Embed Size (px)
Citation preview
1
Equity Analysis and Valuation of HNI Project Team Members:
Travis Monk [email protected]
Evan Burrer [email protected]
John Fletcher [email protected]
John Knust [email protected]
Will Kerlick [email protected]
2
Table of Contents
Executive Summary ...................................................................................... 8
Industry Analysis ..................................................................................... 10
Accounting Analysis .................................................................................. 12
Financial Analysis ..................................................................................... 13
Valuation Analysis .................................................................................... 15
Company Overview ..................................................................................... 17
Industry Overview ...................................................................................... 19
Five Forces Model .......................................................................................... 22
Rivalry Among Existing Firms ..................................................................... 24
Industry Growth ...................................................................................... 24
Concentration ......................................................................................... 28
Differentiation ......................................................................................... 31
Switching Costs ....................................................................................... 32
Excess Capacity .................................................................................... 33
Economies of Scale ................................................................................ 35
Exit Barriers ......................................................................................... 36
Conclusion ........................................................................................... 37
Threat of New Entrants ............................................................................. 37
Economies of Scale ................................................................................... 38
First Mover Advantage ............................................................................... 41
Channels of Distribution and Relationships ....................................................... 41
Legal Barriers .......................................................................................... 42
Conclusion ............................................................................................. 43
Threat of Substitute Products .................................................................... 43
Relative Price and Performance .................................................................... 44
Customer’s Willingness to Switch ................................................................... 45
Conclusion ............................................................................................. 46
Bargaining Power of Customers .................................................................. 46
Differentiation ...................................................................................... 47
3
Switching costs ..................................................................................... 49
Importance of Product for Costs and Quality ............................................. 50
Number of Customers ............................................................................ 52
Volume per Customer ............................................................................ 53
Conclusion ........................................................................................... 55
Bargaining Power of Suppliers .................................................................... 56
Switching Costs ....................................................................................... 56
Differentiation ......................................................................................... 57
Importance of Product for Cost and Quality ...................................................... 57
Number of Suppliers ................................................................................. 58
Volume per Supplier .................................................................................. 58
Conclusion ............................................................................................. 59
Analysis of Key Success Factors in Industry ................................................. 59
Cost Leadership ....................................................................................... 60
Economies of Scale ........................................................................................ 60
Efficient Production Methods ......................................................................... 61
Lower Input Costs .......................................................................................... 62
Lower Distribution Costs .................................................................................. 62
Differentiation .............................................................................................. 63
Customer Service/Flexible Delivery ............................................................. 63
Investments in Research and Development .................................................. 64
Superior Product Quality/Variety ................................................................ 65
Firm Competitive Advantage Analysis ................................................................... 67
Economies of Scale ........................................................................................ 68
Efficient Production ........................................................................................ 69
Low Distribution/Input Costs ............................................................................. 70
Superior Product Quality/Variety ......................................................................... 71
Customer Service/ Flexible Delivery ..................................................................... 72
Investment in Research and Development ............................................................. 73
Conclusion ................................................................................................... 74
Accounting Analysis ........................................................................................ 75
Key Accounting Policies ................................................................................... 76
4
Type 1 Key Accounting Policies .................................................................. 77
Type 2 Accounting Policies ........................................................................ 81
Goodwill ................................................................................................. 81
Pensions/Post-Retirement Benefits ............................................................. 83
Operating and Capital Leases ..................................................................... 85
Accounting Flexibility ...................................................................................... 86
Goodwill ................................................................................................. 87
Research and Development ....................................................................... 88
Pensions/Post-Retirement Benefits ............................................................. 90
Operating and Capital Leases ..................................................................... 91
Evaluation of Accounting Strategy ....................................................................... 92
Goodwill ................................................................................................. 93
Research and Development ....................................................................... 94
Pension/Post-Retirement Benefits ............................................................... 96
Operating and Capital Leases ..................................................................... 97
Quality of Disclosure ....................................................................................... 99
Goodwill ................................................................................................. 99
Research and Development ..................................................................... 100
Pension/Post-Retirement Benefits ............................................................. 101
Quantitative Analysis .................................................................................... 102
Sales Manipulation Diagnostics ................................................................ 103
Net Sales/ Cash From Sales ....................................................................... 104
Net Sales/Accounts Receivable ................................................................... 106
Net Sales/Inventory ................................................................................ 107
Net Sales/Warranty Liabilities ..................................................................... 109
Sales Manipulation Diagnostics Conclusion ..................................................... 111
Expense Manipulation Diagnostics ............................................................ 112
Asset Turnover ...................................................................................... 112
CFFO/OI .............................................................................................. 114
CFFO/NOA ........................................................................................... 116
Total Accruals/Sales ................................................................................ 118
Expense Diagnostics Conclusion .................................................................. 119
5
Potential Red Flags ....................................................................................... 120
Goodwill ............................................................................................... 120
Operating and Capital Leases ................................................................... 121
Undo Accounting Distortions .................................................................... 121
Financial Analysis, Forecast Financials, and Cost of Capital Estimation .............. 132
Financial Analysis ..................................................................................... 132
Liquidity Ratios ......................................................................................... 133
Current Ratio ........................................................................................ 133
Quick Asset Ratio ................................................................................... 134
Working Capital Turnover ........................................................................ 136
Accounts Receivable Turnover .................................................................. 137
Days’ Sales Outstanding ......................................................................... 140
Inventory Turnover ................................................................................ 141
Days’ Supply of Inventory ....................................................................... 142
Cash to Cash Cycle ................................................................................ 144
Conclusion ............................................................................................ 146
Profitability Ratios ..................................................................................... 147
Gross Profit Margin ................................................................................. 148
Operating Expense Ratio ......................................................................... 149
Operating Profit Margin ........................................................................... 151
Net Profit Margin .................................................................................... 152
Asset Turnover ...................................................................................... 153
Return on Assets ................................................................................... 155
Return on Equity .................................................................................... 157
Internal Growth Rate .............................................................................. 159
Sustainable Growth Rate ......................................................................... 160
Conclusion ............................................................................................ 161
Capital Structure Ratios ............................................................................. 162
Debt to Equity ....................................................................................... 163
Times Interest Earned ............................................................................ 164
Debt Service Margin ............................................................................... 166
Altman’s Z-Score ................................................................................... 168
6
Conclusion ............................................................................................ 170
Estimating the Cost of Capital ..................................................................... 171
Cost of Equity ........................................................................................ 171
Size Adjusted ........................................................................................ 173
Alternative Cost of Equity ........................................................................ 174
Cost of Debt .......................................................................................... 175
Weighted Average Cost of Capital (WACC) ................................................. 176
Three Month 60 Slice Highest Adjusted R-Squared ...................................... 178
Income Statement ................................................................................. 179
Restated Income Statement .................................................................... 184
Balance Sheet ....................................................................................... 187
Restated Balance Sheet .......................................................................... 193
Statement of Cash Flows ......................................................................... 197
Restated Statement of Cash Flows ............................................................ 201
Valuation Analysis .................................................................................. 204
Method of Comparables .......................................................................... 204
P/E Trailing ........................................................................................... 204
Forecasted P/E ...................................................................................... 205
Price to Book Ratio ................................................................................. 207
Dividends to Price Ratio .......................................................................... 208
Price Earnings Growth (P.E.G.) ................................................................ 209
Price/EBITDA ......................................................................................... 210
Enterprise Value/EBITDA ......................................................................... 211
Price to Free Cash Flows (P/FCF) .............................................................. 212
Conclusion ............................................................................................ 213
Intrinsic Valuation Models .......................................................................... 213
Discounted Dividends Model .................................................................... 214
Discounted Free Cash Flow Model ............................................................. 215
Residual Income .................................................................................... 217
Abnormal Earnings Growth Model ............................................................. 221
Long Run Residual Income ...................................................................... 224
Analyst Recommendation ........................................................................... 229
7
Liquidity Ratios ...................................................................................... 232
Appendices ................................................................................................ 232
Profitability Ratios .................................................................................. 233
Capital Structure Ratios .......................................................................... 234
Goodwill Restated Financial Statements .................................................... 235
Three Month Regression .......................................................................... 236
One Year Regression .............................................................................. 239
Two Year Regression .............................................................................. 241
Seven Year Regression ........................................................................... 244
Ten Year Regression ............................................................................... 247
Methods of Comparables ......................................................................... 250
Intrinsic Valuation Models ....................................................................... 254
Work cited ................................................................................................. 263
8
Executive Summary
Investor Recommendation: Fairy Valued, HOLD (4/1/2009)
7.70-34.37 2004 2005 2006 2007 2008
2.48B Initial Scores: 7.65 6.69 5.11 4.45 3.83
682.59M Revised Scores: 9.67 3.61 4.98 4.38 3.43
44.32M
As Stated Restated
$10.13 $5.01
26.20% 20.90% AS Stated Restated
10.00% 9.60% Trailing P/E: 10.29 6.44
Forward P/E: 4.86 6.07
Dividends to Price: 0.0838 0.0838
Estimated Beta Ke Price to Book: 1.04 2.1
3-Month 1.47 12.87 P.E.G. Ratio: 3.89 3.9
1-Year 1.466 12.84 Price to EBITDA: 2.98 2.98
2-Year 1.462 12.82 EV/ EBITDA: 5.24 5.23
7-Year 1.453 12.75 Price to FCF: 10.86 10.9
10-Year 1.45 12.73
Published Beta: Stated RestatedEstimated Beta: Discounted Dividends: $7.88 N/A
Size Adj. Cost of Cap: Free Cash Flows: $4.07 N/A
Size Adj. Cost of Equity: Residual Income: $10.74 $8.77
Cost of Debt: Long Run Residual Income: $9.51 $6.16
WACC (BT): Abnormal Earnings Growth: $10.26 $9.347.30%
HNI- NYSE (4/1/2009) $10.50 Altman Z-scores
Current Market Share Price (4/1/09) $10.50
Financial Based Valuations
52 Week Range:
Revenue:
Market Capitalization:
Shares Outstanding:
Book Value Per Share:
Intrinsic Valuations
1.47
8.34%
15.56%
3.82%
1.33
Return on Equity:
Return on Assets:
Cost of CapitalR-Squared
0.2539
0.2532
0.2523
0.2516
0.2516
9
10
Industry Analysis
HNI Corporation resides as the nation’s second-largest office furniture
manufacture and America’s leading producer of hearth and gas stove appliances. With a
workforce of near thirteen thousand employees, the company firmly believes it creates
value by listening to the unique insight of each worker. Over eighty percent of HNI’s
revenue comes from office furniture sales; thus, company success is highly depended
on new office construction or renovation. As expected, the recent downturn in the
economy, especially in the real estate market, has significantly affected HNI’s core
business. While the office furniture industry depends heavily on the commercial real
estate market, HNI’s hearth product demand strongly correlates with residential real
estate trends. The main office furniture competitors for the company are Herman Miller,
Steelcase Inc., and Lennox. The industry features high price competition as well as
dependency on structured contracts with large, reoccurring consumers. HNI in
particular has made a concerted effort to expand its market shares overseas, especially
in China where products are in high demand. Still, as a result of the threat of cheap
imports, the company must continually strive to develop new methods to reduce costs.
This allows them to continue to relay on affordable prices to consumers.
To adequately analyze HNI’s business operations, its best analyze the firm’s two
industries separately. A majority of HNI’s office furniture products are sold through
multi-million dollar transactions to large corporations, wholesalers, the government, and
educational institutions. Overall, revenues are split rather evenly between commercial
and contract segments. The contract segment consists mainly of large corporations who
demand custom designed furniture that fits their business needs. Needless to say, the
office furniture market enjoys success when white collar jobs are rising because this is
when new office construction is high. The industry strongly feels the effects of steel
prices as well. Steel exists as the most significant raw material in HNI’s manufacturing
process. An overview of HNI’s office furniture industry five forces analysis may be
observed below.
11
Office Furniture Competitive Force Degree of Competition
Rivalry Among Existing Firms High
Threat of New Entrants High
Threat of Substitute Products High
Bargaining Power of Customers High
Bargaining Power of Suppliers High
While the office furniture industry competes on cost, HNI’s hearth products
compete more on differentiation due to the individualistic nature of products. A large
portion of sales are made directly to the contractors involved in new home building or
to existing homeowners who choose to remodel. This industry is seasonal (sales are
highest in the fall) and very sensitive to the condition of the housing market. Many
firms in this industry are small, privately managed companies and do not have the same
economies of scale as HNI. Therefore, HNI can dictate pricing standards as well as
trends in the hearth industry. The table below highlights the degree of competition for
HNI’s hearth products division five forces.
Hearth Products Competitive Force Degree of Competition
Rivalry Among Existing Firms Low
Threat of New Entrants Low/Moderate
Threat of Substitute Products Moderate
Bargaining Power of Customers High
Bargaining Power of Suppliers High
Key success factors for both industries include low input costs, superior product
quality, and exceptional customer service. Office furniture industry sales involve a
relatively small base of large-order consumers. To please these buyers, firms in the
industry make an effort to provide superior customers service and the best available
12
delivery options. Losing one customer alone could affect yearly sales by five percent in
some cases. With this in mind, competitors in the industry must make an effort to
ensure product quality remains high while still pricing aggressively. Firms who enjoy
large economies of scale gain an advantage in manufacturing and distributing products
at the lowest price. While the hearth products industry is less competitive than the
office furniture industry, companies are still victim to the demands of the consumers.
Just as fashions change for clothes, the designs and material components of hearths
are consistently changing. Therefore, to remain as industry leader, a firm must be
willing to adapt to consumer demand.
Accounting Analysis
An effective accounting analysis delivers the truth behind firm valuation.
Financial statements, including the balance sheet, income statement, and statement of
cash flows, give us a means of comparison between firms within an industry as well as
looking at a specific firm’s financials year-to-year. The statements can be easily found in
a company’s annual 10-k, which can either be downloaded from the corporate website
or requested by mail. In our accounting analysis, we determine key accounting policies
and then evaluate their level of disclosure. Low disclosure can make it difficult to
properly evaluate a firm while full disclosure provides a great snapshot of firm
operations. The reason why disclosure levels are not consistent among all firms lies in
the fact that various business managers have different goals. These goals are what
predicate whether a firm attempts to hide or manipulate numbers in order to mislead
investors into believing current firm status is better than reality. A firm that only
discloses the minimum information required by GAAP should be carefully evaluated;
there most likely will be a red flag in their accounting practices.
As a whole, HNI meets the minimum requirements regulated by the SEC. The
key accounting policies for the firm concern goodwill, operating/capital leases, and
pensions. Compared to other firms within the industry, HNI adequately reveals its
financials. There are several grey areas concerning the disclosing of interest rates and
13
goodwill evaluation measures. The accounting policy which presents the biggest red
flag is goodwill. A proper rule of thumb is to amortize goodwill at a rate of 20%. If HNI
has done this accordingly, their financial statements would be vastly different. This is
thoroughly discussed further on in this analysis.
Financial Analysis
The purpose of performing a financial analysis of a firm is to measure and
evaluate a specific company’s performance against industry averages throughout time.
When conducting a financial analysis there are certain ratios that are looked at in order
to evaluate the profitability, viability, growth, and stability of a firm. There are three
main categories of ratios that Firms and Analysts use when conducting financial
evaluations. These three categories are liquidity, profitability, and capital structure
ratios. Liquidity ratios are used to measure how fast a firm can turn their assets into
cash in order to meet their short term debt commitments. Creditors and banks also use
these liquidity ratios to determine the credit risk of a company. In our evaluation we
used the following liquidity ratios: current ratio, quick asset ratio, working capital
turnover, accounts receivable turnover, days’ sales outstanding, inventory turnover,
days’ supply inventory, and cash to cash cycle. In our evaluation of HNI, we found that
the liquidity ratios for HNI were average when compared to the Industry.
The next category is the profitability ratios. Profitability ratios compare revenues
and income to the amount of sales and expenses a Firm develops over a period of time.
Profitability ratios essentially provide key statistics which aid in determining a firm’s
ability to generate a profit. The profitability ratios used in our analysis are as follows:
gross profit margin, operating expense ratio, operating profit margin, net profit margin,
asset turnover, return on assets, return on equity, sustainable growth rate, and internal
growth rate. In our evaluation of HNI’s profitability, we have concluded that overall HNI
14
performs above the industry average, but there are recent signs of a downward trend,
due to the recent downturn in the economy.
