2.2.15 | St. Petersburg, FL | Raymond James & Associates analysts, reporting on BIFMA's December 2014 market statistics, again cautioned investors not to get overly bullish/bearish on the basis of one month's data. "Although the recent BIFMA order and shipment statistics have been trending in the right direction, the month-to-month volatility has been notable.... Our belief, as we have discussed in past notes and reinforced by the recent volatility in the numbers, is that the contract office furniture industry is becoming lumpier. This inherently makes sense, given that there has been a shift in the industry towards more project-based business, and the timing of large projects entering the order book can influence the monthly figures."

Analyst(s): Budd Bugatch, Bobby Griffin, David Vargas

>On Monday evening, the Business and Institutional Furniture Manufacturers Association (BIFMA) released its market statistics for December 2014. The month's order and shipment statistics were derived from a sampling of 33 companies in the contract office furniture industry, the combined shipments of which account for ~77% of industry volume.

>BIFMA estimates that December orders increased 13% year-over-year, a notable increase from November's ~-1% order decline. The prior-year hurdle for December was ~100 basis points (bp) easier relative to November (December 2013 orders increased 3% versus a 4% increase in November 2013). Thus, on a two-year stacked basis, December order growth was ~1,300 bp stronger relative to November. December orders increased 2.5% sequentially, more than the normal seasonal trends (the 20-year median November to December percentage change has been down ~4%). Positively, trailing-12-month (TTM) orders totaled $9.76 billion, ~3.8% above the prior year. TTM orders are ~28.9% above the February 2010 $7.57 billion trough.

>According to BIFMA, December shipments increased 13% year-over-year, up from the +4% y/y shipment change reported last month. The prior-year comparison for December was ~600 bp easier relative to November (December 2013 shipments decreased 3% versus a 3% increase in November 2013). Consequently, the two-year stacked shipment growth rate for December 2014 increased ~300 bp to ~10% from ~7% in November 2014. TTM shipments totaled $9.78 billion, up 4.5% year-over-year and ~28.3% above the April 2010 trough of $7.62 billion.

>Thoughts on December BIFMA numbers: Although the recent BIFMA order and shipment statistics have been trending in the right direction, the month-to-month volatility has been notable. Not surprisingly, December's report continued that trend, with double digit year-over-year order and shipment growth. Although December's orders were significantly above our pre-report expectations (orders of ~$778 million, up ~5% year-over-year), we again caution investors not to get overly bullish/ bearish on the basis of one month's data. Our belief, as we have discussed in past notes and reinforced by the recent volatility in the numbers, is that the contract office furniture industry is becoming lumpier. This inherently makes sense, given that there has been a shift in the industry towards more project-based business, and the timing of large projects entering the order book can influence the monthly figures. Furthermore, our pre-report expectations are calculated from a 20-year median of sequential changes. While the methodology seems reasonable as an attempt to guess one month's orders, it is also highly prone to surprise (and variability depending on the number of years analyzed).

>Irrespective of the month to month volatility, we continue to believe the overall health of the industry is improving and the recent earnings release/forward outlook from Steelcase (+8% y/y Americas' backlog growth and 7-10% organic growth guidance) broadly supports that thesis. In addition, December's ~3.8% TTM order growth is the strongest trailing 12-month order growth since March 2012. Accordingly, we remain positive about the long-term fundamentals of the office furniture industry. Given the shift during calendar 2013 and 2014 toward more "project"-based business, we are not entirely surprised by some of the month-to-month variability in the BIFMA numbers. We suspect this "shift" will remain in 2015. Positively, the major disruption industry participants experienced earlier in the year with customers taking a longer time in the "planning process" may be normalizing. In addition, several of the public companies have commented that project sizes, while still large, are smaller (~$1 to $3 million) than they had been earlier in the recovery, illustrating a stronger/healthier recovery.

>On balance, we continue to believe the industry has started to "turn the corner." Calendar year 2014 turned out to be a solid year for the contract office furniture industry, with orders increasing 3.8% y/y and shipments increasing 4.5% versus the prior year. In addition, overall demand accelerated through the back half of the year and the industry is entering 2015 with nice momentum. Industry orders increased 7.4% y/y for the second half of 2014, compared to 0.3% growth for the first half of 2014 (see table below). Furthermore after offsetting improved demand from corporate customers during 2013 and the first part of 2014, Federal government demand is becoming less of a headwind as evidenced by Herman Miller's recent earnings release. On Herman Miller's fiscal second quarter earnings conference call, CEO Brian Walker mentioned GSA business (federal government business) is "growing a little bit year-over-year."

