Research from Water Tower Research, Water Tower Research

Water Tower Research

Water Tower Research is a leading equity research firm that provides research on micro, small and mid cap companies.

Water Tower Research was founded by Wall Street veterans after witnessing a fundamental shift in the investment research industry with the result being a declining knowledge base among investors, a lack of awareness and a shrinking pool of fundamental research being conducted on companies across the small-cap and micro-cap spectrum. The same issues are now increasingly occurring in the mid-cap space. This sea change within the investment community is impacting not only the companies themselves but also current shareholders and potential investors. With significantly less active sell-side sponsorship by Wall Street, a substantial information gap has developed between companies and various constituents in the financial community. The net result is fewer channels for insight and information to flow between companies and investors.

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<h3>KEY POINTS</h3>
<ul>
<li>We are updating our earnings estimates and reflecting on the outlook for Steelcase following its 3QFY23 earnings call. Though adjusted EPS beat our published estimate, we cut our outlook for 4QFY23 and 1HF24. Management commentary and a challenging economic environment prompt these cuts.</li>
<li>We expect the next six to 12 months to remain challenging. Notably, Steelcase confronted the challenges by lowering costs, recapturing margin by pricing actions, and diversifying its customer base into adjacent markets.</li>
<li>The benefits of the first two efforts are visible now in the P&amp;L. Operating expenses fell to 25.2% of revenue, lower Y/Y and sequentially. Gross margin was 28.8%, up 120 bps Y/Y, although about ~30 bps lower sequentially.</li>
<li>Steelcase also launched initiatives to diversify the customer base into the education, consumer, and mid-market office furniture markets. These are long-term efforts but essential to a company experiencing a secular decline in the core business.</li>
<li>On its earnings call, CEO Sara Armbruster speculated that the core North American office furniture market may be ~20-25% smaller than the 2019-2020 pre-pandemic market, after it recovers from current volatility. The company declined to define that market or quantify the impact. We estimate it could represent $500 million-plus in SCS sales.</li>
<li>We now model our 4Q revenue estimate at the mid-point of guidance and non-GAAP (adjusted) EPS near the low end of guidance. With low beginning backlogs, we reduced full-year FY24 EPS estimate to $0.55 from $0.90. We are modeling continued pressure on orders through the first half, with modest recovery in the second.</li>
</ul>
<h3>ESTIMATES</h3>
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<h2>COMPANY OVERVIEW</h2>
<p>Steelcase is one of America’s great companies. Named 15 times by&nbsp;Fortune Magazine&nbsp;as one of the world’s most admired companies, Steelcase is a global market share leader for commercial/contract furniture. Its global capabilities and research-based approach make it a preferred partner for organizations in any part of the world.</p>
<p>Steelcase defines its purpose as “unlocking human promise by transforming work, worker and workplace.” In this way, the company affirms its mission to the workplace. Today, the company’s family of brands includes Steelcase®, Coalesse®, Designtex®, Smith System®, AMQ®, Turnstone®, and Orangebox®.</p>
<p>The Steelcase growth strategy is to translate research-based insights into products, applications, and experiences. Today, Steelcase goes to market through ~800 independent and company-owned dealer locations (~400 in its Americas segment, ~340 in its EMEA segment, and ~60 in its Other segment). The company has 65 locations in 17 countries, 15 of which are dedicated to manufacturing (seven in the Americas, five in EMEA, and three in the Other segment).</p>
<h2>COMMENTARY</h2>
<p>Steelcase reported a 3QFY23 quarter that met expectations and fit comfortably within prior guidance. The outlook remains pressured.</p>
<p>Near-term orders are slowing due to recession fears, pressure on corporate profits, and corporate executives’ reluctance to commit capital on office furniture investments at a time when resources are tight and the future role of the office appears in flux.</p>
<p>Post-pandemic, supply chain disruptions, and inflation/pricing actions of the past three years, the base size of the office furniture industry will be inevitably smaller. The implications for Steelcase are profound. But we found the Steelcase response and openness about the challenge encouraging.</p>
<p>As a hypothetical, CEO Sara Armbruster said that the office furniture industry could be 20-25% smaller than the pre-pandemic industry after the effects of all the buffetting settle. Ms. Armbruster did not intend for investors to use that percentage drop range as a prediction, but rather an illustration of the reality facing Steelcase, one of the several dominant firms in the enterprise-size office furniture market.</p>
<p>She enumerated several strategies to address the environment, including:</p>
<ol>
<li>Lead the industry in hybrid office design and transformation,&nbsp;which plays on Steelcase’s design and product innovation expertise. In addition, Steelcase is transforming the way it engages with customers. Management is redeploying sales resources to more promising markets. Customer contact is being decentralized, away from the Grand Rapids campus and toward more local, regional, and virtual engagement.
<ol>
<li>A corollary to that decentralization is the intended sale of the company’s aircraft fleet and closing of its aviation division. Customers are less willing to travel, post-pandemic. The jets nearly exclusively ferried corporate customers and designers to the Grand Rapids campus. Management will pay off attendant debt ($33 million in term debt due in May 2024), recoup and redirect ~$11 million annual operating expenses, and regain cash capital after the sale of the aircraft.</li>
</ol>
</li>
<li>Diversify the customer base to adjacent markets.&nbsp;Steelcase sees opportunities in (1) education, (2) home office furniture through the online Steelcase store and through retail partners (notably West Elm and Best Buy), and finally (3) addressing mid-market companies and communities more intensely.</li>
<li>Increase margins and profitability.&nbsp;This strategy is already in place the fruits have begun to show. Price increases have started to offset the effects of material, labor, and input inflation. In 3Q, pricing exceeded the inflation impacts by about $55 million, the second consecutive quarter of price-cost improvement. Gross margin improved by 120 bps. Steelcase continues to focus on cost-out strategies, both short and long term.</li>
</ol>
