valuation to their peers, with MLHR and KNL trading at 10x and 14x forward earnings respectively.

Given their overvaluation on a comparable basis and unclear outlook, we believe an investment in Steelcase lacks a margin of safety, making us neutral on the company.

The number of increasing cases of COVID in Europe and the possibility of another round of lockdowns adds risk to an investment in Steelcase, making the risk/reward scenario not compelling enough. We are staying on the sidelines for this one.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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