The third category is the capital structure ratios. The capital structure ratios are
an indicator of how a firm finances its investments and operating activities. Firms
finance their operations in one of two manners, either by debt or equity. Capital
structure ratios are different from the other two categories because capital structure
ratios don’t actually measure performance. Capital structure ratios are important
because they provide clarity and insight to a firms default risk. The ratios used in our
analysis are: debt to equity ratio, times interest earned ratio, debt service margin ratio,
and Altman’s Z-score. Overall, HNI shows a very healthy capital structure and a good
credit rating which should ensure their success in the future even in times of an
economic recession.
The next part of the financial analysis is the estimation of cost of capital. In our
analysis we first found the cost of debt and cost of equity in order to calculate the
before tax weighted average cost of capital. We found our estimated Beta, of 1.47, by
running a linear regression analysis. Over time our Beta remained stable, this is good
because it means that the systematic risk of HNI has not been changing over time.
After we found our Beta we then found the size adjusted cost of equity using the size
adjusted CAPM equation. Our size adjusted CAPM was 15.56%. Next we found the cost
of debt, of 3.82%, by multiplying the interest rates, for specific each liability, times the
weighted average of the liabilities. After we found the cost of debt and equity, we were
then able to calculate the before tax weighted average cost of capital, which was 7.3%,
and 8.34% (using size adjusted Ke).
The last and most important part of our financial analysis was the forecasting of
HNI’s financial statements. When forecasting financial statements the most important
figure is the estimation of sales growth. Due to future sales growth being so important,
many assumptions and trends must be taken into consideration to produce the most
accurate sales growth percentage possible. During our analysis, we took into account
15
the past recession of the early 2000’s while estimating HNI’s future sales growth during
this current recession and beyond. During 2009 to 2011 we assume that the sales
growth will be -14%, -7%, and -3%. For the years 2012 to 2018 we make the
assumption that sales will grow 7%. After sales are forecasted, the rest of the income
statement follows. We use the asset turnover ratio in order to connect the income
statement to the balance sheet. We decided to use 2.1 as an accurate forecast of asset
turnover. To find forecasted total assets we divided 2.1 by the forecasted sales for the
next ten years. The statement of cash flows is the last financial statement to be
forecasted. The statement of cash flows states the cash flows from operating activities
(CFFO), investing activities (CFFI), and financing activities (CFFF). The statement of
cash flows is predominately forecasted last due to the fact that it is the hardest financial
statement to forecast. Overall we feel confident in the forecasting of the income
statement, but are not as confident in regards to the balance sheet because the
statement of cash flows and retained earnings are very difficult to forecast due to the
fact that forecasting future dividends is difficult and inaccurate.
Valuation Analysis
When determining the value of HNI we must conduct a valuation analysis
utilizing two methods; the method of comparables and intrinsic valuation models. The
method of comparables is a set of ratios designed to estimate current stock prices. We
then compared our model prices from our method of comparables to our April 1st
observed share price of $10.50. We decided upon a 15% margin of safety when
determining the value of HNI. This means that anywhere between $8.93 and $12.03
would show HNI as being fairly valued. Anywhere below $8.93 would mean HNI is
overvalued; while any price above $12.03 would mean HNI is undervalued. The method
of comparables takes into account not only data for HNI but also for their competitors.
This allows for comparison of how HNI is performing relative to their competitors. The
results we found from our method of comparables highly varied between the different
16
ratios. Consequently, we found that our results from the method of comparables offer
limited insight into the value of HNI.
Unlike the method of comparables, the intrinsic valuation models offer a better
picture of the value of HNI. Each model is backed by accounting-based financial
theories which offer a higher level of explanatory power than the method of
comparables. We conducted our intrinsic valuation analysis using five models: the
discounted dividends, discounted free cash flows, residual income, abnormal earnings
growth, and long run residual income. Each model consists of forecasted line items
from our forecasted financial statements using both as-stated and restated financials.
By analyzing our forecasted financials, we were able to discount back to our current
valuation date and in effect be able to compare our model prices to our observed share
price. Both discounted dividends model and discounted free cash flows model were
similar in that they involved line items that were difficult to forecast. Forecasting
dividends can be very unreliable due to the fact that dividends are totally up to the
management of the company. The discounted free cash flows model uses the
forecasted cash flows from investing and operating activities. The statement of cash
flows is the hardest financial statement to forecast which leaves this model with a low
explanatory power. Also both models are very sensitive to changes in growth rates. The
smallest changes to growth rates can dramatically affect the model price for both
valuation models. The residual income model offers the highest explanatory power and
was considered a dependable factor when valuing HNI. Our as-stated residual income
model showed HNI to be fairly valued; while the restated model showed HNI to be
fairly valued to slightly overvalued. The next model we conducted was the abnormal
earnings model (AEG). The AEG model and residual income model have some type of
correlation due to the fact that if you subtract each year’s abnormal earnings growth
from your annual change in residual income you end up at equilibrium, or zero. Our
AEG model showed HNI as being fairly valued. Our last valuation model, long run
residual income, showed two different views of HNI. Our as-stated model showed HNI
17
as being mainly fairly valued; while our restated model had HNI as being completely
overvalued.
After further reviewing our valuation analysis, we are convinced that HNI at this
point in time is fairly valued to slightly overvalued. We recommend investors to hold on
to their HNI stock but to carefully monitor the stock price over the next few months.
We believe if HNI’s stock price starts to climb in the next few months past our margin
of safety than investors should pursue selling their stock.
Company Overview
Since 1944, HNI Corporation has strived to provide quality products while
creating long-term shareholder value. The firm’s mission statement perfectly personifies
its motive, stating “when our company is appreciated by its members, favored by
customers, supported by suppliers, respected by the public, and admired by its
shareholders” the vision is met.” By carefully considering all aspects of business,
ranging from employee satisfaction at the lowest level to providing long-lasting
products for consumers, HNI establishes itself as one of the leading companies in
America. Having been recognized repeatedly by Fortunes Magazine as America’s most
admired company in the furniture industry, the company continues to push the
envelope on profitable and efficient manufacturing. In addition to being the second
largest office furniture manufacturer in the world, the firm also is the nation’s leading
hearth producer.
Formed from the imaginative minds of an engineer and an advertising executive,
HNI began operations in part to provide jobs for soldiers returning home from World
War II. The simple production of cabinets and file boxes quickly evolved into a wide
variety of office furniture. HNI’s headquarters is located in Muscatine, Iowa. Respect
and fairness have always been too qualities which have oozed from corporate brass.
Since its origination, employees have been referred to instead as “members” and
18
participate in a profit sharing program. The company stresses environment preservation
and is continually devising methods to limit manufacturing waste. Today, HNI
Corporation employees over 13,000 employees and consists of eight smaller companies
which operation in separate end user segments. By fixating itself in so many market
channels, HNI offers maximum choice to its customers. Each company remains
dedicated to being industry leaders in product quality and customer satisfaction. With
sales of over two and half billion dollars and exports around the world, HNI continues to
grow their acquisitions and internal expansion projects. The company recently acquired
Harman Stove Company.
HNI faces competition in the office furniture industry from companies such as
Herman Miller, Steelcase, and Knoll Inc. These companies all sell similar furniture and
thus compete on price and design innovation. To attain high sales growth, HNI
diversifies its customer base and sells products to corporations, dealers, wholesalers,
retail superstores, and the government. Large company operations exist in the United
States, China, Canada, and Mexico. Products can be found in local stores including
Office Depot and Staples. Meanwhile, the hearth and home industry mainly contracts
with home builders. It can be observed under the brand name Fireside Hearth and
Home. Both operating units within HNI adhere to the RCI (Rapid Continuous
Improvement) model, which increases productivity, lowers manufacturing costs, and
improves product quality. The following table shows the Net sales of HNI’s two product
industries.
19
Net Sales by Industry (Millions)
2003 2004 2005 2006 2007
Office Furniture 1304.06 1570.77 1838.39 2077.04 2108.43
Hearth Products 451.67 522.67 594.93 602.76 462.03
Total Sales 1755.73 2093.44 2433.32 2679.8 2570.46
Industry Overview
The office furniture industry facilitates a high degree of price competition. Since
basic components such as chairs and file storage units only have a finite amount of
uses, firms must constantly innovate these products in terms of efficient design and
lower cost to the consumer. The Business and Institutional Furniture Manufacturer’s
Association estimated that in 2007, U.S office furniture shipments to be 11.4 billion
dollars. This amount represents a sequential increase over the previous two years and
gives optimism to the industry. The top six manufactures in the industry account for
65% of total industry sales (Steelcase 10K). Since the industry relies heavily on other
businesses as its end-user for products, it will be heavily affected by any harsh
macroeconomic factors that drive the economy downwards. Popular office furniture
manufactured products include vertical files, cabinets, bins, executive chairs, general
use chairs, conference tables, cafe tables, workstations, and wall coverings,
Two primary segments exist for the office furniture industry; they are the
contract segment and the commercial segment. The product segment “has traditionally
been characterized by sales of office furniture and services to large corporations,
primarily for new office facilities, relocations, or department and office redesigns” (HNI
10K). To meet customer expectations and fulfill their wishes, the products may be
20
customized according to how they will be utilized and in what environment. Industry
competitors will often compete with one another for a contract sale by offering bids to
prospective customers. Past partnerships also may impact future sales; therefore there
is continual pressure to succeed in surpassing product quality standards. Meanwhile,
the commercial office furniture segment involves smaller order to retail businesses or
home-users. There is less dialogue on product specification in these transactions
because the customers are merely more interested in low price and reliability.
The office furniture industry has faced increasing competition from global
competitors, especially in the recent decade. By having lower labor costs and
advantages of currency over the U.S. dollar, countries such as China have seen office
furniture business’ grow exponentially in size. To compete, firms such as HNI, Herman
Miller, Steelcase, and Knoll Inc., must continue to introduce new products, build brand
equity, provide outstanding customer satisfaction, and strengthen their distribution
networks. This constant need to adapt dictates firm goals and expectations. One
method to adequately gauge the current situation of an industry is to view the total
assets of competing firms. The office furniture industry contains several large firms
whom compete for market share. However, there is definitely a clear-cut leader in
terms of assets within the industry. Steelcase has a significant lead over its competitors
in terms of assets. Recently, the gap between the four top firms has shrunk marginally.
This can be observed in the graph on the following page.
21
The hearth industry remains hard to identify in terms of market make-up.
Although heavily dominated by HNI, which makes up 94% of total industry sales,
countless small private companies wedge into the industry each year hoping to compete
on differentiation. The industry is seasonal with most modeling activities occurring from
September to December. Sales are generally contracted with home builders during the
construction of new homes or home-owners during periods of renovation. The hearth
industry encompasses gas, electric, and wood burning fireplaces as well as inserts,
stoves, facings, and accessories. As people around the world become more
environmentally concerned, safe and renewable fuel research is becoming an important
element to businesses. Obviously, due to the recent mortgage crisis, new homebuilding
and renovating has taken a drastic downturn which negatively affects sales for the
0.00
500.00
1000.00
1500.00
2000.00
2500.00
3000.00
2003 2004 2005 2006 2007
Office Furniture Industry Total Assets (Millions)
HNI
Herman Miller Inc.
Steelcase
Knoll Inc.
22
hearth industry. The housing industry is “limping through the worst downturn in
decades and gearing up for what's set to be an abysmal spring selling season. Builders
know cash is essential to pay the bills and survive, so they're trying anything to make a
sale, even if it further stresses margins as cash flow concerns mount” (WSJ “Builders
Offer…” 2009). In addition, the median price of a home has decreased 9.6% in the past
year (Forbes.com).
Five Forces Model
Generally speaking, the foremost universally accepted principle of business is
that firms operate in such a manner as to maximize shareholder wealth. This in turn
forces business managers to focus on either maintaining or increasing company profit
margins depending on social economic conditions. The five-forces model offers a
dynamic approach to analyzing an industry’s market structure. Such data aids in
recognizing industry classification and identifying key firm profitability factors; who,
what, and how are all topics evaluated and answered by the model. The five-forces
model can be separated into two parts: actual/potential competition and the bargaining
power of buyers/sellers. Competition may be further divided into three categories which
include rivalry among existing firms, threat of new entrants, and threat of substitute
products. Each of these three categories presents its own unique challenges to a firm.
They essentially dictate the level of competition in a given industry and affect how a
firm may price its products.
A firm that maintains a high degree of competition with existing firms must be
price conscious. Furthermore, the higher the threat of new industry entrants and
substitute products the more competitive prices and margins must be. Substitute
products are sometimes unexpected and adverse effects on firm profit. As mentioned
previous, the rest of the model deals with bargaining power. A perfect firm would hold
power over both suppliers and customers; however, such a scenario fails to exist due to
23
market competition. Two aspects compromise bargaining power. They are price
sensitivity and relative bargaining power. Price sensitivity stems from a customer’s
window of cost at which they are willing to purchase a product. Narrowly missing a
customer’s maximum price expectancy can spell bad news for a firm. Relative
bargaining power associates the buyer’s ability to dictate costs. Suppliers lose
bargaining power as more firms enter the industry and offer buyers alternate means of
acquiring a product. Seller’s meanwhile, may build on relationships and innovation to
distinguish themselves from competitors.
A conclusion derived from the five forces model places an industry’s competition
level among three possibilities: high competition (cost competitive), mixed competition
(elements of both and high and low competition) and low competition (specialization).
The model measures the factors contributing to an industry’s or individual firm’s
profitability. Tables presenting information concerning the degree of competition for the
competitive forces may be seen on the following page.
Competitive Force (Office Furniture) Degree of Competition Rivalry Among Existing Firms High Threat of New Entrants High Threat of Substitute Products High Bargaining Power of Customers High Bargaining Power of Suppliers High
Competitive Force (Hearth Products) Degree of Competition Rivalry Among Existing Firms Low Threat of New Entrants Low/Moderate Threat of Substitute Products Moderate Bargaining Power of Customers High Bargaining Power of Suppliers High
24
Rivalry Among Existing Firms
Rivalry among existing firms reflects the amount of direct competition in an
industry. Markets tend to become more competitive as demand for products weaken
and price-cuts occur. Additionally, as firms become more plentiful and equal in size
within an industry, companies must vigorously compete for market share. By carefully
analyzing certain competitive elements of an industry, one may gain an understanding
of pressures faced by firms; it also gives insights into the advantages and
disadvantages enjoyed by similar operating entities. Within any industry, there exist
only a finite amount of consumer expenditures. As a result, firms must compete against
one another in order to enjoy profit. Price and product differentiation alike serve as the
two main sources to drive firm competition.
Industry Growth
Industry growth rates allow us to market competition. In a high-growth market,
new consumers are readily available to firms who wish to advance their market share.
Firms must effectively entice these new consumers to try their product. Competition
among firms in this market is much less strenuous than one which has a slow or stale
growth rate. When industry growth rates are low, the only means of market share
growth is to take consumers away from competing firms. Aggressive pricing campaigns
often ensue in low growth rate markets.
The table below depicts the product and consumption of the U.S. office furniture
market. Production represents the total sales value of office furniture manufacturers
located in the U.S. to all locations in the world. Consumption represents the value of all
office furniture sold in the U.S. from all sources in the world including those in the U.S
(BIFMA.com). Notice the downturn in production and consumption beginning in 2001.
25
This occurrence coincides with the economic slowdown which resulted from the events
of September 11th. Unfortunately, events within the past year have most likely negated
what positive trends have been seen in the furniture industry market within the past
four years. The graph on the following page illustrates the changes in quantity of
exports and imports of the office furniture industry since 1990.
VALUE OF U.S. OFFICE FURNITURE MARKET
(Millions of U.S. Dollars)
Year U.S. Production %
ChangeImports Exports Consumption
%
Change
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
$11,420
$10,820
$10,070
$8,935
$8,505
$8,890
$10,975
$13,285
$12,240
$12,350
$11,460
$10,040
$9,435
$8,850
$8,160
$7,710
$7,228
$7,863
5.5%
7.4%
12.7%
5.1%
(4.3)%
(19.0)%
(17.4)%
8.5%
(0.9)%
7.8%
14.1%
6.4%
6.6%
8.5%
5.8%
6.7%
(8.1)%
$2,563
$2,531
$2,280
$2,022
$1,870
$1,777
$1,806
$2,094
$1,772
$1,532
$1,236
$968
$798
$677
$548
$440
$394
$446
$565
$492
$438
$347
$307
$338
$430
$496
$430
$454
$443
$360
$345
$375
$364
$324
$288
$245
$13,419
$12,859
$11,912
$10,610
$10,068
$10,328
$12,351
$14,883
$13,591
$13,428
$12,253
$10,648
$9,888
$9,152
$8,345
$7,826
$7,334
$8,064
4.4%
7.9%
12.3%
5.4%
(2.5)%
(16.4)%
(17.0)%
9.5%
1.2%
9.6%
15.1%
7.7%
8.0%
9.7%
6.6%
6.7%
(9.1)%
*BIFMA.com
26
The office furniture industry is largely a cyclical one. That is, it is strongly
correlated with the upward and downward swings of the economy. As one may observe
from the chart, the U.S. market consumes more than it produces. According to the
Business and Institutional Furniture Manufacturer’s Association (BIFMA), an emerging
global market has heavily impacted the industry. Asian countries, especially China, are
creating a substantial demand for products and competing with American furniture’s
chief importer, Canada. In a short period of eight years, the amount of exported United
States furniture to Canada decreased from 62% to 40%; meanwhile, China has risen
from 13% to near 40% (BIFMA). Therefore, industry growth looks positive due to
constant global market evolution. The table below further breaks down furniture
production in the United States.