<p>Our “back-of-the-envelope” guess pegs the impact of a shrinking office furniture market on Steelcase in the $500 million-plus range, or 20-25% of the Americas segment, a $2.6 billion business in 2020. The initiatives in adjacent markets have been positive and encouraging. Management states that the Smith Systems furniture for K-12 has more than doubled in size over the past three years. The retail partnerships have been growing. The mid-market order trend is improving, but much smaller, and there is entrenched competition in this arena.</p>
<p>For the intermediate term, we are taking a cautious approach. Top-line improvement over the next 12-18 months depends on the length and depth of a recession, and the speed and urgency of the return to office (which has been disappointing over the past year). We think it is prudent to take a wait-and-see approach to those unknowns.</p>
<p>Our revised estimate for FY24 assumes a 4.2% decline in total revenue. On profitability, we give the company credit for gross margin and cost-out efforts, modeling a 2.7% operating margin versus 1.6% in FY23. A full model is below.</p>
<h2>LIQUIDITY AND BALANCE SHEET</h2>
<p>Steelcase has shown discipline cutting costs, preserving cash, and strengthing the corporate liquidity.</p>
<p>At quarter-end, the company had a total of $55 million in cash, up about $3 million sequentially, while reducing outstanding borrowing on the corporate credit line by $48 million. With the sale of the aircraft fleet, plus internally generated cash, management expects to reduce short-term debt to near zero by the end of 4Q. That will leave a $445 million long-term obligation, due in 2029, as the only outstanding debt.</p>
<p>The debt/EBITDA ratio is currently about 2.9x, or about 2x of net debt/EBITDA. Investors would like to see share repurchases with the stock currently below $7. We would be more comfortable with repurchases when debt/EBITDA falls to or below 2x.</p>
<h2>INVESTMENT THESIS</h2>
<p>Water Tower Research does not make recommendations or establish price targets. We can provide information on the valuation as well as our commentary on results, outlook, and the quality of the company. We would note that the office furniture names have become cyclical stocks since 2000 and the end of the dot-com bubble. We observe that they typically outperform during economic recoveries at the inflection point when aggregate corporate profits begin to recover. They bottom as the economy enters recession and the outlook is most challenging.</p>
<p>Below we examine the SCS price on metrics we believe may be important to value-oriented investors: EV/GAAP EBITDA and Price to Book Value.</p>
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<h2>RESULTS &amp; FINANCIAL MODEL</h2>
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<h3>DISCLOSURES</h3>
<p>Water Tower Research (“WTR”) is a professional publisher of investment research reports on public companies and, to a lesser extent, private firms (“the Companies”). WTR provides investor-focused content and digital distribution strategies designed to help companies communicate with investors.<br><br>WTR is not a registered investment adviser or a broker/dealer nor does WTR provide investment banking services. WTR operates as an exempt investment adviser under the so called “publishers’ exemption” from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940. WTR does not provide investment ratings / recommendations or price targets on the companies it reports on. Readers are advised that the research reports are published and provided solely for informational purposes and should not be construed as an offer to sell or the solicitation of an offer to buy securities or the rendering of investment advice. The information provided in this report should not be construed in any manner whatsoever as personalized advice. All users and readers of WTR’s reports are cautioned to consult their own independent financial, tax and legal advisors prior to purchasing or selling securities.<br><br>Budd Bugatch and Rex Henderson, CFA who are the writers of this report, covers the Consumer Hardlines sector for WTR. Mr. Bugatch and Mr. Henderson, CFA including members of their household have no personal or business-related relationship to the subject company other than providing digital content and any ancillary services WTR may offer.<br><br>Unless otherwise indicated, WTR intends to provide continuing coverage of the covered companies. WTR will notify its readers through website postings or other appropriate means if WTR determines to terminate coverage of any of the companies covered.<br><br>WTR is being compensated for its research by the company which is the subject of this report. WTR receives no more than a maximum of $10,500 per month from a given client and is required to have at least a 6-month commitment. None of the earned fees are contingent on, and WTR’s client agreements are not cancellable for the content of its reports. WTR does not accept any compensation in the form of warrants or stock options or other equity instruments that could increase in value based on positive coverage in its reports.<br><br>WTR or an affiliate may seek to receive compensation for non-research services to covered companies, such as charges for presenting at sponsored investor conferences, distributing press releases, advising on investor relations and broader corporate communications and public relations strategies as well as performing certain other related services (“Ancillary Services”). The companies that WTR covers in our research are not required to purchase or use Ancillary Services that WTR or an affiliate might offer to clients.<br><br>The manner of WTR’s research compensation and Ancillary Services to covered companies raise actual and perceived conflicts of interest. WTR is committed to manage those conflicts to protect its reputation and the objectivity of employees/analysts by adhering to strictly-written compliance guidelines.<br><br>The views and analyses included in our research reports are based on current public information that we consider to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness, timeliness, or correctness. Neither we nor our analysts, directors, officers, employees, representatives, independent contractors, agents or affiliate shall be liable for any omissions, errors or inaccuracies, regardless of cause, foreseeability or the lack of timeliness of, or any delay or interruptions in the transmission of our reports to content users. This lack of liability extends to direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, losses, lost income, lost profit or opportunity costs.<br><br>All investment information contained herein should be independently verified by the reader or user of this report. For additional information, all readers of this report are encouraged to visit WTR’s website www.watertowerresearch.com.</p>

