According to research from IBISWorld, the U.S. office-furniture manufacturing industry has contracted by a compound annual growth rate of 4.1% from 2008 to 2013. Manufacturers like Herman Miller (NASDAQ:MLHR), HNI (NYSE:HNI), and Knoll (NYSE:KNL) have revenues in the billions, but they have not fared well either. Their absolute size and well-known brands don't seem to have helped them against the onslaught of low-cost importers from Asia.
The results speak for themselves; the profitability of the office-furniture manufacturers has fallen off a cliff over the past few years. Herman Miller's 2013 return on invested capital of 10.5% is almost one-quarter of its 2008 peak ROIC of 38.5%, while HNI has seen its ROIC halve from 13.8% to 7.2%. For Knoll, the smallest of the three, its fiscal 2012 ROIC of 12.1% is more than a notch down from its 2008 ROIC of 18.1%.
Big, but not bigger
A company's size relative to its competitors has a bigger impact on profitability than absolute size. While the listed office-furniture players generate revenues in excess of $1 billion dollars each year, they are not that much larger relative to each other and their non-listed peers.
The U.S. office-furniture market, estimated at $23 billion, is very fragmented, with more than 3,800 companies. None of the publicly traded office-furniture manufacturers have more than 15% market share, and no single office-furniture company enjoys any significant cost advantage over its peers. For example, HNI and Herman Miller generate revenues about double that of Knoll, but all three companies achieve similar gross margins in the 33%-34% range.
To understand the lack of a disparity in gross margins, let's look at steel, a key raw material in the manufacturing of office furniture. Since steel is used in a wide variety of applications, and the quantity of steel that the office-furniture manufactures purchase is small relative to the entire steel industry output, office-furniture manufacturers have relatively little bargaining power when it comes to steel prices.
Similarly, when it comes to research and development spending, the bigger office-furniture makers don't realize any cost efficiencies by spreading their R&D costs over a larger revenue base. Both Herman Miller and HNI generate close to or about $2 billion in revenues annually; but Herman Miller reinvests 2.7% of its sales in R&D, while HNI's R&D expenses represent only about 1.3% of its top line.
Great brands matter only if...
Brands by themselves are rarely competitive advantages, unless customers are willing to pay more or actually buy the products more often. Neither seems to be the case with office-furniture brands.
In the December 2012 issue of the Contract Magazine Brand Report, Herman Miller was named as the top company and brand ahead of Knoll in the second spot. The most number of respondents among 355 surveyed working at architectural or design companies picked Herman Miller as the company whose brands inspire them to create their best commercial- design solutions. This should lead to the conclusion that Herman Miller should be able to charge a price premium for its products.
However, the financial numbers tell a different story. Based on trailing-12 months data from Morningstar, both Herman Miller and Knoll delivered identical gross margins of 32.7%.
The office-furniture manufacturers also place a strong emphasis on innovation, given that new product innovation is key in maintaining brand equity. For example, Knoll won an innovation award at NeoCon, a national industry trade show for Antenna Workspaces, a unique workplace design that it developed. In May, HNI disclosed at its annual shareholder meeting that it has launched more than 70 new products in the past 18 months.
However, unlike the iPhone, customers aren't likely to be motivated to buy a new office chair just because it is the latest model. An average office chair lasts for between seven to 15 years, depending on the warranty period. In fact, since a designer from Herman Miller invented the office cubicle in 1967, innovation in office furniture has been more evolutionary rather than revolutionary, something to be expected of a mature industry like office furniture.
Foolish final thoughts
Big companies build great brands that are instantly recognizable to their customers, making their products the undisputed choice. This sounds good on paper, but this is just one of many fallacies that investors have fallen into. The large variability in profit margins and the low barriers to entry represent the best evidence that absolute size and brands aren't competitive advantages in the office-furniture industry.