27
ANNUAL U.S. PRODUCTION BY PRODUCT CATEGORY
Year
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
Seating
27.9%
26.5%
26.3%
26.5%
26.6%
25.8%
25.2%
24.9%
25.3%
24.6%
24.8%
25.1%
24.9%
25.6%
24.4%
24.9%
24.8%
24.4%
Desks
11.0%
10.9%
11.1%
11.0%
11.0%
11.7%
11.5%
11.9%
11.5%
12.4%
10.2%
10.7%
10.6%
10.8%
11.3%
10.8%
8.9%
9.1%
Storage
7.3%
7.4%
7.6%
7.9%
8.0%
7.4%
6.0%
4.9%
4.4%
4.3%
5.3%
5.6%
5.4%
5.5%
5.3%
5.3%
5.5%
5.5%
Files
12.7%
13.3%
14.6%
14.1%
13.5%
13.1%
12.6%
12.4%
12.9%
12.8%
13.5%
13.8%
15.1%
14.3%
15.8%
15.1%
14.9%
15.1%
Tables
7.5%
7.2%
7.5%
7.2%
6.8%
7.2%
7.1%
6.4%
6.9%
6.3%
6.8%
6.8%
6.1%
6.2%
6.7%
6.3%
6.4%
6.2%
Systems
28.8%
29.6%
28.8%
29.4%
30.5%
32.1%
33.7%
36.6%
36.0%
35.9%
36.1%
34.6%
34.8%
35.1%
33.4%
34.0%
35.2%
34.8%
Other
4.8%
5.1%
4.2%
3.9%
3.5%
2.8%
3.9%
3.0%
2.9%
3.7%
3.3%
3.4%
3.0%
2.4%
3.1%
3.5%
4.3%
4.8%
As technology has improved, less production in the files and systems categories
have been necessary. Firms may store large amounts of information on fewer devices
thanks to increases in data hard drives, processing power, and computer memory
upgrades. The sales performances of the top four American office industry producers
over the past five years are presented in the following graph. As one can see, sales
have been up and down over this period. The relative sales gains in 2003 and 2004
result from the down economies of 2001 and 2002. During a bad economy, new office
furniture is often sacrificed to minimize expenses.
28
The hearth and home market is an interesting market. HNI dominates the
landscape by controlling 94% of the hearth producing market. The little competition
that it faces is mainly offered from small privately operated businesses. In this industry,
many of the sales are completed during the home construction process. In fact, nearly
70% of sales for hearths fall in this category. Thus, as number of new homes being
built rises or decreases, hearth sales will dramatically be affected.
Concentration
The number and relative sizes of the firms in an industry dictate the industries
concentration. Concentration charts provide us a good picture of a firm’s market share.
2003 2004 2005 2006 2007
HNI 3.73% 19.24% 17.06% 9.35% -4.08%
Herman Miller Inc. 0.13% 13.25% 14.62% 10.46% 4.86%
Steelcase -9.33% 11.43% 9.76% 7.96% 10.44%
Knoll Inc. -9.83% 1.31% 14.38% 21.56% 7.50%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Office Furniture Industry % Change in Sales
HNI
Herman Miller Inc.
Steelcase
Knoll Inc.
29
Having a higher concentration ratio allows a large firm to more actively dictate the price
movement of products, while firms with low ratios must follow the lead of their
competition. Being able to set the market’s prices for products allows a firm to focus on
other aspects of their business while the smaller companies are kept busy trying to
compete on prices. Highly concentrated markets are harder to enter into; this often
results from big firm collaboration. On the other hand, fragmented industries can’t
afford to overprice products. In an industry composed of many small market share
companies, cost-price strategies play a prominent role in competition which in turn lead
to lower profits for everyone.
Although HNI enjoys being one of the largest office furniture manufactures in the
world, it constantly clashes with competitors for market share. Since the industry
focuses highly around price, many companies have ventured into the industry in hopes
of reaping profit. HNI Corporation competes with manufactures such as Steelcase,
Herman Miller, and Knoll as well as The Global Group, Kimball International, KI, and
Teknion Corporation. Furthermore, the opportunity for new entrants, particularly on the
global scale, may impact industry concentration in the future.
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
45.00%
2003 2004 2005 2006 2007
Office Furniture Industry Market Share (Sales)
HNI
Herman Miller Inc.
Steelcase
Knoll Inc.
30
Market shares in the office industry have been fairly consistent in the past few
years. HNI and Steelcase tend to inversely correlate to one another in terms of gaining
command over the market.
Knoll Inc., is by far the smallest of the four firms and must continually struggle to
meet the standards put forth by Steelcase and HNI.
Meanwhile, HNI’s hearth products also must compete with prefabricated
fireplaces provided by small independent contracting companies. By dominating the
market share in the hearth product market, HNI Corporation may dictate prices.
However, due to the recent recognition of prospects for profits in offering energy-
efficient heat alternatives, new firms may attempt to invade the market at an increasing
rate. “While many small businesses continue to struggle with tight credit and declining
sales, one fledgling industry is seeing a boom in investment and sales growth:
alternative energy. Alternative-energy firms are reporting an influx of inquiries and
business from a wide range of companies looking to increase their energy efficiency,
28.37%
22.21%
37.76%
11.65%
Market Share 2007
HNI
Herman Miller Inc.
Steelcase
Knoll Inc.
31
especially from those that believe the Obama administration will impose stricter
regulations requiring them to conserve energy” (WSJ “Alternative-Energy…” 2009).
Thus the concentration in this market could easily change in the next decade to one
that has moderate amount of large-scale firms
Differentiation
A firm may gain advantage over their competition through differentiation.
Differentiation refers to the likeness correlation between competing firms products.
Without differentiation, firms would have to compete on price alone. For example, two
products that are similar in appearance, how they conduct, and what they produce
would be classified as having a low level of differentiation between one another. The
higher the level of differentiation, the fewer firms must focus on price as a means of
competition. Therefore, differentiation can have a major impact on a firm’s profitability.
Appearance, features, quality, and build materials are all factors which may differentiate
a product
Office furniture products compete in a price conscious environment. Along these
lines, there are several different target markets for furniture and prices for these
markets vary accordingly. One naturally assumes that a quality lavish office chair for the
president will cost more than a simple desk produced for a high school science class.
However, even at the low-cost end of office furniture, firms in the industry strive to
differentiate themselves through several measures. Reliability and reparability is a
major selling point for products. Customers want to be assured that the furniture the
purchase will be time withstanding. Therefore, failure rates in this industry are
extremely low. Another means of differentiation is through furniture designs and style.
While the core construction principles of furniture in the industry remains relatively
stable, product elements including color, texture, impression, and material all may
32
impact product appearance. Ideally, furniture shoppers have a reasonable varying
selection when considering furniture options. Lastly, through personnel and brand
reputation, office industry firms hope to achieve a comfortable union with buyers so
that business relationships, especially at the large-scale corporate level, continue into
the future.
The hearth and home industry offers the opportunity for much differentiation.
Products can be created in a wide variety of shapes and sizes. Some hearths for
instance are meant to serve the purpose to heat the nearby area, while others simply
serve as decorative additions to the room. Customers today demand energy-efficient
home and hearth products. “Extra tax savings make it worthwhile for energy-conscious
homeowners to take a closer look, especially given continued uncertainty in natural-gas
and heating-oil prices” (WSJ “How to Save…” 2008). A testament to the industry's level
of differentiation may be observed in the number of small private hearth and home
companies which serve a minute of the market. These companies offer a very select
service, and therefore inhibit the ability to give customers exactly what they want.
Fireplaces and stoves both may use different heating sources; the buyer’s preference
can impact who they will purchase from. Thus, the hearth and home industry competes
on product appearance as much as product quality.
Switching Costs
The costs associated with discontinuing company direction and beginning to
compete in a different industry is known as a firm’s switching costs. Low switching costs
indicate a firm can use its resources to produce in another industry at a relatively low
expenditure, while high switching cost make it much more difficult for firms to leave an
industry. Changing industries can destroy a firm with high switching costs. However,
high switching cost industries do have one advantage for established companies; they
don’t have to constantly engage in price wars with competing firms. Consequently, low
33
switching costs allow firms to enter and leave the industry as they please with little
penalty for doing so.
The office furniture industry as well as the hearth and home industry has high
switching costs. Manufacturing plants are specially tailored to produce products with the
most efficient means possible. However, a smooth manufacturing process for office
furniture would not work well for another product such as producing tires. Heavy
investment in property and equipment indicates the industries (especially office
furniture) have high switching costs. In addition, a key resource for these two industries
is the in depth knowledge of actively innovating employees. It would take time, energy,
and financial strains to retrain specialized workers into another craft. With all of this in
mind, office furniture firms as well as hearth and home firms are more likely to attempt
to reconcile internal challenges rather than pack up and change company direction.
Excess Capacity
Excess capacity occurs when the supply of goods and services within an industry
is larger than the demand. To rid themselves of surplus goods, firms cut prices in hopes
that consumers will purchase more of the product. In periods of long surplus, prices
may dip to unexpectedly low prices. In order to prevent excess capacity, firms must
carefully monitor expected sales forecasts and inventory levels. By maintaining a
healthy infrastructure, they can then maximize profit on supply/demand opportunities.
China’s economy has no doubt affected the excess capacity of office furniture industry
firms. “Now, amid the global financial crisis and the downturn in demand, the
government is encouraging consolidation among China's more than 1,000 steelmakers
to deal with excess capacity” (WSJ “Chinese Steelmakers…” 2009). Thanks to these
steel producing companies, many of which export to the United States, steel supply
remains at an adequate level and companies therefore do not have to over invest in
34
product component inventory. This in turn allows firms such as HNI to limit their
warehousing and delivery expenditures to what it actually needs instead of having to
make bad investments in a long period futures market contract which could negatively
affect future sales margins.
One method to effectively measure an industry's excess capacity is to take firms
sales and divide that by their property, plant, and equipment. This ratio indicates if a
firm's fixed costs are actively producing reasonable sales. In the graph, the lower the
ratio, the more excess capacity that exists, thereby resulting in increased price
competition amongst firms.
As the graph and chart indicate, all firms in the industry have enjoined a steady
rise in their sales/PP&E ratio. This shows that they are limiting their excess capacity and
discovering new ways to increase production efficiency.
2003 2004 2005 2006 2007
HNI 5.62 6.72 8.32 8.65 8.42
Herman Miller Inc. 6.42 7.76 8.55 9.76 10.25
Steelcase 3.29 4.31 5.47 6.49 7.15
Knoll Inc. 4.51 4.68 5.68 7.13 7.35
0.00
2.00
4.00
6.00
8.00
10.00
12.00
Office Furniture Industry Sales/PP&E
HNI
Herman Miller Inc.
Steelcase
Knoll Inc.
35
Economies of Scale
Quickly glancing over a review of Fortune 500 companies proves a company’s
size often positively correlates with its success. In most industries, large profits result
from large operations. The longer a firm resides in an industry, the more it learns the
nuances of the business. Assuming it grows as it endures these experience, the firm
gains an advantage of new entrants to the industry. As businesses expand, they often
are able to produce product at a lower cost than before. This is due to the spreading of
fixed costs over a superior customer base. Furthermore, larger distributors encompass
the capacity to demand more competitive pricing from their upstream suppliers; Wal-
Mart is a great example of this procedure. Frequently, firms will attempt to enhance
their economies of scale in order to reduce their marginal cost of additional research
and development endeavors. Firms in high R&D industries understand how to finance
such costs while remembering it is imperative keep up with the technology and
advances of the industry. Those firms who are new to the industry may not have the
knowledge or financial capabilities to fund such operations and thus must fight an uphill
battle with market giants.
As far as the office furniture industry is concerned, firms have made great
advancements in the past ten years in terms of production efficiency. They therefore
lessen their demand for land and heavy machines. Due to advancements in technology,
furniture may be manufactured faster, cheaper, and with less power. Management
procedures which stress quality control and prevent faulty products have increased
production for current and even aging facilities. The HNI production culture centralizes
around RCI (Rapid Continuous Improvement). This process not only encourages new
tools to manufacture faster but also empowers employees with the ability to make
smart innovative design decisions. In addition, limiting input costs offers opportunity for
higher profit margins. Currently, the industry as well as steelmakers have attempted “to
36
band together to get some leverage over the larger mining firms that supply them with
raw materials “ (WSJ Miners Stall…). The graph below indicates firm pp&e statistics.
Office Furniture Industry PP&E (Millions)
2003 2004 2005 2006 2007
HNI 312.37 311.34 294.66 309.95 305.43
Herman Miller Inc. 208.50 195.40 203.30 196.60 196.30
Steelcase 713.80 606.00 524.80 477.10 478.40
Knoll Inc. 154.65 150.99 142.17 137.73 143.64
The graph shows the industry’s recent trend towards increasing production efficiency.
In addition, firms’ pp&e are being depreciated at a faster rate than which the pp&e of
acquisitions add up to. Steelcase has seen a significant drop in their fixed assets since 2003.
This may partly be attributed to a change of its accounting practices in relation to depreciation
it incorporated in 2001.
Exit Barriers
From time to time, firms make the decision to leave an industry. These decisions
are not without cost. The costs and regulations associate with leaving an industry are
known as exit barriers. Exit barriers may prevent a firm from exiting an industry.
Liquidation presents a huge obstacle for firms who offer specialized products. Often,
these products are hard to liquidate quickly. Losing fair value on these specialized
products as well as the extensive R&D into such product field deter firms from exiting
an industry.
37
The office furniture industry has high exit barriers due to firms’ large investments
in pp&e. Besides the complications in having to sell property that sometimes has not
been properly maintained, millions of dollars of specialized equipment would be difficult
to turn to cash. The hearth and home industry faces fewer exit barriers. Many
companies in this industry operate on a small scale, made-to-order basis. They did it in
order to rely more on manpower and human ingenuity rather than vast amounts of
property and machine. Therefore, more firms are willing to dip their feet into the hearth
and home market yet find it hard due to HNI’s already large market share discrepancy.
Conclusion
The office furniture industry is a competitive industry. With high exit barrier costs
and low industry concentration, there remains a constant struggle to produce the best
quality furniture at the lowest price. All facets of the manufacturing process, ranging
from input costs to employee talent to product differentiation, affect a firm’s ability to
compete within the industry. In order to succeed, constant improvements must be
sustained. On the other hand, the hearth industry relies more on innovation and
individualism. Thanks to its large, dominating market share in the industry, HNI can
dictate prices for the different segments of offered hearth products.
Threat of New Entrants
Competition is what drives innovation, efficiency, and value in every industry,
with multiple participants. Competition should and will always be expected in every area
of the business world. Although firms mostly worry about competing with existing firms,
in their own industry, the threat of new entrants should never be taken for granted.
38
New entrants to an industry seek existing market share and profits from established
firms. In an industry of high competition, like the hearth products and office furniture
industries, a firm cannot afford to lose market share to a new entrant.
The threat of new entrants to an industry is determined by how well a new
entrant can overcome obstacles that the industry throws at them. The difficulty of
overcoming these obstacles varies by industry. The basic obstacles that a new entrant
to an industry might face would include scale of economies, first mover advantage,
Access to channels of distribution and relationships, and legal barriers. In the office
furniture and hearth products industry, the threats of new entrants to these markets
are relatively high and should be taken into consideration to insure success of
established firms. The following sections will break down and explore, in detail, the
obstacles that a new entrant of one of these two industries might face.
Economies of Scale
An economy of scale is the basic idea that when a firm increases the size of their
production, input costs decrease. Success in any manufacturing industry relies on the
ability of a firm to produce high volumes of finished products while continuously
working on lowering and maintaining input costs. The ability of a firm to produce scales
of economies has increasingly become more difficult in the office furniture and hearth
industries. In both industries, firms achieve economies of scale by heavily investing in
property, plant, and equipment to achieve a larger manufacturing capacity. New
Entrants to either industry would find it very difficult to achieve the same level of
property, plant, and equipment, as well as manufacturing capacity, as some of the
industry leaders.