KEY POINTS

We are updating our earnings estimates and reflecting on the outlook for Steelcase following its 3QFY23 earnings call. Though adjusted EPS beat our published estimate, we cut our outlook for 4QFY23 and 1HF24. Management commentary and a challenging economic environment prompt these cuts.
We expect the next six to 12 months to remain challenging. Notably, Steelcase confronted the challenges by lowering costs, recapturing margin by pricing actions, and diversifying its customer base into adjacent markets.
The benefits of the first two efforts are visible now in the P&amp;L. Operating expenses fell to 25.2% of revenue, lower Y/Y and sequentially. Gross margin was 28.8%, up 120 bps Y/Y, although about ~30 bps lower sequentially.
Steelcase also launched initiatives to diversify the customer base into the education, consumer, and mid-market office furniture markets. These are long-term efforts but essential to a company experiencing a secular decline in the core business.
On its earnings call, CEO Sara Armbruster speculated that the core North American office furniture market may be ~20-25% smaller than the 2019-2020 pre-pandemic market, after it recovers from current volatility. The company declined to define that market or quantify the impact. We estimate it could represent $500 million-plus in SCS sales.
We now model our 4Q revenue estimate at the mid-point of guidance and non-GAAP (adjusted) EPS near the low end of guidance. With low beginning backlogs, we reduced full-year FY24 EPS estimate to $0.55 from $0.90. We are modeling continued pressure on orders through the first half, with modest recovery in the second.

