FLXS: A Furniture Net-Net

There are few industries worse than the furniture business right now. Retailers are closed. There is massive unemployment. Who is thinking, “Let’s make a large, highly discretionary, easily postponable expense!”

Hence the opportunity in Flexsteel, a 126 year-old furniture manufacturer based in Iowa. Sales are probably down 80-90% right now, and they will be burning cash until demand returns.

The company had already been burning cash through 2019 due to a series of restructurings. They rationalized SKUs and shut down facilities with low utilization. Inventory was written down. Flexsteel has also been fixing a disastrous SAP implementation which burned close to $100 million (yes, the market cap is currently $70 million).

The old management team rode a few product winners to new heights in the 2012-2016 period but left the pipeline dry. They compounded this with the flubbed the ERP implementation. The result of these miscues is the stock is down about 85% from the peak and is trading at 2009 levels.

On the bright side, the company hired a new management team. The new CEO’s primary experience is from a rival furniture manufacturer called HNI. He wrote an annual letter which outlined some ambitious goals. And insiders are even buying some stock.

The only fear: Are they moving too fast? I’m all for moving fast but it came at a large cash cost. Was it necessary to hire Alix Partners? Perhaps I’m just too cheap and short-sighted (I am a net-net investor after all). Regardless, after all the restructuring and cash costs, the core business was on the cusp of profitability.

And then the pandemic struck. Now the question is how much cash will they burn this year before demand comes back? The company is hunkering down. My estimate is that they could burn $30 million this year if demand comes back slowly. So by the end of the year, it goes from a 60% net-net to a 100% net-net. Still cheap, but then we’ll have to worry about 2021.

However, it seems like a company that will last. It’s been around forever. People talk about Flexsteel on BIFL forums on Reddit. It’s not the highest end, but they are known for making decent furniture.

When the dust settles, they should have a leaner operation. They will have flexible sourcing, manufacturing, and distribution. They will have an omni-channel presence. At their goal of 7% margins, this company is trading at about 3x earnings.

With that said, this one is not without risk. It could be down a decent amount in 1-2 years. But it’s a net-net. The odds are good it will be worth more, perhaps much more.

KTCC: An EMS Net-Net

Electronic manufacturing service companies like Key Tronic are frequent guests on Net-Net lists. They have razor thin margins, are asset heavy, and have all the hallmarks of a terrible business.

But things aren’t quite as bad as they seem. EMS companies add value by enabling customers to outsource their manufacturing. Because manufacturing is a core competency and they have scale, they can manufacture at lower costs than the customer can themselves. The key for the EMS companies is to turn the assets fast enough, keep costs low, and not do any bone-headed projects. If following the above rules, companies can churn out relatively consistent profits and even a decent ROIC.

Their balance sheets are usually quite good. They don’t typically have inventory risk due to price-protection or other agreements with suppliers. These agreements enable the company to sell the inventory back to the manufacturer should end demand for the product go awry. The receivables are usually safe since they are working with larger customers.

Key Tronic fits the model of a typical EMS player. It is on the smaller side so doesn’t have the scale to compete with the larger players for the big programs. But it does have the capability of manufacturing a wide range of products from consumer electronics to industrial equipment to fitness equipment.

Key Tronic has missed numbers the past few years and underperformed due to various reasons including program losses and China tariffs. Earnings recently haven’t been good and are there will be puts and takes with the recent pandemic. One customer represents 17% of sales per their last 10-K. As a result, KTCC currently trades at roughly 90% of net-current-asset-value and 42% of tangible book.

It’s not all terrible. The company has diversified facilities in China, Vietnam, and Mexico. When the company normalizes, it could achieve its stated ROE goal of 10%+, a number it has hit in the past. This upside case would imply a P/E of about 4x.

The main risk appears to be management. Craig Gates has been with the company for 25 years and CEO for 11. He owns a relatively modest 2% of the company. Under his tenure, operating results have been mixed, with plenty of disappointing quarters relative to guidance.

Capital allocation has been questionable. They don’t pay a dividend or repurchase shares. In 2014, the company paid $48 million in cash for an acquisition yet the total market cap of Key Tronic is about $47 million today. These decisions appear terrible in retrospect. While it may not be fair to assess total blame on management, this may be enough to pass on the investment here.

On the positive side regarding management, the key metric they are compensated on is ROIC relative to peers. This is a lot better than most alternatives.

Overall, I believe tangible book should be relatively steady, and should be increasing over time. It’s not crazy for this business to earn a decent ROIC over time (as it has in the past), and if there is some normalization, the stock should be worth at least it’s tangible book value.

This stock is relatively low risk, and might be worth trying to squeeze a puff. But I’d sleep better if I felt better about management.