Although it takes a lot of capital and expertise to achieve the same economies of
scale as industry leaders, it is still possible to do so for new entrants to the office
39
furniture industry from lower-cost countries. The Office furniture market has
increasingly become more price competitive with lower and lower profit margins. This is
because many firms are outsourcing labor and cutting costs on research and
development. Most Office furniture is relatively simple in nature, there is less focus put
on innovation and more focus put on design, which is influenced by market trends.
After all, how many different ways can you design the functionality of a chair, desk, or
file cabinet? Many new firms simply copy the innovations and designs of industry
leaders and do not make expenditures on R&D. The threat of emerging entrants to the
office furniture industry has become more prevalent from firms like these, especially
from Asia. New entrants from Asia are less likely to put themselves at a cost
disadvantage when entering the market because of cheaper labor costs. In order to
combat labor costs disadvantages, Industry leaders use different techniques to
maximize manufacturing quality and efficiency while maintaining economies of scale.
The graph on the following page exhibits the PP&E of competitors within the office
furniture industry. Take note in the significant slide in total PP&E of Steelcase from
2003 to 2007. This illustrates their reform in accounting methods beginning in 2003,
most of which dealing in depreciation practices.
40
New entrants to the hearth industry are less likely to achieve economies of scale.
This is because product design and innovation is more important in this industry. New
firms would be at an immediate disadvantage because of their lack of research and
development. New firms would have to make large expenditures on R&D in order to
compete with existing firms in this industry. New entrants making large expenditures on
R&D will also have less capital to utilize on PP&E and thus will have a very difficult time
achieving economies of scale.
0.00
100.00
200.00
300.00
400.00
500.00
600.00
700.00
800.00
2003 2004 2005 2006 2007
Office Furniture Industry PP&E (Millions)
HNI
Herman Miller Inc.
Steelcase
Knoll Inc.
41
First Mover Advantage
The second obstacle that a new entrant to an industry will have to face is First
mover advantage. First mover advantages are created by the existing firms that are
considered to be “pioneers” of the industry. New entrants are at an immediate
disadvantage, when it comes to first mover advantages, because first movers set
industry standards and build important relationships with suppliers and customers.
When firms are in Industries that compete mainly on low production costs, having great
relationships with raw material suppliers is a huge cost advantage. New comers will
simply have a hard time finding the essential low cost raw materials to complete their
products in a cost efficient matter. New entrants will also have a difficult time creating
purchase agreements with new customers. Many firms in this industry have a select
number of large customers that represent a large percentage of their sales each year.
In 2006, HNI’s ten largest customers represented approximately 34% of its
consolidated net sales (HNI Corp. 10-K). This simply stresses how important it is to
maintain and build relationships in any industry.
Channels of Distribution and Relationships
Creating channels of distribution and relationships in any industry is expensive
and can be difficult. In the office furniture industry there are multiple channels of
distribution. HNI states in their 10-K that they have five specific channels of distribution
for their office furniture products. New entrants to this industry can benefit by there
being multiple channels of distribution because they have several options when
attempting to enter a channel. Some channels in this industry can prove to be more
difficult to enter than others though. According to BIFMA, the channel that consists of a
firm selling to a Corporation, or end user, is 23% the total market in the office furniture
industry. It would be very difficult for a new firm to enter a channel that comprises of
42
the manufacture and the end-user because there are relationships that were previously
established in this channel. A new entrant would have an easier time entering a channel
that consists of the manufacture and a wholesaler but this channel would probably not
be as profitable for a new firm.
In the hearth industry, new entrants would find it much more difficult to enter
into relationships and distribution channels because the channels are different in this
industry. Finished goods in this industry are either sold to the end user or sent to
corporation-owned distribution and retail outlets. A new entrant would have to invest in
outlets, sales staff, and independent manufacturer’s representatives in order to be
successful in this market. Doing any or all three of these successfully would be very
expensive for a firm, especially for a new one.
Legal Barriers
Legal barriers are the last issue that a new entrant would have to face in an
industry. In this day and age there is a growing concern about the impact that humans
have on the planet, because of this, one of the biggest legal barriers in every
manufacturing industry are environmental standards that are enforced by governmental
and industrial agencies. Environmental regulations set by government entities can prove
to be costly for a firm to follow and/or break. Along with environmental regulations,
patents and trademarks prove to be a large legal barrier in the hearth and office
furniture industries.
HNI states in its 10K that “the corporation believes that neither any office
furniture patent nor the Corporation’s office furniture patents in the aggregate are
material to the corporation’s business as a whole”. What this means is that in the office
furniture industry, creating and holding patents does not necessarily create a
competitive advantage. Office furniture is basic in functionality and there is little product
innovation that affects how the furniture is used. “The Corporation actively protects its
43
trademarks that it believes have significant value” (HNI 2007 10K). In this industry the
use of trademarks contributes more to the success of a product because value in this
industry is created by heavily branding products. New product lines put out by new
entrants are at a disadvantage because existing brands by existing firms are going to
have more perceived value to the end users.
In the hearth industry patents are more important because of various technical
innovations that insure a competitive advantage. A new entrant to this industry would
have to spend tremendous amounts of capital to compete with existing products. A lot
of research and development goes into hearth products and because of this the
development and use of patents creates competitive advantages for existing firms
competing with new entrants. In this industry a new entrant would have to create
innovative products that could compete with existing hearths.
Conclusion
In the Office Furniture industry the threat of a new market entrant is relatively
high from an entrant from a lower-cost country. The growing and expanding economies
of Asia pose a high threat to existing firms because of the availability of cheap labor
and the high amounts of capital available. The threat of new entrants into the hearth
industry poses a minimal threat to the existing firms because product innovation and
research and development play a higher role in being competitive in their market.
Threat of Substitute Products
The treat of substitute products exists in all industries and is substantial for
entities facing high competition. These industries, such as office furniture, are very
44
broad compared to industries functioning in a specialized division. Numerous well-
established companies operate worldwide in office furniture manufacturing, and this
leads to an industry centralized around cost efficiency and acquiring lifetime customers.
The highly competitive nature of this industry has led many businesses to develop new
strategies in order to surpass the competition. Several companies look to add a
competitive advantage by implementing products or services that differentiate from
competitors. However, dominant characteristics of the office furniture industry clearly
point to the fact that it is cost leadership oriented, due to minimal switching costs and
immense competition.
In the hearth products industry, some components are different but most are
similar. Hearth product companies compete a little differently but the industry is still
geared toward minimizing costs. There are many more private companies with generic
distribution channels, which show the downside in competition. The threats of
substitute products are not independent from relative price. Switching costs are an
important part of market strategy. All industries face different but relevant threats of
substitution.
Relative Price and Performance
All profit-oriented companies are looking to beat the competition by introducing
products or services that provide the greatest satisfaction to customers. These
companies must compete on relative price and performance to be effective in the office
furniture industry. This industry is made up of two primary segments, the project
segment and the commercial segment. These segments provide different levels of
competition, which makes things more complex. Office furniture shipments have
increased by 7.08% annually over the last six years. This means competing on relative
price and performance is more important now than ever, if companies are looking to
increase market share and ultimately make a profit.
45
In the project segment, large corporations are looking for big single purchases to
completely fill in a new facility or department. These corporations are looking to match
the furniture with the building based of personal preference and price. Project furniture
typically is bought through dealers who can customize their products exactly to what
the customer needs. Differentiation here can be imperative. Companies are looking to
add any little detail in order to gain customer attention and stand out from the
competition. For example, HNI Corporation has a company that is recognized as the
leader in project furniture design innovation. It also has 9 different subsidiaries making
office furniture which shows variety to customers.
The commercial segment consists of smaller orders of office furniture for
businesses or offices at home. Performance here is measured by quality, selection, and
reliability of delivery services. Manufacturers deal with a more simplistic process and
decreased competition. Innovation is essential; products are not tailored for individual
demand and products need to stand out from others. Performance is very important
because if consumers are consistently buying a type of product, companies can sell that
product for a premium. Price is always important, but here in the commercial segment
performance needs additional attention.
Customer’s Willingness to Switch
The threat of switching costs for customers is low in the office furniture industry.
The large worldwide competition and well developed distribution channels means brand
loyalty is not significant. Companies look to compete on cutting costs, differentiation
from other products and help satisfy future or existing customers. Keeping customers
satisfied with quality and service helps build success. Now remember that office
furniture has two segments. In the commercial segment customers are less willing to
switch compared to the project segment. In the commercial segment, it would take
46
longer for a customer to find what he wants when switching products. It is easier to
get attention from sellers and compare directly between products in the project area.
The hearth products industry causes customers to have higher switching costs.
Quality and performance instill confidence in the customer to continue with the same
manufacturer. I would like to reiterate the fact that these products are typically
purchased and installed during the construction or reconstruction of buildings and
homes. So it would take some research for the customer to find exactly what they
want, due to differentiation and innovation of products. Plus you would take on the risk
of having a problem with distribution and instillation because of the unfamiliarity you
have with that particular company.
Conclusion
To beat competition and make profit in the office furniture industry, a firm must
compete through cost leadership. Weak differentiation and low switching costs for
customers help the industry gain market share. In the hearth products industry,
innovation, performance and quality are the main focus. Switching costs increase and
the threat of substitutes is moderate.
Bargaining Power of Customers
The bargaining power of customers is determined by the customers’ ability to set
and control the prices of an industry. The customer’s ability to dictate prices has a
direct correlation to the overall profitability of the industry. If the customer has a high
bargaining power than they can drive down prices, resulting in smaller profits. When
47
the customer has a low bargaining power the industry can set prices, resulting with
larger profits. Before we start discussing the bargaining power of customers of the
office furniture and hearth industries, it is essential to understand who the customers
and final consumers of the industries are.
The office furniture industry has four main customers: wholesalers, retail
superstores (ex. Office Max, Staples, Office Depot), independent retailers, and end-
users (generally large corporate accounts or governmental agencies). Medium and
smaller sized companies generally buy office furnishings through the wholesalers,
independent retailers, and retail superstores. Large corporations and government
agencies generally buy their office furnishings in large volumes straight from office
furniture manufacturers. The main customers of the hearth industry are independent
dealers, distributors, homebuilders, and retailers. The final consumers in the hearth
industries are generally homeowners and contractors, who are putting hearth products
like fireplaces and pellet stoves into homes.
There are many factors and variables we must discuss to further understand the
customers bargaining power over the office furniture and hearth industry. Factors
ranging from global and national economic conditions to even seasonal weather
patterns will be discussed in further detail below to help understand if they can have an
adverse affect on bargaining power. These factors along with the variables discussed in
the following subsections act as guides in determining the bargaining power customers
have over the office furniture and hearth industry.
Differentiation
Differentiation is important to understand when discussing bargaining powers of
customers. In an industry where there is no differentiation, the companies compete
only on price. On the other hand, an industry with a differentiated product line
competes not as much on price but rather appearance, exceptional quality, superior
48
variety, and superior customer service. Understanding differentiation in an industry is
important because it can either aid or hinder customers’ ability to dictate prices.
The office furniture industry operates in many different product segments.
Desks, chairs, office systems (like cubicles and other modular moveable workspaces),
and storage systems are all products sold by companies in the industry. As a customer
you can find anywhere from high end specialty products to low end undifferentiated
products. For example, HNI operates through seven different companies that provide
different levels of office furniture, from low end to high end. In many cases customers
buy these specialized products straight from the manufacturers so they can fit their
needs and wants better. This sounds like the industry as a whole competes on the basis
of a differentiated product line. However, by taking a looking closer at the
manufacturer/customer relationship we can assume that in a lot of cases net sales
come from undifferentiated product lines. Wholesalers, independent retailers, and office
retail superstores represent a large share of office furniture sales and buy office
furniture products that they know they can sell to final consumers. These customers
have identified that final consumers mostly base their buying decisions on low prices so
they buy undifferentiated product lines that many competing companies offer. The
office furniture industry offers a lot of differentiation amongst products segments but
this doesn’t necessarily mean the customers hold a low bargaining power. In fact,
customers have a relatively high bargaining power because a significant percentage of
net sales come from customers who buy on the basis of price.
Similar to the office furniture industry, the hearth industry offers many different
products segments to their customers. Due to the lack of corporate hearth companies it
is hard to really define if the industry is run by differentiation. HNI’s hearth division,
Hearth and Home Technologies, provides a wide range of products running from low
end undifferentiated hearth products to high end specialized hearth products. Wood
fireplaces, gas fireplaces, electric fireplaces, inserts and pellet stoves are all hearth
products; each offering a wide variety of selections based on price, style, appearance,
functionality, and customer service. Hearth industry customers identify final consumers’
49
wants and needs and then buy products that fit those needs. A lot of independent
hearth product retailers buy a wide variety of products to give homeowners a good
selection to choose from. The hearth industry primarily offers a differentiated product
line to its customers. However, the differentiation of the industry’s products does not
mean that the customer have a low bargaining power. The differentiation of the
industry does play a role in determining customers bargaining power but there are
many other factors that will be discussed later that have a bigger effect on bargaining
power.
Switching costs
As related to the bargaining power of customers, switching costs refer to the
costs that a customer incurs when switching between companies in the industry. Low
switching costs are generally from industries with an undifferentiated product lines.
Industries with more differentiated, specialized products have a lot higher switching
costs for customers. When switching costs are low the customer can afford to put forth
time, money and effort to find a lower price which results in a high bargaining power
over the industry. In contrast, a customer with higher switching costs has a lower
bargaining power because the customers are not willing to incur such costs to seek out
a lower price.
At first glance the differentiation of the industry’s product line makes you believe
that the customers have a high bargaining power. But as stated in the Differentiation
sub section above, a large percentage of sales come from customers who buy
undifferentiated product lines. Due to the undifferentiated products, these customers
incur relatively low switching costs because they can afford to search for the lowest
possible price. For example, Office Max is an office retail superstore that buys
undifferentiated office furniture from manufacturers. Over the past 5 years, office
furniture sales has accounted from anywhere between 10 to 12 percent of Office Max’s
net sales (Office Max 10k). These sales are fairly steady and retail superstores like
Office Max are willing to seek out the lowest possible prices on office furniture in efforts
50
to earn more profits. In contrast, the customers that buy specialized products incur
higher switching costs. These customers are willing to pay a higher price for better
features and switching in between competitors is not worth their time. The office
furniture industry is unique in that there are different switching costs for different
customers. The customers who buy undifferentiated product lines have a high
bargaining power than the customers who buy more specialized product. The
undifferentiated product buyers that represent a large percentage of the industries net
sales are able to dictate prices by seeking out the lowest prices.
The hearth industry is very similar to the office furniture industry because
switching costs can fluctuate depending on the customer. Independent retailers who
only buy hearth products during the colder months have higher switching costs due to
the cost they incur on using inventory and floor space in warmer months for unsold
hearth products. On the other hand, homebuilders who buy large volumes of hearth
products to put in new homes would have lower switching costs. These homebuilders
are buying a more undifferentiated hearth product to put into a large number of homes
and are willing to seek out the lowest prices to reduce building costs. In this instance,
the homebuilders would have a higher bargaining power than the independent retailers.
By seeking out the lowest prices these firms stimulate the industry to price more
competitively. These customers have a relatively high bargaining power due to their
demand over the industry to sell hearth products at lower and lower prices.
Importance of Product for Costs and Quality
The importance of the products cost and quality to the customers own cost and
product quality structure is beneficial in determining customers bargaining power. If the
cost of the product is deemed to have a significant cost to the customer’s final product
than customers are more willing to search for a lower priced alternative. On the flip
51
side, if the product lowers the quality of the customers final product than the customer
will seek a product of better quality regardless of a higher price.
For most businesses, furnishing your office is a major expense and they will
expend effort to seek out the best price and quality for their office environment. For
instance, if a business buys office furniture strictly on price than there is a good chance
that the product is of poor quality and the business would be stuck with faulty office
furniture. This means that one company in the industry can not strictly offer their office
furniture at price significantly lower than competitors. Not one customer will buy
malfunctioning office furniture, regardless of how low the price is. The importance of
making quality office furniture puts pressure on the companies of the industry to
compete not only on price but quality. The resulting pressure makes the office furniture
industry even more competitive. The importance of product quality is one of the
underlying reasons that BIFMA has written guidelines for product quality standards that
each member has to abide by. Each company within the industry now knows that they
cannot earn revenues by mass producing an inferior product to sell at the lowest
possible price without expecting customers to switch to competitors offering better
quality products.