ESTIMATES

COMPANY OVERVIEW
Steelcase is one of America’s great companies. Named 15 times by&nbsp;Fortune Magazine&nbsp;as one of the world’s most admired companies, Steelcase is a global market share leader for commercial/contract furniture. Its global capabilities and research-based approach make it a preferred partner for organizations in any part of the world.
Steelcase defines its purpose as “unlocking human promise by transforming work, worker and workplace.” In this way, the company affirms its mission to the workplace. Today, the company’s family of brands includes Steelcase®, Coalesse®, Designtex®, Smith System®, AMQ®, Turnstone®, and Orangebox®.
The Steelcase growth strategy is to translate research-based insights into products, applications, and experiences. Today, Steelcase goes to market through ~800 independent and company-owned dealer locations (~400 in its Americas segment, ~340 in its EMEA segment, and ~60 in its Other segment). The company has 65 locations in 17 countries, 15 of which are dedicated to manufacturing (seven in the Americas, five in EMEA, and three in the Other segment).
COMMENTARY
Steelcase reported a 3QFY23 quarter that met expectations and fit comfortably within prior guidance. The outlook remains pressured.
Near-term orders are slowing due to recession fears, pressure on corporate profits, and corporate executives’ reluctance to commit capital on office furniture investments at a time when resources are tight and the future role of the office appears in flux.
Post-pandemic, supply chain disruptions, and inflation/pricing actions of the past three years, the base size of the office furniture industry will be inevitably smaller. The implications for Steelcase are profound. But we found the Steelcase response and openness about the challenge encouraging.
As a hypothetical, CEO Sara Armbruster said that the office furniture industry could be 20-25% smaller than the pre-pandemic industry after the effects of all the buffetting settle. Ms. Armbruster did not intend for investors to use that percentage drop range as a prediction, but rather an illustration of the reality facing Steelcase, one of the several dominant firms in the enterprise-size office furniture market.
She enumerated several strategies to address the environment, including:

Lead the industry in hybrid office design and transformation,&nbsp;which plays on Steelcase’s design and product innovation expertise. In addition, Steelcase is transforming the way it engages with customers. Management is redeploying sales resources to more promising markets. Customer contact is being decentralized, away from the Grand Rapids campus and toward more local, regional, and virtual engagement.

A corollary to that decentralization is the intended sale of the company’s aircraft fleet and closing of its aviation division. Customers are less willing to travel, post-pandemic. The jets nearly exclusively ferried corporate customers and designers to the Grand Rapids campus. Management will pay off attendant debt ($33 million in term debt due in May 2024), recoup and redirect ~$11 million annual operating expenses, and regain cash capital after the sale of the aircraft.


Diversify the customer base to adjacent markets.&nbsp;Steelcase sees opportunities in (1) education, (2) home office furniture through the online Steelcase store and through retail partners (notably West Elm and Best Buy), and finally (3) addressing mid-market companies and communities more intensely.
Increase margins and profitability.&nbsp;This strategy is already in place the fruits have begun to show. Price increases have started to offset the effects of material, labor, and input inflation. In 3Q, pricing exceeded the inflation impacts by about $55 million, the second consecutive quarter of price-cost improvement. Gross margin improved by 120 bps. Steelcase continues to focus on cost-out strategies, both short and long term.

Our “back-of-the-envelope” guess pegs the impact of a shrinking office furniture market on Steelcase in the $500 million-plus range, or 20-25% of the Americas segment, a $2.6 billion business in 2020. The initiatives in adjacent markets have been positive and encouraging. Management states that the Smith Systems furniture for K-12 has more than doubled in size over the past three years. The retail partnerships have been growing. The mid-market order trend is improving, but much smaller, and there is entrenched competition in this arena.
For the intermediate term, we are taking a cautious approach. Top-line improvement over the next 12-18 months depends on the length and depth of a recession, and the speed and urgency of the return to office (which has been disappointing over the past year). We think it is prudent to take a wait-and-see approach to those unknowns.
Our revised estimate for FY24 assumes a 4.2% decline in total revenue. On profitability, we give the company credit for gross margin and cost-out efforts, modeling a 2.7% operating margin versus 1.6% in FY23. A full model is below.
LIQUIDITY AND BALANCE SHEET
Steelcase has shown discipline cutting costs, preserving cash, and strengthing the corporate liquidity.
At quarter-end, the company had a total of $55 million in cash, up about $3 million sequentially, while reducing outstanding borrowing on the corporate credit line by $48 million. With the sale of the aircraft fleet, plus internally generated cash, management expects to reduce short-term debt to near zero by the end of 4Q. That will leave a $445 million long-term obligation, due in 2029, as the only outstanding debt.
The debt/EBITDA ratio is currently about 2.9x, or about 2x of net debt/EBITDA. Investors would like to see share repurchases with the stock currently below $7. We would be more comfortable with repurchases when debt/EBITDA falls to or below 2x.
INVESTMENT THESIS
Water Tower Research does not make recommendations or establish price targets. We can provide information on the valuation as well as our commentary on results, outlook, and the quality of the company. We would note that the office furniture names have become cyclical stocks since 2000 and the end of the dot-com bubble. We observe that they typically outperform during economic recoveries at the inflection point when aggregate corporate profits begin to recover. They bottom as the economy enters recession and the outlook is most challenging.
Below we examine the SCS price on metrics we believe may be important to value-oriented investors: EV/GAAP EBITDA and Price to Book Value.


