4.23.12 | St. Petersburg, FL | Raymond James & Associates, Inc. analyst Budd Bugatch reaffirmed a “Strong Buy” rating on Knoll, Inc. following the company's first-quarter 2012 earnings release and conference call. He cited better-than-expected operating income, year-over-year improvement in gross margin, and “encouraging” commentary by company executives.

• Before Monday's market open, Knoll reported 1Q12 EPS of $0.15, below our $0.18 estimate and the $0.20 consensus. 1Q12 EPS included a $0.03 negative impact from unrealized foreign exchange losses and a write off of deferred financing fees. Excluding those items, EPS was in line with our model.
• Total sales declined 11.0% year-over-year to $196.7 million, below our $209.8 million estimate and the $207 million consensus. Consistent with last quarter, the decline was driven by weakness in government sales activity and "reduced purchases from a single financial services client." CEO Andrew Cogan noted that commercial sales increased year-over-year excluding those two areas, though demurred to quantify the percentage growth. Management also noted that "the worst of these declines are now behind us [and] our own internal indicators are supportive of a more positive back half outlook."
• Despite the headline EPS miss, results actually beat our model by $0.01 at the operating income line, as higher gross margin (up $0.02) was partially offset by lower sales (down $0.01) and slightly higher SG&A ratio. Gross margin improved ~110 basis points year-over-year to 32.1% (above our 31.2% estimate), benefitting from pricing realization and favorable mix (presumably due to lower government and large project activity). Normalized operating income was $15.5 million (7.9% of sales), down from $21.4 million (9.7% of sales) in the prior year, but ahead of our $15.0 million (7.2% of sales) estimate.
• Drilling down, Office sales declined 14.5% year-over-year. Segment EBIT margin declined from 7.1% to 5.0%, implying a 19% contribution margin. Studio sales decreased 7.0% year-over-year; segment operating margin decreased from 15.1% to 12.0%. Coverings sales increased 7.2% year-over-year, segment operating margin declined from 19.6% to 17.9%.
• Knoll ended the quarter with $11.7 million of cash and $228 million of debt, suggesting a net leverage ratio of about 2x. The company secured a new $450.0 million bank facility that extends through 2017.
• We expected Knoll to have a difficult revenue quarter due to headwinds from declining government business (to which Knoll has the highest exposure relative to peers) and tough prior year comparisons. Nonetheless, we are encouraged by management's commentary regarding commercial activity and share the view that business is poised to accelerate in 2H12 as the company cycles the initial government declines and the domestic macro recovery gains traction.
• Shares are likely to come under pressure in Monday's trading given the revenue shortfall and headline EPS miss; however, we would characterize 1Q12 results as broadly in line with our pre-report expectations. We will have additional commentary following management's 10:00 a.m. (EST) conference call.

KNL: 2H12 Story Still On Track; Reaffirm Strong Buy

• Recommendation: We reaffirm our Strong Buy rating on Knoll while adjusting estimates following its mixed, but generally in-line 1Q12 EPS release and management's conference call. While 1Q12 revenue missed our model, sales declines were expected given tough comparisons and lower government project demand. Importantly, despite lower sales, Knoll delivered better than expected operating income driven by gross margin improvement and disciplined expense management. Looking ahead, we were encouraged by CEO Cogan's upbeat comments that internal leading indicators trended higher and strengthened through the quarter, which increases our confidence that sales will re-accelerate in 2H12 as comparisons ease. In the meantime, we find shares attractively valued, trading at ~13x forward EPS (versus its ~7 year median forward P/E of 16x).
• Event: 1Q12 sales light; operating income beats. As detailed in an earlier note, Knoll reported 1Q12 EPS of $0.15, $0.03 below our $0.18 estimate (consensus was $0.20). Total sales declined 11.0% year-over-year to $196.7 million - below our $209.8 million estimate (consensus was $207 million). Results beat our model at the operating income line by $0.01 driven by better gross margin; unrealized foreign currency losses and other items were a $0.03 drag below the operating line.
• Conference call commentary encouraging. Excluding government business and a decline related to a single financial services client, commercial sales increased a low single digit percentage. Leading indicators of demand (including client visits, mock-ups, etc.) trended higher by a double digit percentage- strengthening as the quarter progressed and accelerating in March. The company believes 1Q12 will mark the trough for shipments, anticipating sequential improvement (though still down year-over-year) in 2Q12. Knoll believes improving macro trends, strength from internal indicators, and easier comparisons support a positive view for the second half of 2012.
• Estimates: We are reducing our FY12 EPS estimate from $1.10 to $1.05, as the 1Q12 headline miss and a reduction to our 2Q12 estimate are partially offset by a modest increase to 2H12. 2Q12 goes from $0.27 to $0.24 driven by a lower revenue estimate, offset partially by better gross margin. We assume 2Q12 SG&A of $53 million, reflecting higher expenses related to the NeoCon trade show and the launch of the ReGeneration chair. FY13 goes from $1.30 to $1.25.
• >Valuation: Our $19 price target (unchanged) is based on our EVA/FCF-derived estimate of intrinsic value and represents ~15x our FY13 EPS estimate (roughly in line with historic norms).