Hearth products can be major investments for some customers. According to the
Hearth Patio and Barbeque Association, installation for hearth products range from
$3000 to $5000 (www.hpba.com). For a majority of homeowners that is a lot of money
to spend just to install a new fireplace and that doesn’t even cover the cost of the
fireplace. On the other hand, for large homebuilders who build many homes at a time,
hearth products represent a small fraction of their total home-building costs. Product
quality also plays a big role in customers buying decisions in the hearth industry.
Companies understand that they will not survive in the industry by offering an inferior
product at the lowest price on the market. For example, a new homebuilder buys a
large volume of fireplaces strictly on finding the lowest price and they all end up with
faulty vents. The homebuilder would have been better off buying a better quality
fireplace at a higher price rather than sticking with the faulty fireplaces and spend time,
52
effort, and money to fix them. This puts pressure on the industry to make better quality
products. Companies now have to compete on the basis of quality and price to sustain
an acceptance in the marketplace.
Number of Customers
The number of customers of an industry is important to understand because it
has a direct correlation to product pricing in the industry. A low number of customers in
an industry can dictate product prices because each customer represents a large share
of the market and is looking for low prices. This creates a highly competitive industry
where firms are competing on the basis of price to gain customers. On the other hand,
it is harder for customers to dictate prices when there are a lot of customers in an
industry because the companies of the industry have many options to sell their
products.
The office furniture and hearth industry have many different customers to
choose from when selling their products. Both the office furniture and hearth industries
sector their customers into different segments. Within each segment are numerous
individual customers that buy their products. For example, according to Hearth and
Home magazine, there are more than 4,600 retailers across North America that sells
hearth products (www.hpba.com).
There are many factors that affect the number of customers in both industries.
The economy plays a big role in the number of customers in an industry. The current
poor global economic climate has had an adverse affect on both industries. According to
an article by Conor Dougherty in the Wall Street Journal, unemployment has risen in
every state and the housing and manufacturing industries have been hit the worst (Wall
Street Journal). This is bad news for office furniture manufacturers because fewer
businesses are starting up and current businesses are cutting costs. Future earnings
look bleak for office furniture manufacturers as the recession deepens within our
economy. According to BIFMA, “As 2009 and 2010 approach, there is little good news.
53
The commercial and office sectors will be stalled by restricted credit and waning
demand” (bifma.org). This means with fewer numbers of businesses willing to buy
office furniture products; customers like wholesalers and retailers might purchase
smaller volumes of products to comply to the lowered market demand. This could lead
to a decline in the number of customers in the industry which in effect could hinder the
industry’s overall profitability.
The hearth industry is affected by this because of the declining housing market.
Fewer homebuilders may not include hearth products in the construction of new homes
in the event to cut back on home-building costs. This could drastically decline the
number of customers in the hearth industry. Also, the hearth industry is affected by
seasonal customers. Many customers buy hearth products during the colder seasons
because of the high demand for home heating during these months. Many new
customers enter the hearth industry during this time. Factors such as economic climate
and seasonal demand play a role in the number of customers for both industries.
Volume per Customer
The volume of products bought by customers can have a significant or
insignificant effect on the relative bargaining power of customers. Large volume
customers can dictate the prices of an industry. They have a high bargaining power
over the industry because they represent a large percentage of sales and won’t buy
products that have a higher price than they are willing to pay. In contrast, small volume
customers have relatively low bargaining power over the industry because they
represent a small percentage of the industry’s sales.
When discussing volume per customer in the both industries we must first sector
the industries customers into two separate divisions: individual customers and customer
segments. In regards to the individual customers division, we must understand that the
majority of the companies within both industries try not to have a large percentage of
54
their net sales come from one individual customer. This means that a company can
stand to lose a large amount of sales if a relationship with a large volume individual
customer suddenly dissolves. This industry standard is well justified and has been
established by the majority of the companies in the industry.
However, when talking about the customer segment division we must recognize
that some of the different customer segments buy larger volumes than others.
Wholesalers buy large amounts of office furniture that they inventory and sell to
independent and local retailers across the nation. Retail superstores also buy large
amounts of office furniture that they then distribute to their stores throughout the
country. Depending on their size and relative need, end users such as corporations and
government agencies can buy large volumes of office furniture at one time. These
customer segments that buy large volumes of office furniture can hold a significant
bargaining power. The different segments can dictate prices within the industry by
seeking out the lowest possible price for a quality product and never wavering from
their low price standard. This in effect drives the industry to be even more competitive.
This means that small volume customers have to buy office furniture at prices that
companies within the industry set to attract large volume customer segments. In
conclusion, the large volume customer segments have a higher bargaining power than
smaller volume customers due to their ability to dictate industry prices.
In a similar way, the hearth industry has different customer segments that buy
different volumes of their products. Distributors buy larger volumes of products straight
from hearth manufacturers and in turn sell them to the independent retailers and
dealers across the country. Homebuilders also buy large volumes from manufacturers
and then put them into their many homes under construction. These large volume
customers represent a huge percentage of the industries net sales and are able to
dictate the industry’s prices. The industry understands that they will be unable to earn
adequate profits unless they sell their products at prices that the large volume buyers
are willing to accept. Similar to the office furniture industry, the larger volume customer
55
segments have a significantly higher bargaining power over the hearth industry
compared to small volume customers.
Conclusion
These variables all play a role in how we can decipher who controls the
bargaining power. However, some variables play a bigger part than others when finding
customer bargaining power within both industries. Large volume customer segments
have lower switching costs which lead to a high bargaining power for customers. These
customers represent a large percentage of the industries net sales and are able to
dictate prices with relative ease by never wavering from their low price standard. This
forces both industries to drive down prices to accommodate the large volume buyers.
This in effect forces the industries to be highly competitive on the basis of price.
The importance of product quality also drives these industries to be more
competitive. Customers generally seek low prices but are not willing to buy unless the
product is of good quality. Companies within both industries are now forced to make
quality products to be able to turn profits. This makes the industries even more
competitive because now they have to compete not just on the basis of price but also
quality. Customers now have a high bargaining power over the industries due to driving
the industries to be more highly competitive to earn larger sales.
Large volume customers with low switching costs have the highest bargaining
power over the two industries. These customers control they way both industries
conduct their product pricing but also set the prices low which in turn helps the smaller
volume customers. The large volume customer’s ability to dictate prices and product
quality is the reason why the customers have a high bargaining power over both
industries; which in effect forces the industries to act highly competitive.
56
Bargaining Power of Suppliers
The bargaining power of suppliers is dependent upon simple supply and demand
economics. When competition is low with few substitutes, suppliers can become
exceptionally powerful. That being said, if demand increases and/or supply increases,
the bargaining power of the supplier will be adversely affected. Greater demand for a
product is typically directly correlated with the number of suppliers. When there are
many substitutes available, there will be a high level of competition among its suppliers
which will inevitably drive costs down.
Switching Costs
The switching cost is dependent on the amount of suppliers available and how
easily attainable the supplies are. The switching cost for the industry is going to be low
due to the large numbers of substitutes and suppliers available. The raw materials sold
by suppliers to produce office furniture consist of coil steel, aluminum, lumber, fabric,
paint, hardware, and other commodities. The industry, like other large manufacturers,
uses a variety of suppliers to purchase raw materials, and there are multiple sources
available for most items. Many manufacturers of similar size order from different
suppliers simply because their orders are too large to be satisfied by just one supplier.
Case in hand, switching from one lumber manufacturer to another would have no
impact on our manufacturing process or final product. Since there are a variety of
suppliers and multiple sources, there would be minimal switching cost and it would be
relatively easy to do so.
The hearth and home industry faces similar conditions. Most of all the raw
materials used to manufacture these products are commodities. In fact, they use many
of the same materials used in the office furnishings industry. The switching cost for the
57
hearth and home industry is low as well. Overall, the supplier for the industries will be
in a weak bargaining position with both the office furnishings and hearth and home
industries.
Differentiation
Undifferentiated raw materials supplied by the supplier causes them to lose
power over the industry. The office furniture and hearth industry’s raw materials are
commodities and should be undifferentiated among suppliers. The aluminum produced
by one supplier should be practically identical to that of another supplier. One way a
company might differentiate themselves from others is through excellent customer
service, timely delivery, and the ability to produce mass quantities while holding quality
constant. The only products that might be differentiated in these industries are high
quality leather from low quality leather, or heat treated steel from basic steel. Other
than these specialty goods that make up a small portion of their revenue, there is
virtually no differentiation.
Importance of Product for Cost and Quality
The cost of raw materials is generally the most important determining factor in
what and how the industry will price their products. Most of the commodities used in
production are stable and rarely incur drastic changes in price. Coil steel is the most
volatile of the industry’s major raw materials. “Shares of U.S. Steel closed up 4.6%
Wednesday (August 20, 2008) at $142.41, off about 28% from their June peak” (WSJ).
The price of steel in the past years has proven to be one of the most volatile
58
commodities in the business. A volatile commodity in short supply will drive demand
prices through the roof. This creates profit losses for the industry. The product itself
should not have any changes in quality because of its high or low demand prices.
Number of Suppliers
Globally, there are thousands of suppliers for the industry. The supplies that the
industries require to make their products are highly sought after goods for many
industries. Having suppliers all over the country reduces shipping costs for the
industry’s subsidiaries which are spread throughout the United States. Both industries
sit in a good position globally as well. Raw materials such as lumber, aluminum, and
fabric can be found anywhere on the planet because they are commodities that
businesses everywhere need. This weakens the bargaining power of the suppliers. Even
if the industries are struggling, its suppliers will have other sources of income from
other businesses that will give them the cash flow to stay in the game. Since most of all
the supplies for the industries are commodities, suppliers should be handily available
and easily accessible.
Volume per Supplier
The volume per supplier is a key factor when determining relative bargaining
power. A large industry needs large suppliers to fulfill its needs as efficiently as
possible. Bulk orders lower cost per unit and should be taken into consideration when
minimizing cost. Many companies in the industry will order the same commodity from
different suppliers because orders are often too big for just one supplier to fill. Suppliers
are often too busy to shop around for the cheapest shipping cost for the industry.
59
“Suppliers often focus more on time than cost. For this reason, they may not always
select the cheapest shipping option” (WSJ). To minimize cost, it is best if the firm shops
for their own shipping company. The industry holds considerable power over its
suppliers because companies in this industry are large buyers with numerous
alternatives to choose from.
Conclusion
It is clear that the office furnishing industry, as well as the hearth and home
industry, is price sensitive due to the large numbers of substitutes and suppliers. The
company’s undifferentiated products and low switching cost puts them in a favorable
position for bargaining amongst suppliers. If the industry is not satisfied with the price a
supplier is offering, it will simply move on to the next of many options. The industry will
make price consciences decisions while exercising its bargaining power over the
supplier.
Analysis of Key Success Factors in Industry
Firms in all industries share a common goal and that is to create/maintain some
sort of sustainable competitive advantage over existing firms in their industry. Firms
achieve a competitive advantage by using one of the two basic business strategies, or a
combination of the two. The first strategy is differentiation. A differentiation strategy is
used when a firm competes within an industry by producing products that are unique
and highly valued by consumers. Firms can achieve this by offering products of superior
quality, variety, and that are considered innovative in nature. Firms can also
differentiate themselves from their competitors by offering flexible delivery, superior
customer service, and by offering unique bundled services with the purchase of their
60
products. The second strategy that firms operate by, in order to sustain a competitive
advantage, is cost leadership. Cost leadership is achieved when a firm produces
products at lower costs without decreasing profit. Cost leadership is used in an industry
where firms produce similar products that are relatively simple in functionality and
design. Firms can become a cost leader by achieving economies of scale, using efficient
production processes, and by lowering distribution and input costs. The use of these
two strategies creates value for a firm and ultimately increases shareholder’s wealth. In
the office furniture and hearth products industries, firms use a combination of cost
leadership and differentiation in order to create value.
Cost Leadership
As previously discussed, firms within the office furniture and hearth industries
produce and offer a wide variety of specialized and undifferentiated products with low
switching costs for most consumers. A corporation, in either industry, faces significant
price competition and is required to focus on key components that lead to cost
leadership. For a firm to compete in either industry, they must develop a cost
leadership strategy. The key components for cost leadership, in both industries, are
economies of scale, efficient production methods, and lower input/distribution costs.
These components will be discussed in the following sections.
Economies of Scale
Firms in both industries have high economies of scale due in part to high levels
of property, plant, and equipment. As previously mentioned, economies of scale are
achieved when a firm is capable of producing more units of goods, while maintaining or
lowering input costs. Theoretically, when a firm continues to grow in size, and
61
continuously increase their level of production, the firm will be able to lower costs at the
same time. Therefore a firm will be capable of providing the same product at a lower
price. When this process happens a firm increases their market share and bottom line.
In the price sensitive market of the office furniture industry, firms must achieve
economies of scale in order to create and maintain a competitive advantage. In this
competitive industry, leaders must invest heavily in production assets and efficient
production methods to achieve economies of scale. In the office furniture industry
bigger is better, more production facilities equals more finished product with cheaper
average costs per unit. When a firm is capable of achieving this scenario, they will
capture market share in the industry. In the office furniture industry, the level of
property plant and equipment that a firm possesses can coincide with the amount of
market share a particular firm controls. In 2007 Steelcase had the largest amount
property plant and equipment, with 478.40 million dollars, compared to its competitors.
In that same year Steelcase held 37.76% of the market share, which was the largest
amount held by a firm in the industry.
The hearth products industry is mostly dominated by one corporation, HNI. This
market is highly fragmented with smaller private companies that try to compete with
this giant. Since HNI is the only large corporation that competes in this industry, there
are little known facts about the market. Firms have a difficult time competing in this
industry simply because they cannot achieve the same level of production assets as the
industry leader. Overall the products in this industry are difficult and complex in design,
which makes it even harder for firms to match economies of scale.
Efficient Production Methods
Firms in the office furniture and hearth products industries produce their
products on a large scale by using efficient production methods. Efficient production
methods are strategies that utilize production resources in the most efficient way
possible. Successful firms within the office furniture industry use efficient production
62
methods to maintain their scale of economies and to achieve cost leadership. There are
various ways to achieve and maintain efficient production methods in the Office
furniture industry. One trend in the Industry has been for firms to acquire smaller
subsidiaries. This in return aids in the quick increase of production capacity for a firm. It
is easier for a large corporation to expand and achieve efficient production methods by
purchasing already successful manufacturing subsidiaries because it is difficult, risky,
and expensive to develop new production facilities. Efficient Production is mainly
achieved by developing and tailoring efficient process strategies. Every big competitor
in the Office Furniture Industry has introduced firm wide programs to stress efficiency
across the board for all of their operations.
Lower Input Costs
In price sensitive markets, lowering input costs is a huge advantage. One way
that firms lower input costs is by building relationships with their suppliers. In the office
furniture and hearth industries, products are produced with relatively the same raw
materials. Firms that buy materials in mass quantities have a greater chance at
receiving a discount from a supplier. Firms in both industries can use purchase
contracts with their suppliers to further decrease material costs. “Steelcase uses
purchase contracts for most of all of their raw materials in order to acquire large
purchase discounts.”(Steelcase 10-k)
Lower Distribution Costs
At this point in time it should be easy to understand that when firms cut
operating costs, they increase their competitive advantage within their industry. In
order to be a cost leader in an industry, a firm should be able to not only cut pre-
production cost but post-production costs as well. One area where a firm can lower
post-production costs is in the channel of distribution. Firms in the office furniture and
63
hearth industries can lower distribution costs by maintaining their own channels of
distribution. One way firms can do this is by building relationships with shipping
companies, retail stores, and outlet stores. Another way firms can lower product
distribution costs is by cutting the middle man out entirely. Firms can get rid of the
middleman by selling their products directly to the end user. One example of this is in
the Hearth Products Industry, HNI sells 70% of their Hearth Products to the end users,
home builders. Overall, lowering distribution cost aids in the advantage of being a cost
leader in any industry.
Differentiation
Differentiation within an industry in its broadest terms refers to how a firm
implements a strategy that sets them apart from their competitors. A company that
establishes this strategy can achieve differentiation through several different means.
The Five Forces analysis discussed earlier in our valuation is designed to help
understand the competitiveness of a particular industry. The cost leadership and
differentiation strategies are intended to help see how a firm can execute a strategy to
gain competitive advantages over others in the industry. In discussing the office
furniture and hearth industries, we have found key factors within the differentiation
strategy that could help establish success for firms in the industry. Superior product
quality, variety, customer service along with flexible delivery and investment in research
and development are different characteristics within the differentiation strategy that can
provide success for firms in both industries.