RESULTS &amp; FINANCIAL MODEL






DISCLOSURES
Water Tower Research (“WTR”) is a professional publisher of investment research reports on public companies and, to a lesser extent, private firms (“the Companies”). WTR provides investor-focused content and digital distribution strategies designed to help companies communicate with investors.  WTR is not a registered investment adviser or a broker/dealer nor does WTR provide investment banking services. WTR operates as an exempt investment adviser under the so called “publishers’ exemption” from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940. WTR does not provide investment ratings / recommendations or price targets on the companies it reports on. Readers are advised that the research reports are published and provided solely for informational purposes and should not be construed as an offer to sell or the solicitation of an offer to buy securities or the rendering of investment advice. The information provided in this report should not be construed in any manner whatsoever as personalized advice. All users and readers of WTR’s reports are cautioned to consult their own independent financial, tax and legal advisors prior to purchasing or selling securities.  Budd Bugatch and Rex Henderson, CFA who are the writers of this report, covers the Consumer Hardlines sector for WTR. Mr. Bugatch and Mr. Henderson, CFA including members of their household have no personal or business-related relationship to the subject company other than providing digital content and any ancillary services WTR may offer.  Unless otherwise indicated, WTR intends to provide continuing coverage of the covered companies. WTR will notify its readers through website postings or other appropriate means if WTR determines to terminate coverage of any of the companies covered.  WTR is being compensated for its research by the company which is the subject of this report. WTR receives no more than a maximum of $10,500 per month from a given client and is required to have at least a 6-month commitment. None of the earned fees are contingent on, and WTR’s client agreements are not cancellable for the content of its reports. WTR does not accept any compensation in the form of warrants or stock options or other equity instruments that could increase in value based on positive coverage in its reports.  WTR or an affiliate may seek to receive compensation for non-research services to covered companies, such as charges for presenting at sponsored investor conferences, distributing press releases, advising on investor relations and broader corporate communications and public relations strategies as well as performing certain other related services (“Ancillary Services”). The companies that WTR covers in our research are not required to purchase or use Ancillary Services that WTR or an affiliate might offer to clients.  The manner of WTR’s research compensation and Ancillary Services to covered companies raise actual and perceived conflicts of interest. WTR is committed to manage those conflicts to protect its reputation and the objectivity of employees/analysts by adhering to strictly-written compliance guidelines.  The views and analyses included in our research reports are based on current public information that we consider to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness, timeliness, or correctness. Neither we nor our analysts, directors, officers, employees, representatives, independent contractors, agents or affiliate shall be liable for any omissions, errors or inaccuracies, regardless of cause, foreseeability or the lack of timeliness of, or any delay or interruptions in the transmission of our reports to content users. This lack of liability extends to direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, losses, lost income, lost profit or opportunity costs.  All investment information contained herein should be independently verified by the reader or user of this report. For additional information, all readers of this report are encouraged to visit WTR’s website www.watertowerresearch.com.

Steelcase Confronts Challenging Office Furniture Market with Cost Cuts, Margin Improvement, Cash Preservation, and Market Diversification

Steelcase Inc Cl A

Steelcase Confronts Challenging Office Furniture Market with Cost Cuts, Margin Improvement, Cash Preservation, and Market Diversification