2014 BIFMA Order Growth

First Half of 2013 Orders       4,785
First Half of 2014 Orders       4,800
Y/Y Growth-First Half of 2014   0.3%

Second Half of 2013 Orders       4,615
Second Half of 2014 Orders       4,955
Y/Y Growth- Second Half of 2014  7.4%

Full Year 2014 Y/Y Growth        3.8%

>Using the same (admittedly flawed) sequential methodology and looking ahead, the 20-year median change in orders from December to January has been roughly -13%, which would imply January 2015 orders of ~$721 million (up ~15% year-over-year versus January 2014 orders of $625 million). The previous year-over-year percentage change in orders for January is -3%,

>We characterize most of the industry's key drivers as positive or improving. Moving into 2015, real job growth continues to be one of the questions facing the industry. Overall job growth has been positive since October 2010, but the trend has been choppy and the gains modest. Ongoing improvements in employment in 2015 should continue to benefit industry demand. Overall, corporations are experiencing near-record levels of profitability (based on the Bureau of Economic Analysis data). This should also benefit the industry moving forward, as long as the macro and geopolitical environments do not drastically deteriorate.

>Additionally, while the absolute level of office construction remains depressed, trends have stabilized (following a roughly 50% peak-to-trough decline based on Census Bureau data) and are beginning to slowly improve. December 2014 (the most recent data) office construction spending (not seasonally adjusted) improved ~21.2% y/y and the trailing-12-month office construction spending trend improved ~18.9% y/y in December. Trailing-12-month office construction spending has been positive for twelve consecutive months. The Architects' Billing Index - which we believe leads non-residential construction by 8-13 months - increased in December to 52.2 from 50.9, nicely above 50.0, the line of demarcation between expansion and contraction.

>According to Reis, net office space absorption was positive by ~33.5 million square feet in 2014, and is forecast to continue to slowly improve going forward (Reis is currently forecasting ~48.6 million square feet of net office space absorption in 2015, followed by ~58.9 million in 2016). Vacancy rates peaked in 1Q11 and have begun to tick lower, but remain elevated relative to history. This should support continued office churn, as corporations move and/or consolidate space, taking advantage of favorable lease rates and motivated landlords.

>On December 02, 2014, BIFMA released an update to its 2014/2015 forecast that is prepared for the trade association by IHS (formerly the Global Insight forecast). At the time, BIFMA forecasted that 2014 orders and shipments would grow by 3.6% and by 3.7%, respectively. In addition, BIFMA expects 2015 orders and shipments to increase 4.2% and 4.0%, respectively.

>While we respect the consumption-based methodology used by IHS to develop the current and next year forecasts, industry participants and observers have learned to not put too much weight on the point estimates since the track of the forecasts typically look significantly higher at the left axis than at the middle or right - at least until we get into the current year. In examining the forecast rationale, we note that the authors refer to both the fact that they forecast modest GDP and employment growth near-term without much help from price and/or investment in healthcare and/or commercial structures. The IHS model does not account for vacancy rates though the authors note an "upside risk" to the forecast due to the high vacancy rates. In its commentary, the authors also provide pessimistic (recovery stalls) and optimistic (recovery reignites) scenarios (15% probability each)

>We would point out to our readers that the current forecast for orders for 2015 now only assumes a slight acceleration in growth versus the actual reported number in 2014. So, while we do not place an abundance of weight on BIFMA's forecast, we would expect this forecast to be revised higher in 2015.

>We view price-to-earnings multiples for Steelcase, Herman Miller, and Knoll as attractive given our positive longer-term view on the cycle and prospects for higher sales and margins in coming years. Generally speaking, industry margins should benefit from favorable mix (normalizing levels of commercial versus government business), better net pricing/input costs, and improved efficiencies due to more consistent production partially offset by increasing levels of investment in product development, marketing, and other growth initiatives. Strong balance sheets and positive cash generation also seem likely to benefit shareholders through further deleveraging, dividends/stock buybacks, and tuck-in acquisitions.

>We believe office furniture is a structurally attractive industry for investors. Collectively, the four publicly-traded manufacturers (Herman Miller, HNI Corporation, Knoll, and Steelcase) hold roughly a 60% North American market share. While the industry is highly competitive, it is largely rational. Furthermore, the industry has historically been successful at passing through pricing to recover input cost inflation. In contrast with residential furniture, office furniture has also been resistant to significant import penetration given the high degree of customization and exacting requirements of architects and building managers.

>Each of the companies we cover is well managed and of high quality, in our opinion, boasting solid balance sheets, positive cash flow, attractive operating leverage, individual competitive strengths, and somewhat differentiated strategies. Despite choppy macro conditions, we continue to believe we are in multiyear revenue and margin recovery, which bodes well for shareholder returns given the high historical correlation between industry volumes and equity performance. Our Outperform ratings on Herman Miller and Knoll reflect our long-term bullish view about the industry. Our Strong Buy rating on Steelcase, discussed below, reflects our high regard for management's domestic market share gains and determination to improve its EMEA performance during the next several years. Our Market Perform rating on HNI reflects the shares' premium valuation compared to its public office furniture peer group.