Customer Service/Flexible Delivery
Throughout the world, superior customer service is highly valued can allow a
firm to differentiate itself from others in its industry. This theory is no different when it
64
comes to the office furniture and hearth industry. Providing superior customer service in
both industries can help a firm gain a competitive advantage over the industry. The top
companies in the industries pay no expense when dealing with customers. In depth
corporation sales representatives help companies earn more revenues by providing their
sales services to large accounts as well as train retailers and dealers in the different
aspects of each of their products. The vast technological improvements that have been
made over the past decade have helped pave the way for companies to upgrade their
customer relations. For example, many of the top firms in the office industries offer
particular technologies that help answer many customers’ problems such as: office
interior design, how to control occupancy costs, workplace strategies consulting,
furniture/asset management, office reliability, and e-commerce. These services provide
customers with invaluable information that can help increase workplace efficiency.
Providing superior service is a great way to win over the respect of customers
but these services don’t matter unless you also offer sufficient delivery options. We live
in a world that covets instant gratification and a more punctual flexible delivery time
can help firms gain a competitive advantage over others. To able to offer flexible
delivery options, firms within both industries must constantly seek out ways that can
provide products to their customers in a timely fashion. Applying lean manufacturing
principles, just-in-time deliveries, and owning or selling to large distribution channels
are some of the ways that top companies within both industries can cut down on
delivery time. Applying these ideas can help companies not only gain a competitive
advantage but also earn customer loyalty.
Investments in Research and Development
When companies decide to invest in research and development they are looking
to satisfy their target customers wants and needs. In return, through new innovational
designs these companies are trying to achieve a larger share of the market and gain a
competitive advantage within their respective industry. This strategy is no different
65
when discussing the office furniture and hearth industries. In regards to both industries,
companies that invest in product development and improving manufacturing processes
do so to create higher customer demand for their products. For example, a company in
the hearth industry might invest in designing a new fireplace that significantly cuts
homeowners heating costs. In doing so the company directly identifies many of their
customers’ needs and wants while increasing their new products demand inside the
marketplace. Investing in research and development is a great way for a company in
the office furniture industry to differentiate itself from competitors. New innovations in
office furniture that emphasize ergonomics and reconfiguration could help a company
gain a competitive advantage over others.
When discussing the office furniture and hearth industries, it is important to
understand that there is always a certain risk involved when investing in research and
development. There is never a certainty of return when companies in these industries
decide to invest in product development. I doesn’t matter how much money you invest,
if you make a product that the customers won’t buy than you are not going to see a
promising return on your investment. For this reason, companies in both industries
expend a lot of time and resources to identify customers’ wants and needs in order to
start on new product development.
Superior Product Quality/Variety
Quality is a characteristic that all customers value when searching for products.
Producing quality products time after time can be a great way for companies within
both industries to develop a solid customer base. These customers realize that it can be
a major expense when they buy large volumes of products from either industry but they
don’t have to worry about their products falling apart. In regards to the office furniture
industry, BIFMA has implemented a product quality standard that every member must
adhere to when manufacturing office furniture. BIFMA includes a brief synopsis of these
standards on their website; which states, “The standards are intended to provide
66
manufacturers, specifiers, and users with a common basis for evaluating safety,
durability, and the structural adequacy of the specified furniture, independent of
construction materials” (bifma.org). These standards give customers a sense of security
because they know that they bought a good quality product from a BIFMA company
that has a reputation of manufacturing quality products. Not one customer wants to buy
a product that has a relatively short useful life and if companies don’t make quality
products then it will be hard for them to earn profits. Maintaining product quality is not
only just a way to differentiate a company from others in their industry but also helps
any company sustain profits while developing a positive relationship with their customer
base.
Variety in the products one company sells can help distinguish themselves from
others in the industry. Offering a variety of products for customers can help a company
target new customers by fulfilling their specific needs. In the office furniture industry
many large corporations are looking for style, ergonomics, and general aesthetics for
supplying their offices with new furniture. A company that decides to differentiate from
its competitors could offer a variety of products to cater to more customers needs.
While demand for more specialized office furniture is declining due to the current
economic crisis, there is still a market out there and a company’s ability to offer a
variety inside their respective product lines can help them earn some extra shares of
the market. The hearth industry offers a differentiated product line and if a company
produces an assortment of different products than they can gain a larger market share.
For example, Hearth & Home Technologies is a company of HNI Corporation which
offers a wide variety of differing hearth products within each of their product segments
which allows them to accommodate many different homeowners’s needs and wants.
This product variety allows for HNI to hold a large portion of the market share. By
offering a wide variety of products that accommodate to customer needs, companies
within both industries can gain a competitive advantage over their competitors.
67
Conclusion
As we discussed in our introduction, firms try to gain an edge over their
competitors by instituting one or both strategies. To maximize profits, cost leadership
should be implemented in a commodity market while the differentiation strategy is most
effective in the specialty goods market. But is it ever good to apply both to gain an
advantage over others? The office furniture and hearth industries use key
characteristics of both strategies to gain acceptance in the market and also continuing
success over a long time. Economies of scale, lower input costs, efficient production,
and low cost distribution are vital core competencies that a company within both
industries must establish to become successful. These characteristics allow for a firm to
earn profits by cutting costs throughout the manufacturing process. Superior product
quality and variety, flexible delivery schedules, and investment in research and
development are all core competencies of the differentiation strategy that attributes to
success in both industries. Applying these characteristics will allow for a firm to identify
customers want and needs and provide a product that satisfies the market. Applying a
“mixed” strategy within both industries can help a firm gain a competitive advantage
and an increasing share of the market.
Firm Competitive Advantage Analysis
HNI Corporation competes in two industries, yet they apply the same business
strategies to both. Cost leadership and differentiation have made HNI a leader in the
office furnishings and hearth and home industries. When implementing these strategies,
several core competencies arise from within. Consistently improving economies of scale,
efficient production, input costs, customer service, product quality and variety, and
research and development will improve the firm’s value.
68
Economies of Scale
A scale economy is the measure of how large a firm has to be in order to enter
an industry and succeed. In a large economy of scale, high outputs require low per-
unit cost. Purchasing supplies in bulk to meet consumer demand gives HNI Corporation
a significant advantage over smaller companies in the same industries.
HNI Corporation’s large economy of scale in the office furniture industry grants
them the ability to compete in five principle distribution channels. The five distribution
channels consist of independent dealers, office furniture products distributors, corporate
accounts, wholesalers, and all levels of government offices. Only a firm with a
significant market share could maintain profits across all five distribution channels.
Keeping this is mind, it is important to note that a large portion of the firm’s sales can
attributed to wholesalers that serve as distributors. “In fiscal 2007, the Corporation’s
ten largest customers represented approximately 37% of its consolidated net sales…
The substantial purchasing power exercised by large customers may adversely affect
the prices at which the Corporation can successfully offer its products” (HNI Corp 10-K).
This can be looked at from two perspectives. The first of which is the industry has a
hand full of large, powerful customers to secure net sales from one year to the next.
The second thought that comes to mind is the revenues that will be lost if one of its
larger customers switches suppliers. Their competitive advantage rests in the first of the
two notions. As long as the Corporation can hold steady its relationships with these
customers, large volume sales will strengthen their cost leadership position in the
industry.
Most hearth products manufacturers are private and cannot compete on cost
leadership. This puts HNI Corporation in a unique position as a hearth products dealer.
Since “hearth products are typically purchased by builders during the construction of
new homes” (HNI Corp. 10-K), they have the competitive advantage to produce
fireplaces and other hearth products on a mass scale.
69
Efficient Production
Cost leadership is difficult to achieve and maintain without an efficient production
process. Many variables are incorporated in an efficient production process and
inevitably help the firm minimize cost while operating a better conducive working
environment. In 1992, HNI Corporation introduced a program titled RCI (Rapid
Continuous Improvement) which was focused on improving streamlining design,
manufacturing, and administrative processes. “The application of RCI has increased
productivity by reducing set-up and processing times, square footage, inventory levels,
product costs, and delivery times, while improving quality and enhancing member
safety” (HNI Corp. 10-K). By following through with this strategy, the firm can establish
long-term values within itself and subsidiaries. With the addition of Lamex in 2006, the
office furnishings segment of the firm has expanded its manufacturing abroad to China
to satisfy demand in Asia. RCI minimizes stress in the transition period because it lays
down ground rules and procedures that everyone can uniformly follow. Although other
firms in the industry have similar procedures designed to achieve maximum efficiency,
HNI Corporation is confident that RCI has revolutionized the office furnishing industry
and gives them a strong competitive advantage.
The same goes for the firm’s hearth and home division as well. Since most
hearth manufacturers in North America are privately owned, it is difficult for them to
achieve such efficiency on such a small scale, comparatively. 70% of HNI’s products are
sold to the new construction/builder channel. In order for them to produce products on
a large scale at high consumer demand, efficient production must be utilized. HNI
Corporation’s efficient production process in the hearth industry has allowed them to
increase its economy of scale and become a market leader.
70
Low Distribution/Input Costs
To be a cost leader in the office furniture and hearth and home industries, low
distribution and input costs must be established. Undifferentiated products play a vital
role in low distribution and input costs as well. HNI Corporation has a competitive
advantage over other firms due to their ability to compete in two separate industries
with the same, undifferentiated supplies. Low input costs permitted the firm to enter
the hearth industry with ease. The hearth and home division of HNI Corporation, which
accounts for about one fifth of the firms net sales, brought in $0.5 billion in fiscal 2007.
Domination of this industry is essential because HNI has practically no switching costs
for suppliers. The revenues brought in from its hearth products could be reinvested in
the Corporation’s much more competitive office furniture industry. This gives HNI
Corporation a competitive advantage over other firms that compete in just the office
furniture industry.
The volatility of a raw material can have a significant impact on input costs too.
Plastic is used in many products HNI office furnishings offers. One of the key
ingredients used in the creation of plastic is oil, which is extremely volatile. Although
the connector industry does not buy oil themselves, it does play into how much the
price of plastics cost. The Wall Street Journal states “oil [put] together a 43% rally since
hitting a 2008 closing low of $33.87 a barrel Dec. 19” (WSJ). These declining crude oil
prices, poor economic conditions aside, do not hurt the firm’s profits one bit. Their main
concern should be with the high volatility of it. Right now crude oil is not in high
demand or short supply, so the industry will not suffer profit losses directly related.
Low distribution costs are met through the firm’s ability to acquire raw materials
from nearby suppliers. HNI Corporation has several production plants and subsidiaries
spread throughout North America. This will decrease the amount of transportation costs
71
for their supplies. Furthermore, practically all of the Corporation’s raw materials and
supplies are commodities. Due to the firm’s various production plants and easily
accessible suppliers, they will gain a competitive advantage over single nuclei firms in
the office furnishing and hearth and home industries.
Superior Product Quality/Variety
In any competitive industry, there are several different products with different
qualities. HNI Corporation has seven different operating units in the office furniture
industry. With these seven different units, HNI is able to compete in different
specialized areas to help maintain a stable profit. These operating units specialize in
different types of office furniture; from formal to casual designs. This gives anyone the
opportunity to find exactly what they need according to their personal preference.
“With dealers and servicing partners located in more than fifty countries” (HNI Corp.
10-K), this shows how diverse and widespread the company’s products have become.
HNI International is a subsidiary offering products to selected markets outside the
United States. This firm is able to bring a different variety of products from several
companies to satisfy their specific wants. Quality products are very important, as well
as variety. The HNI owned company, Gunlocke, has sat eight United States Presidents.
This clearly shows that the company demonstrates quality manufacturing, but it also
has lower quality products. Without a “lower-end” brand of products the company
would fall due to high competition and low switching costs for customers. Especially
with the current economic situation, the fact that HNI has a strong reputation for
quality will help them because the demand for specialized products has decreased.
HNI Corporation also competes in the hearth products industry where they are
the market leader. Variety is still important but less significant in comparison to office
furniture. Quality is the main area of focus. Fireside Hearth and Home is the retail
brand and main distribution service for HNI. Hearth products accounted for 20% of the
company’s revenue. This industry is less competitive. The main market area is the
72
United States and Canada. Many hearth products are installed during the construction
of a new building or during reconstruction. This allows HNI to keep their large portion
of the market share. With their own distribution they can be timely and respectful to
customers. They can give the customer full attention and make sure that person is
satisfied. Competing in a larger, worldwide market gives them experience to really
excel in the smaller hearth products industry. Providing insufficient products will
eventually decrease revenue and hurt credibility. HNI must continue to expand on their
knowledge of customer relationships and superior quality.
Customer Service/ Flexible Delivery
Most customers appreciate reliable and satisfying service from whoever they are
buying from. As a matter of fact, sometimes sub-par service can result in you losing
your customer in the future. “HNI Corporation sells its office furniture products through
five principal distribution channels” (HNI Corp. 10-K). They also sell through online
catalogs and export furniture to distributors in foreign markets. These strong
distribution channels, specifically in North America, enable them to readily make
products for rapid delivery to customers anywhere in the world and help maintain
strong customer service. “The corporation manufactures hearth products in Iowa,
Maryland, Minnesota, Washington, California and Virginia” (HNI Corp. 10-K). With a
smaller market and corporation-owned distribution, HNI has been able to capitalize on
their strong reputation. Mastering the hearth products industry in North America has
helped them concentrate on the larger office furniture industry, where they are
constantly looking for ways to improve customer service.
A deliver process that is both flexible and reliable will result in a corporation
having a competitive advantage. This is a strong competitive advantage because it will
not only help the firm with sells, but also helps them gain a good reputation among the
public and customers. “To achieve flexibility and attain efficiency goals, the Corporation
has adopted a variety of production techniques, including cellular manufacturing,
73
focused factories, just-in-time inventory management, value engineering, business
simplification, and 80/20 principles” (HNI Corp. 10-K). These techniques were
developed from the principles of RCI (Rapid Continuous Improvement). It has helped
the company reduce set-up time, processing time, cut costs and improve product
quality. RCI techniques have helped employees develop quality products in a successful
learning environment and continue to improve on these techniques, so the company
never falls behind. This process actually helps the firm to move ahead of the
competition and continue to cut costs in a globally suppressed economy. The
manufacturing industry had its lowest period of activity in 30 years (WSJ). This
emphasizes how weak the economy really is and shows the benefit Rapid Continuous
Improvement provides for HNI Corporation.
Investment in Research and Development
Research and development is more important to some than others in the office
equipment industry. HNI Corporation, Steelcase and Herman Miller are all currently
ranked in front of Knoll for market leaders. These three top companies fluctuate in
their rankings based upon which fiscal year is being analyzed. HNI Corporation does
their research and development a little differently. HNI, among many others in the
industry, worries about new breakthrough developments in products design. The firm’s
main focus is, “The Corporation’s product development efforts are primarily focused on
developing end-user solutions that are relevant and differentiated and focused on
quality, aesthetics, style, and on reducing manufacturing costs,” (HNI Corp. 10-K). This
company is determined to increase efficiency in their manufacturing process. Cutting
costs is an extremely important way to control expenses. HNI over the years may be
74
slightly behind in sales revenue but is able to cut costs through research and
development. This helps them gain a better or equivalent gross profit and income from
operations. This table shows in millions of dollars what companies have invested in
research and development:
This table shows that HNI invests less money than Steelcase and Herman Miller
but are just as effective in their own ways. At the corporate level, employees are
working for new development in products design, product features, and materials
usage. At the operating level, efforts are focused on improving manufacturing
processes and product features. Given the annual results of operations, it seems HNI
Corporation is investing a good portion of sales back into research and development.
However, it is interesting to see their top competitors spending much more over the
past four years.
Conclusion
HNI Corporation uses a mixed business strategy, applying both cost leadership
and differentiation to the office furniture and hearth and home industries. Efficient
production and low distribution and input costs have lead HNI Corporation into a
commanding position in economies of scale. By applying the core competencies which
combine superior quality with variety, the company differentiate themselves from its
competitors. Innovative research and development along with excellent service to their
2002 2003 2004 2005 2006 2007
HNI 25.8 25.8 27.4 27.3 27.6 24
Steelcase N/A N/A 46.9 41.1 47.4 44.2
Herman
Miller
33.9 33.3 34.6 32.7 36.7 42.1
Knoll 9.7 9.3 12.8 10.8 12.7 15.9
75
customers gives HNI Corporation a significant competitive advantage over numerous
other firms in the industries. The revolutionary Rapid Continuous Improvement program
can be linked to the success of each core competency the Corporation focuses on. The
firm must continue to operate at these levels of productivity to hold or gain market
share in the industry.
