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Tuesday, February 2, 1999

An Investment Opinion
by Warren Gump

Comparing Furniture Makers

Assembly required. Two words that strike fear in the furniture aisle of any discount store. Past experiences with these products likely conjure some type of nightmarish experience. Figuring out how to lug the 80-pound box from the store into your home or apartment. Trying to interpret instructions and diagrams that are poorly written. Assembling three-fourths of a bookshelf, only to realize that you mixed up the top and bottom panel and need to start over. Having strewn the various pieces of a home entertainment center across your home only to learn that a screw or connecting joint is missing. Does anyone remember how sore your arms were after twisting in 85 screws? Arghh!

Despite those drawbacks, it's hard not to notice that more and more of this ready-to-assemble (RTA) furniture is popping up in stores. You see it at Wal*Mart (NYSE: WMT), Home Depot (NYSE: HD), Costco (Nasdaq: COST), Office Depot (NYSE: ODP) and even Sears (NYSE: S). While I don't have any hard statistics, it seems as if an increasing amount of space is being devoted to these stores. Part of the reason for this raised prominence is the emergence of home offices, which need to be filled with some furniture. Because of reasonable prices and an increasing array of attractive decorative features, RTA is filling the bill.

The three largest companies in the business are Sauder Woodworking, O'Sullivan Industries (NYSE: OSU), and Bush Industries (NYSE: BSH). Sauder, the largest manufacturer, is a privately held company based in Archbold, Ohio. It's always disappointing when a category leader isn't publicly traded, but there are still two more players. Which one of the two remaining players is a more attractive investment option? I find O'Sullivan to be the more compelling story for the reasons outlined below.

Beyond having a larger industry presence, the earnings outlook for O'Sullivan is much brighter. The company is already showing signs of recovering from a mild earnings downturn last year, whereas Bush is still experiencing a severe earnings squeeze. For the December quarter, O'Sullivan has already reported that earnings per share (EPS) increased 45% to $0.29 in the December quarter. After a December warning, analysts expect that Bush will earn $0.09 per share, down 79%. To be fair, O'Sullivan's prior year results were depressed, but the December 1998 results are still a couple of pennies ahead of those reported in December 1996.

The weakness in December 1997 was caused by lower than expected sales, as well as the rollout of new software and equipment at a factory. The recent earnings report suggests both of these problems have been resolved (sales were up 14% and gross margin increased to 28.7% from 27.3%). Analysts currently expect O'Sullivan to post earnings of $1.21 in calendar 1999, resulting in a price/earnings (P/E) ratio a bit under 13x. Long term growth is estimated at about 15%.

Bush's current problems sound eerily similar to those experienced by O'Sullivan, but more severe. Slower than expected revenue growth has been compounded by manufacturing issues at a recently acquired manufacturing facility. Revenue growth was up 23% because of acquisitions, but gross margin dropped to 27.0% from 29.3% and earnings plunged 81% to $0.07 from $0.36. Analysts expect earnings to continue falling for the next two quarters with a rebound in the latter half of 1999. While the stock is trading just under 11x current First Call estimates for 1999, those projections are more tenuous since they incorporate a turnaround that is not assured.

Investors should never stop at the income statement when looking at a company. Key information is also available on the balance sheet and statement of cash flows. Bush's October 3, 1998 balance sheet shows long-term debt of $125.6 million and shareholders equity of $122.8 million, resulting in a debt/equity ratio a tad over 1.0x (125.6/122.8).

While not absurdly high, I prefer seeing the number a little lower when a company is in a somewhat cyclical industry. (Yes, the furniture business -- even if the product category is relatively cheap -- is still cyclical.) In comparison, O'Sullivan has a fairly low debt/equity ratio of 0.2x based on its September 30, 1998 balance sheet shows debt of $39 million and shareholder's equity of $166.7 million. O'Sullivan definitely has a more favorable financial structure for investors.

I also checked out two balance sheet statistics for each company, days sales in inventory and days sales in receivables, to measure the efficiency with which working capital is managed. O'Sullivan had 51 days sales in inventory whereas Bush had a slightly higher 55 days. Both companies appear to maintain inventories at similar levels.

On the receivables front, however, O'Sullivan has a quite high 70 days sales in receivables, while Bush has a much more reasonable 38 days. I checked into this statistic further since they were so divergent. In the comparable prior year quarter, O'Sullivan had 73 days sales in receivables and Bush had 48 days. Both companies showed improvement, although Bush's was more impressive. O'Sullivan's reduction of this number over the past year alleviated some of my concern that its receivables were so high relative to sales.

Reading O'Sullivan's 10-K, I learned a probable reason for the high level of receivables. The company's top five customers account for about 58% of sales. In fact, its two largest customers, OfficeMax (NYSE: OMX) and Office Depot (NYSE: ODP), account for 20.1% and 11.6% of sales, respectively. Significant business with such powerful retailers likely means that O'Sullivan grants generous credit terms. Such a strategy is fine, but there is increased risk if one of those companies encounters financial problems.

Moving over to the cash flow statement, O'Sullivan has better operating cash flow than Bush. Through the first nine months of 1998, Bush had negative cash flow of $9 million. During the same period, O'Sullivan's operating cash flow was a positive $26.9 million. The biggest cause for this difference was a much higher investment in inventory for Bush.

Considering the various company characteristics described above, I believe O'Sullivan to be the better investment option. While its P/E multiple on 1999 estimates is slightly higher at 13x compared to 11x for Bush, O'Sullivan has a much stronger balance sheet. Because of this, O'Sullivan will have much more flexibility to address unforeseen opportunities and problems. Also noteworthy is the fact that O'Sullivan is reporting rising earnings, while Bush's earnings are falling. Obviously, investors tend to prefer placing their money into companies where earnings and cash flow are rising.

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