KNL: Grass Not Growing Under Knoll

This article is a reprint of my 29 July 2008 RealMoney column.

These are tough times for office furniture makers, which have seen their shares fall 20% to 50% over the last year. A difficult economic environment and poor showings from office retailers such as Office Depot (ODP) have investors worried.

Customers, on the other hand, appear relatively unfazed. Last month, Herman Miller (MLHR) kicked off earnings season with a positive surprise. Last week, HNI (HNI) and Knoll (KNL) followed suit. Only Steelcase (SCS) posted disappointing numbers.

The one that looks most attractive to me is Knoll. The company managed to grow sales by 7.5% compared with last year, and its backlog grew at an even faster 9.7% rate. The growth is significantly higher than that of the industry, which is basically flat. Andrew Cogan, Knoll’s CEO, said, “The strategy we embarked on earlier in the decade to diversify our sources of revenue and profits away from a dependence on North American systems sales and to focus on high design content businesses is paying off in a challenging macro-economic environment.”

Better still, it seems that investors haven’t fully grasped the significance of Knoll’s strategic shift. The stock, which traded at $24 little more than one year ago, rallied after the earnings report but remains well off those highs. Analysts are expecting full-year growth of just 4.1% this year and 0.8% next year, suggesting a slowdown is imminent when the backlog growth is saying exactly the opposite.

Unbought Guidance

The skepticism is so strong that while 2008 earnings estimates have gone up only 12 cents in the last 90 days, the entire increase is attributable to the positive first- and second-quarter surprises. The raised third-quarter guidance, I suppose, is free. Meanwhile, estimates for 2009 have barely moved and at $1.63 are actually lower than the 2008 estimates. So we have a stock with decent sales growth and a string of positive earnings surprises under its belt trading at a single-digit P/E. That in itself is enough to spark my interest.

That spark becomes a flame when I see that the company generated $90 million in free cash flow over the last 12 months, or 12% of the market capitalization. With Treasuries yielding just 3.4%, the 850 basis-point premium is enough to compensate me for Knoll’s risk even if the cash flow remains stagnant. The cash flow has been put to a variety of good uses, including last year’s acquisition of Teddy & Arthur Edelman Ltd. for $71 million and the return to shareholders of more than $65 million through dividends and buybacks. The share count is 2 million lower (about 4%) than it was one year ago.

As I see it, Knoll should trade at no less than 10 times free cash flow, even if the growth potential is limited. Meanwhile, I believe the cash flow can grow, possibly in line with the recent growth in backlog. Under those circumstances, I believe the market cap could be closer to $1 billion than the current $750 million. That would represent a $21 share price, or 34% appreciation from the current level.

Disclosure: At time of publication, William Trent owns shares of Office Depot (ODP)

William Trent currently has a short position in put options related to Office Depot (ODP).