Accounting Analysis
Before an accurate valuation of a firm may be assessed, it is important to do a
thorough accounting analysis. Inaccurate or manipulated accounting numbers may
prevent misleading information and distortion. With this in mind, a structured
accounting analysis offers an in depth look into a firm’s operating processes. A proper
accounting analysis consists of six steps, the first of which is to identify key accounting
policies. These policies dictate a firm’s accounting strategy and how they approach
certain measures of performance. The second step involves assessing the flexibility of
these policies. A high amount of flexibility allows firms to decide how they wish to
record certain elements of the balance sheet; the decisions they make can greatly
affect company financials. For example, the recording of leases as operating expenses
prevents them from appearing as liabilities on the balance sheet. The next step
involves detailing the firms accounting strategy. Pressures from investors often force
business managers into maximizing revenues at all cost and this may lead to a
distortion in accounting records. Stock-based compensation, an extremely popular
method of retaining key employees, often may detract managers from recording low
numbers for a given year.
After conducting the accounting strategy analysis, the aim is to evaluate the level
of disclosure. A good way to measure the level of disclosure is to compare a firm with
its competitors. An example of high disclosure is presenting interest rates and the
length of individual company debt contracts. By exploring the level of detail in a firm’s
financial, one may conclude if it is being fair in presenting information. The fifth step is
76
to recognize any red flags in the firm’s accounting records. Unexplained jumps in
numbers from year to year or quarter to quarter must be questioned. Finally, the last
step is to undo any accounting distortions. To do this, we properly adjust any
accounting records which were distorted due to management decisions. Correcting
these will give a better understanding of a company’s current financial situation.
Although it is not quite a monopolistic environment, HNI is by far the largest firm
in the hearth and home industry. Competing firms in this industry are mostly small and
privately operated. In addition, HNI’s 10-K does not segment its financials between the
two industries very well; it only does this for a few important numbers such as net
revenue. For this reason, we find it to be unfair to compare the company’s financials
with the other firms in the hearth and home industry. Therefore, we will compare HNI’s
accounting methods only with its office furniture competitors. This resolution allows for
reasonable examination of the company. Our accounting analysis will cover the time
period of 2003-2007; at the time this analysis was published not all firm 10-K’s had
been made available. All in all, accounting analysis provides investors will an
observation on the possible accounting manipulations of a firm.
Key Accounting Policies
The first step in an accounting analysis is to identify the key accounting policies.
An in-depth analysis of HNI’s accounting polices gives a clear inspection into how the
firm’s key success factors are presented to investors through accounting records.
Essentially, all firm managers begin on one side of the spectrum; accurately disclosing
all financial information in a consistent and fair manner. However, over time, these
managers may make decisions which could avalanche into major distortions in company
records. These distortions will give misrepresentations of company competitive
advantages. A firm’s key success factors often lead to accounting distortions. A
complete understanding of key success factors allows one to observe how a firm
77
creates value through its accounting policies. Key accounting policies have a direct
relationship to what drives value for a firm. “In accounting analysis, therefore, the
analyst should identify and evaluate the policies and the estimates the firm uses to
measure its critical factors and risks,” (Palepu and Healy). If an analyst wants to
evaluate effectively he must breakdown the key accounting policies into two types.
Type 1, key accounting policies, shows the correlation to business activities. The key
success factors for HNI are cost control, economies of scale/efficient production
methods, lower input costs, lower distribution costs, customer service/flexible delivery,
research and development, and superior product quality/variety. These factors and
their amount of disclosure is what will help analysts determine type 1 key accounting
policies. Type 2 key accounting policies have particular relationships with these items
that will affect a firm when restating the financials. Goodwill, pension/post-retirement
benefits, and operating and capital leases are the accounting policies which would
affect success factors. Examples of accounting policies which have a significant impact
on the key success factors discussed earlier in this analysis include the following:
goodwill, operating and capital leases, pension and company benefits, and hedging in
respect to currency. Thanks to the flexibility afforded to companies by GAAP, these
policies can be distorted to make financial ratios appear better than they actually are.
In addition, GAAP only requires a minimal amount of disclosure; firms may take
advantage of this and fail to offer important information to investors. A low amount of
disclosure in respect to any of these policies signifies that an investigation in the policies
is necessary.
Type 1 Key Accounting Policies
Keeping a tight grip on cost control is pivotal for beating out the competition. A
firm must cut costs without losing control on the quality of the finished products to
increase revenue. HNI’s disclosure on product quality is high when showing us how
they manufacture these quality products. However, detail is limited when describing
how they deliver these products at low costs. They also do not disclose information on
78
how to keep costs down to increase revenue over time, although they do provide the
numbers.
Economies of scale are essential for many firms because you are able to produce
large amounts of your products at a lower cost. The total amount of assets for a firm is
significant for assessing how big the firm is and looking at ways to take advantage of
those assets through economies of scale. HNI’s 10-K provides high levels of disclosure
in detailing the types of production facilities and what the firm does with facilities is
regards to its primary operations.
Efficient production methods allow firms to produce a larger number of products
at a lower cost than the competition. To produce products efficiently firms must
produce high amounts of revenue and low amounts of costs to be an industry leader.
All the firms in the office furniture industry provide detail about revenue. An effective
analyst needs high levels of disclosure for cost of goods sold to really break down
efficient production. This level of disclosure for HNI is moderate. They do provide
detail on how they keep costs lower than their competitors, but do not really show you
the difference in their financials. High levels of disclosure in financial statements for the
cost of goods sold, is very important when drawing conclusions on exactly how efficient
HNI is.
HNI does not provide us any detail for input costs but has great levels of
disclosure in relation to distribution costs. Low distribution costs are important because
it cuts costs on products. The firm does an excellent job in showing its manufacturing
and distribution center’s size and location in their 10-K. They provide a good amount of
detail for these centers, even showing us which centers are owned/leased, how large
they are, and the operations that take place at each center.
Superior product quality and variety is very important in the office furniture
industry. Maintaining quality over long periods will continue to please customers and
help your brand image in the market. Variety is also essential to keep a strong
customer base because you have to show innovation and differentiation to surpass
79
competition. Without product variety in this industry, a firm could not exist.
Differentiation is key when comparing the office furniture firms. You will see that not
only does HNI have great variety, but has also been able to develop new products
without taking any significant losses in the last 6 years.
A competitive advantage can be acquired through research and development in
the office furniture industry. With research and development, firms are able to cut
manufacturing costs and seek breakthroughs in product development. Research and
development can be defined simply as taking risks now by investing in the present, and
hoping those risks result in future benefits. The plan for research and development is
to provide value in the future for an extended period of time. Typically, long period
expenses that provide value can be seen as an asset and will be expensed over some
time period. However, research and development does not guarantee results, which is
why GAAP prohibits you to expense them over time. This has a direct effect on the
income statement and balance sheet, decreasing profitability.
Not only is research and development critical in the office furniture industry, it
plays an important role in numerous industries around the world. The industry
competition is made up of HNI, Knoll, Steelcase, and Herman Miller. The competition in
this industry differs slightly from others. “Efforts are primarily focused on developing
end-user solutions” (HNI 10-K). The competition is focused on customer satisfaction.
Although these firms do focus on improving product design at the corporate level, more
attention is directed toward improving manufacturing processes at the operating level.
Knoll differs slightly, concentrating more on corporate level design, “by combining the
designer’s creative vision with our commitment to developing products that address
changing business needs, we continue to generate strong demand for our products
offerings while cultivating brand loyalty among target clients” (Knoll 10-K). Whether
there is a slight difference or not, all these firms devote time to both the operating and
corporate level. This is exactly why firms in the office furniture industry take part of
their earned profit and apply it to research and development.
80
Many firms would like to record research and development as an asset because
of its relevance to the firm’s market growth. Generally Accept Accounting Principles
states that research and development must be recorded as an expense instead of an
asset because the benefits are vastly uncertain. Since research and development must
be recorded as an expense it causes net income to be understated and expenses on the
balance sheet to be overstated. The following table shows all effects.
Assets Liability Equity Revenue Expenses Net Income U N U N O U
HNI invests a considerable amount from sales into research and development.
However their top two competitors, Herman Miller and Steelcase, invest more. Herman
Miller leads the industry, investing over 2% of their sales every single year. They spent
$42.1 million in 2007, an increase of about 14.7% from 2006. The other R&D expenses
from sales are between 1% and 2% most of the time, with the exception being HNI in
2007. HNI is the only firm in the office furniture industry to decrease annually over the
last 5 years, in regard to their amount invested in research and development from
sales. The following tables show the expense of research and development and the
expense as a percentage of sales in the office furniture industry.
Research and Development* 2004 2005 2006 2007 2008 HNI 29.8 27.3 27.6 24 27.8 Herman Miller 34.6 32.7 36.7 42.1 38.8 Steelcase 46.9 41.1 47.4 44.2 60.9 Knoll 12.8 10.8 12.7 15.9 16.3 *in millions
R & D as percentage of sales 2004 2005 2006 2007 2008 HNI 1.42 1.12 1.03 0.93 1.12 Herman Miller 2.58 2.15 2.11 2.19 1.93 Steelcase 1.99 1.25 1.65 1.43 1.78 Knoll 1.81 1.33 1.29 1.5 1.46
81
HNI is extremely focused on research and development at the operating level.
This includes the process of RCI (rapid continuous improvement). HNI over the years
has developed manufacturing flexibility and removed excess cost through RCI
principles. This means the firm has been able to cut down on research and
development costs over the years by increasing efficiency at the operating level. They
can cut down on these costs to increase net income in times of an economic recession
or if cutting costs is needed from the threat of new market entrants.
All firms in the office furniture industry are trying to surpass the competition.
Research and development can help firms gain a competitive advantage by introducing
superior products or services and cutting costs. GAAP requires firms to list research
and development as an expense, which causes expenses to be overstated and net
income to be understated. To be successful firms and investors must believe that
investing money in research and development will provide them with a future economic
benefit. Evaluating the future benefits of the money currently invested is absolutely
essential. Although research and development will cause net income to be lower in the
current year, the following years’ net income could increase significantly. This is
something all investors should take into consideration.
Type 2 Accounting Policies
Goodwill
Goodwill is the price a company pays over fair market value when acquiring a
new firm. Therefore, the amount over the fair market value of the newly acquired firm
becomes an intangible asset filed on the balance sheet. According to the Statement of
Financial Accounting Standards (SFAS) No. 142 title “Goodwill and other Intangible
Assets,” goodwill is evaluated at the end of every year and if the fair value of goodwill
82
is less than the carrying value of goodwill, than goodwill must be impaired. Also, No.
142 states that a company with goodwill must state the nature of goodwill on their
annual reports. This means the company must state if any goodwill has been attained
throughout the year, as well as how they are testing for impairments. As one might
think, impairing goodwill can be a very subjective issue within a company; which could
eventually lead to distorted figures on their balance sheet. Many managers
compensation and job security depends upon attaining certain target profits. Therefore,
managers have extra motivation to achieve these goals and will seek out different
accounting policies so profits will rise. As you see in the graph below, managers have
an extra incentive to not impair goodwill so net income can be overstated.
Effect on Financial Statements by Not Reporting Impairments
Assets Liabilities Equity Revenues Expenses Net Income
Overstated No Effect Overstated No Effect Understated Overstated
In regards to HNI and the rest of the office furniture industry, economies of scale
can play a big part in market share. Acquiring firms outside the country has become
increasingly more common in efforts to increase market share and profits. As a result,
goodwill for the most part has increased over the past five years for HNI and its
competitors. The ratio of “Goodwill to Long Term Assets” can help in understanding the
effect that goodwill has on a company. When goodwill represents a percentage over
10% of long term assets, a company may be withholding impairments in efforts to
boost profits. As you can see from the graph below, HNI and its competitors have
exceeded this 10% target and one can assume that they have not significantly impaired
goodwill over the past five years. In HNI’s case, goodwill represents a greatly higher
percentage of long term assets than their competitors; which may raise some concerns
in the accuracy of their financial statements.
83
Goodwill to Long Term Assets
2003 2004 2005 2006 2007
HNI 34.32% 37.44% 37.06% 35.70% 36.26%
Herman
Miller 11.37% 13.76% 14.41% 14.07% 13.89%
Steelcase 13.94% 14.87% 16.08% 17.35% 18.24%
Knoll, Inc. 11.28% 11.49% 11.78% 11.63% 16.65%
Pensions/Post-Retirement Benefits
Defined benefit and pension plans are designed to provide a retired employee
with a constant cash flow through forecasted benefit packages. Costs associated with
benefit and pension plans are recorded as liabilities at the present value of the future
expenditures. Pension and other postretirement benefits consist of large accounts that
must be audited carefully in order to avoid legal trouble. Pension liabilities can be
relatively easy for managers to distort due to the large amount of cash passing through
the pension and benefits accounts. Aggravation of quality numbers can arise when the
liabilities for these accounts do not take place in the same time period. Furthermore,
health care costs, inflation rates, discount rates, and lifespan are all variables that make
it difficult for the firm to predict how much postretirement value they should provide.
Stock-based compensation is another way companies can keep their employees
pleased, particularly key personnel. HNI Corporation’s stock based compensation plan
was created in 1995. According to HNI’s 10-K “the Corporation may award options to
purchase shares of the Corporation’s common stock and grant other stock awards to
executives, managers, and key personnel” (HNI Corp. 10-K). Issuing stock options as
84
rewards is an excellent way of motivating employees to act in the long term best
interests of the firm’s shareholders.
The Sarbanes-Oxley Act of 2002 was the United States government’s response to
the numerous accounting scandals corporate America had recently been involved in.
The act cracks down on audit firms, as well as other critical disclosure information,
which makes it much more difficult to manipulate these numbers. One tactic a
manager could apply to cut cost and save money with minimal distortion is tweak
discount rates by fractions of a percent. Since discount rates are set by managers, the
firm’s liabilities are at risk of being overstated or understated if the discount rate is too
low or too high, respectively. The table below compares HNI Corporation’s annual
pension plan discount rates with its competitors.
Top Competitor Pension Plan Discount Rates
2004 2005 2006 2007 2008
HNI Corp 5.75% 5.5% 5.8% 6.4% 6.7%
Herman Miller 6.5% 5.75% 6.5% 6.0% 6.75%
Steelcase 5.75% 5.25% 5.0% 5.5% 6.5%
Knoll 6.25% 5.9% 6.0% 6.5% N/A
The table shows that HNI Corporation’s discount rate has been consistent with
its fellow competitors over the past five years. Based on these numbers, there should
be no concern that HNI is understating its liabilities. If these rates are not assessed
with great caution, defined benefit and pension plans would lack the funds to meet its
obligations. To reduce risk in this particular area, firms should comply with the
Sarbanes-Oxley Act when disclosing information to their investors.
85
Operating and Capital Leases
When a firm decides to commit to a lease contract, it opts to treat it as either an
operating lease or a capital lease. These two lease types are quite distinguishable, and
a firm’s choice of selection may greatly affect the balance sheet. To understand their
respective impacts on the balance sheet, one must comprehend the core comments of
each lease type. An operating lease, treated like rent, only offers the “lessee” the right
to use the property. This is a common agreement between apartment complexes and
their renters. On the other hand, capital leases act more or less as ownership. Capital
leases act as an asset to the lessee, thereby increasing both the left and right hand
portions of the balance sheet. Firm’s often aim to minimize their total amount of these
types of leases because it increases their liabilities. Having increased liabilities can
negatively affect a firm’s ability to acquire credit at the lowest rate possible due to a
decline in its debt to equity as well as other key financial ratios. By understating
liabilities, firms may mislead investors into making non-fruitful decisions. It is difficult
to convert the values in their entirety of operating leases to capital leases because of a
lack of information disclosed in company financial statements. Examples of facts which
are often not disclosed include interest rates on leases and time periods of individual
lease contracts. The simple chart below exhibits the effects of recording a lease as
operating when it should be properly classified as a capital lease. The “U” signifies
understatement on the balance sheet while “O” signifies overstatement.
Assets = Liabilities + Equity
U U O
Additionally, operating leases are absent of depreciation expense and interest
expense. Without these two expenses, the expense account of a firm may be vastly
understated. This may lead to overstated net income and will affect many important
86
financial ratios, specifically return on equity. A higher return on equity will please both
current investors and attract potential ones alike.
In the office furniture and hearth products industries, firms use both operating
and capital leases. Although both types of leases are used in these specific industries,
firms substantially use operating leases more and use fewer capital leases. This
strategy of using operating leases over capital leases seems to be an industry standard
with competitors in the office furniture industry. HNI follows this industry standard and
uses a heavy amount of operating leases with very few capital leases. After the year
2010, HNI no longer has any capital lease obligations, according to their 2008 10-K.
HNI appears to use the operating lease whenever possible in order to decrease the
amount of liabilities on their books.
Accounting Flexibility
Accounting policies differ in their degree of flexibility, and it is up to firm
managers whether they take advantage of such flexibility or not. For example, there is
a lot of “wiggle-room” for firms to calculate the present value of costs and liabilities of
the future; meanwhile, GAAP is very strict in its limitations on recording research and
development. Flexibility derives from the issuances by GAAP as well as other company
standards and regulations. The legal authority which developed GAAP and regulates
financial statements is a private organization called FASB (Financial Accounting
Standards Board). It is this organization which deems what firms can do on the
balance sheet in terms of flexibility. In cases of high flexibility, firms determine how
they wish to represent their current situation (most often as positive as possible). In
many popular news worthy cases such as Enron or Arthur Anderson, creative measures
used by highly skilled accountants allowed high-level decisions makers in the firms to
mislead outsiders’ views on company processes. In the following paragraphs, we will
87
identify the flexibility of the accounting policies which are driven by HNI’s key success
factors.
Goodwill
Goodwill is an intangible asset that is loosely defined as the premium paid for
acquiring a company over its fair market value. Before the SFAS, the Accounting
Principles Board would amortize goodwill over an arbitrary 40 years. This means that
they viewed goodwill as having a definite life that needed to be impaired over time.
Under the current SFAS, goodwill is defined as having an indefinite life that should be
tested annually to determine if the fair value is less than the carrying value.
Nonetheless, either way to account for goodwill is hard to determine. As a result, most
of the time goodwill is impaired upon management’s discretion. Therefore, the
potential for accounting flexibility is very prevalent in regards to goodwill.
Reported Goodwill over past 5 years (in millions)
2003 2004 2005 2006 2007
HNI 192.086 224.544 242.244 257.844 260.339
Herman
Miller 39.1 39.1 39.1 39.1 39.1
Steelcase 209.8 210.2 210.2 211.1 213.4
Knoll, Inc. 45.101 45.408 45.333 44.637 75.59
As you can see in the graph above, goodwill represents a substantial amount on
the balance sheet for HNI and its competitors. In regards to HNI, they have impaired
goodwill twice over the past five years. On these two occasions the impairments were
relatively insignificant compared to their substantial amount of goodwill. This can be a
88
cause for concern because by not impairing goodwill regularly, HNI is not showing an
accurate picture of their company’s performance. As you can see, goodwill has
increased over the past five years for most of these office furniture manufacturers.
This could be due to companies trying to increase their market share by actively
acquiring new companies. But due to the potential for accounting flexibility these
companies have made insignificant impairments of goodwill over this period; which
raises questions about the accuracy of their financials. To be blunt, determining
goodwill is very subjective and for the most part is up to the management of a firm.
Therefore, having the impairment of goodwill to be determined by management can
lead to a high potential for accounting flexibility.
Research and Development
Research and development in the office furniture industry helps firms grow and
cut costs. HNI and other firms in all industries would like the option of recording
research and development as an asset. GAAP is very clear in their policies, and firms
must record research and development as an expense. This leads to overstated
expenses and understated net income. Flexibility is limited for this recording process.
Managers are trying to be effective as possible, making sure research and development
will provide future economic benefits. R&D in the office furniture industry helps firms
cut costs by increasing efficiency at the operating level and focusing on product
innovation at the corporate level. The SEC’s strict requirement for reporting research
and development can be seen as inaccurate. Many firms would like the flexibility to not
record R&D as an expense. Although the logic for recording research and development
seems unreasonable to some, at least management can understand where the numbers
came from.
89
Top management of firms can control research and development, by determining
exactly where to apply the expense. This is the only control managers have due to the
strict regulations of GAAP requirements. In the office furniture industry accounting
flexibility is constrained to developing manufacturing or operating techniques to cut
costs at the operating level and product quality innovation at the corporate level.
Consistency is an important indication for seeing what the firms are doing annually. If
a firm has a steady pattern with no significant drops in their research and development
expense, assumptions can be made. You can assume that the firm is not making any
extreme changes in what it records as research and development. The following graph
shows HNI’s research and development expense as a percentage of net sales.
Research and Development Expense as Percentage of Net Sales
HNI’s research and development expense has decreased annually due to its
success in cost cutting techniques. Years of research and development success in the
past, has enabled them to lower the current research and development expense while
being just as productive.
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1 2 3 4 5
HNI
HNI
90
Pensions/Post-Retirement Benefits
A pension plan is made up of a firm’s contributions into a pool of funds which are
used to provide benefits to employees upon retirement. The discount rate, which is set
by the firm annually, determines how much pension the company will distribute.
Different companies have their own methods of estimating the present value of its
future pension payments. Managers must be watchful when exercising flexibility in
determining the discount rate because miscalculations either way can skew the firm’s
liabilities. HNI Corporation’s 10-K discloses that “the discount rate is set at the
measurement date to reflect the yield of a portfolio of high quality, fixed income debt
instruments” (HNI Corp. 10-K). Herman Miller determines their discount rate similarly
in that “this assumption is established at the end of the fiscal year based on high-
quality corporate bond yields” (Herman Miller 10-K). Although these firms set their
discount rates based on yield curves, fixed income debt instruments and net income
investments are set by management.
The annual contributions of HNI Corporation are taken from employee eligible
earnings and results of operations, and common stock. Contributions from the firm’s
employee eligible earnings and results of operations declined this past year dropping
from $28.1 million to $24.5 million, a 12.8% decrease. This is likely due to the current
weak economy but should not be ignored when accounting the growth rate estimated
for future costs, as well as growth rates in medical costs and the assumed growth rate
on existing plan assets. HNI also eliminated its plan assets invested in 2008. This may
be of concern considering plan assets are used to generate revenue and manage risk.
By eliminating plan assets, the firm tightened its budget and financial flexibility because
they now have fewer options to choose from when preparing for and assessing the
present value of its future pension related obligations.
91
FASB standards give managers flexibility on how they decide to report pension
liabilities. Lack of quality information can arise if management does not disclose all of
their pension obligations in the financial reports. In Enron’s case, neglecting to report
large losses and debt in their financial statements resulted in bankruptcy for the
corporate giant. Not only did the accounting practices of this company commit fraud by
failing to report these liabilities, they also claimed pension dollars as assets. The
understatement of liabilities and overstatement of assets can cause substantial
distortion in the accounting equation.
Operating and Capital Leases
The topic of operating versus capital leases remains one of the most critical and
manipulative maneuvers businesses utilize when presenting financial data. Thanks to
the flexibility afforded by GAAP and FASB, firms may shift company approach to
handling these leases rather quickly. As previously stated, operating leases serve as a
proof of rent of property for an agreed upon periods of time for an agreed upon fee.
They are recorded on the income statement as expenses but not on the balance sheet.
This allows a firm to bypass depreciation and interest expenses; now not only are
liabilities understated but net income may potentially be overstated. FASB recommends
capitalizing a lease when it acts as an installment purchase. A more conservative
business will capitalize a higher percentage of their leases, thereby adequately
recording their increased liabilities. Benefits, such as accrued collateral in terms of
asset base, result from capitalizing leases. How a firm views the choice between capital
and operating leases can affect investor outlook. The higher the ratio of leases to total
liabilities, then greater the impact a switch from operating to capital leases may have.
92
As previously noted HNI goes along with the industry standard and has 99
percent of its lease obligations classified as operational leases (HNI Corp. 10-K). This
means that almost all of HNI’s leased facilities’ costs are left off of their balance sheet.
The use of operational leases, by HNI, greatly impacts the clarity of their financial
statements and makes themselves appear more credit worthy to their creditors.
Evaluation of Accounting Strategy
After recognizing the flexibility of accounting policies, it is time to actually identify
the account strategy used by the firm. There are essentially two basic approaches a
firm may take: an aggressive accounting approach or a conservative accounting
approach. The flexibility afforded by GAAP allows managers to alter their revenues and
expenses by using different accounting methods. A conservative approach may employ
accrual accounting practices, which record assets at historical cost. Accrual accounting
usually results in understating assets and overstating expenses. Meanwhile, aggressive
accounting often causes a manipulation of financials in order to promote inflated or
beneficiary numbers. A high amount of deception may be obtained with the right
amount of flexibility. It is thus essential to correctly determine the accounting strategy
employed by a firm in respect to their accounting policies. It is important to compare
these strategies with those of other firms in the industry to garner a good assessment.
Investors prefer transparency in financial statements and evaluating accounting
strategy will deem if they proper financials are being disclosed.
93
Goodwill
Goodwill in an intangible asset stated on a company’s balance sheet. It is
important to understand the accounting polices attributed to goodwill when you are
trying to figure out goodwill impairments. The old way to impair goodwill was to
amortize goodwill over an arbitrary 40 years. This means that goodwill has a definite
life (40 years) and that it needed to be amortized yearly over its useful life. Under the
current accounting policy goodwill is defined as having an indefinite life that is tested
for impairments annually by determining if the fair value is less than the carrying value
of goodwill. When the fair value is less than the carrying value, an impairment has
occurred and the firm must impair goodwill to the new fair value and treat the
impairment as an expense.
When determining the actual accounting strategy for goodwill of a firm it is
important to understand the disclosure of goodwill in the firm’s annual report. Within
the office furniture industry the quality of disclosure varies between each company.
Steelcase has a very high level of disclosure compared to the others in the industry.
Steelcase provides excellent information on how they perform each test for impairing
goodwill as well segment information on goodwill in their North America and
International segments. This information provides a great view for how they impair
goodwill on an annual basis. For HNI, Herman Miller, and Knoll adequate disclosure
information is in their annual reports but it is not nearly as informative as Steelcase.
For each of these companies they define how their goodwill is to be determined but not
how they perform these tests to find out if impairment is needed. HNI discloses how
and why the goodwill balance has decreased or increased over the year. This is helpful
for understanding the nature of the goodwill balance over a particular year. That being
said, HNI has a low level of disclosure when discussing goodwill in their annual report.
Another important step when evaluating the actual accounting strategy of a
company is to assess whether a company is using an aggressive or conservative
accounting policies. An aggressive accounting policy in terms of goodwill is to not
94
impair goodwill which would overstate assets, understates expenses, which in turn
would inflate net income. A conservative accounting policy would to impair large
amounts of goodwill in efforts to realize a boost in future profits. Herman Miller has not
impaired goodwill at all over the past five years; while Steelcase and Knoll have
impaired every year. Even though Steelcase and Knoll have impaired every year, the
impairments have been relatively insignificant in size and can be contributed to a more
aggressive accounting approach. For HNI, goodwill has been impaired twice over the
past five years. Just like Steelcase and Knoll, HNI’s goodwill impairments were
relatively small when compared to the size of the goodwill balance. It seems that the
office furniture industry has applied an aggressive accounting policy in efforts to boost
their reported earnings.
In conclusion, the industry for the most part has a low level of disclosure when
discussing goodwill. Steelcase is the exception and actually had a lot of information in
their annuals reports when it comes to goodwill. Also, the industry exhibits an
aggressive accounting policy when determining impairments on goodwill. In regards to
HNI, the aggressive accounting policy and low level of disclosure raises some red flags
when determining the accuracy of their financial statements.
Research and Development
In the office furniture industry, research and development is relatively small in
comparison to sales and assets. GAAP requirements for research and development
expenses are to expense these costs at the time they actually happen. This causes
financial reports to curtail disclosure and flexibility. GAAP also requires research and
development to be recorded as an expense, but in reality firms would like the option of
recognizing this expense as an asset. Firms want this option because as it is now,
financial reports are partly inaccurate. Inaccurate financial statements result from
overstated expenses and understated net income. A good solution to increase reliability
95
of these statements would be to capitalize research and development as an asset over
the life of the project.
In the office furniture industry, disclosure is insufficient. Real numbers on
reporting research and development are the only reliable information recorded on
financial statements. HNI’s financial reports state, “the Corporation’s product
development efforts are primarily focused on developing end-user solutions that are
relevant, differentiated and focused on quality, aesthetics, style, sustainable design, and
on reducing manufacturing costs” (HNI 10-K). This provides brief detail about what the
firm does with its research and development expense. It does not break down these
numbers and is very direct with information about recording their R&D expense in an
aggregate, non-specific way. The firm’s competitors have even less disclosure in their
financial statements. They describe their procedures in a very similar fashion, if not
exactly the same. Although HNI has smaller expenses annually for research and
development than its top competitors, it has the most detail about what they are
actually doing with the expenses.
Typically between 1% and 2% of revenue is applied to research and
development expenses in the office furniture industry. HNI’s top competitor Herman
Miller is the exception, averaging about 2.31% annually. In this industry flexibility and
disclosure are low. This leads to financial statements that are less accurate. Firms can
practice different accounting methods based on managers’ preferences. These
methods include conservative or aggressive practices, which add to sub-par accuracy in
financial statement reporting. I would like to reiterate that expensing research and
development results in overstated expenses, which leads net income to be understated.
Since net income is understated and is applied to retained earnings, owner’s equity will
be understated. Firms would like the option of recording this expense as an asset.
Capitalizing research and development expenses as an asset would lead to increased
accuracy in reporting. GAAP rules and FASB regulations make this impossible.
Expensing research and development on financial statements makes accountants
perform a more conservative strategy.
96
Pension/Post-Retirement Benefits
HNI Corporation supplies their employees with defined contribution profit-sharing
plans and defined benefit plans. The defined contribution plans are funded by the
individual employee, with an annual contribution from the Corporation. The firm’s
contribution “is based on employee eligible earnings and results from operations” (HNI
Corp. 10-K). The downside of defined contribution plans, as opposed to defined benefit
plans, is there are no promised monthly payments. The defined benefit plan
guarantees the employee a definite amount of benefit upon retirement with little to no
risk. This comes from the fact that unlike the defined contribution plan, the employee
will receive benefits regardless of the investment’s performance. The plan will adjust
the fixed monthly payments in cohesion with increases of cost of living to further secure
the employee.
The discount rates at fiscal-year end 2004-2008 for HNI Corporation stood strong
when compared to their competitors. All firms showed an increasing discount rate over
this period of time which means the industry as a whole must be doing well. The
growth rate estimated for future costs is low and the company expects a 2.75%
increase in future benefit payments come 2013. Strangely enough, the estimated
future benefit payments in the 2007 10-K are about 22% lower than those stated in the
2006 10-K.
97
HNI Corporation Estimated Future Benefit Payments vs. Benefits Paid
(In thousands)
Year Estimated Actual
2004 1133 1780
2005 1166 1503
2006 1199 1218
2007 1376 1361
2008 1120 1147
This jump was probably due to the previous benefits paid being higher than
expected and therefore should not raise any questions. In addition, other firms in the
industry separate domestic numbers from international numbers. Since HNI
Corporation does have offices set up in China, failure to disclose this information
separately can lead to aggravated numbers.
It is also difficult to assess HNI’s net pension expense per year considering they
do not disclose the length of time they will be amortizing it over. Matter of fact,
Herman Miller is the only competitor in the industry that does reveal it at 12 years. If
the firm is using a large number to amortize its net pension expense, they could be
hiding expenses by spreading them out over time. The overall net amortization of HNI
Corporation is similar to its other competitors in the industry and therefore should not
be of concern.
Operating and Capital Leases
HNI uses an aggressive accounting strategy in the area of operating leases.
HNI’s heavy use of operating leases, instead of capital leases, allows the firm to keep
lease obligations off of their books. This strategy greatly reduces risks for the firm by
98
not having to commit to owning a substantial amount of long term property assets.
There are many implications that occur from the use of this particular strategy, first is
that the firm gets to report these leases as an expense on their income statement,
which in return can mislead investors on the value of the firm’s retained earnings.
Another implication of this strategy is that nothing is recorded as an asset or liability,
which results in a more favorable debt to equity and return on asset ratios, all of these
implications can mislead investors.
HNI leases over 26% of their properties with 99% of those leases classified as
operating leases. If HNI were to reclassify their operating leases to capital leases the
outcome would result in a substantial increase in debt for the firm. Increasing the
firm’s debt would have two negative results, the first result would make the firm look
less attractive to existing and potential investors; the second would make the firm
appear less credit worthy to its creditors and lenders.
The following table summarizes HNI’s Contractual obligations and Commercial
commitments as of January 3, 2009 and was taken from HNI’s 10-K.
Payments Due by Period
Total
Less than
1 Year
1 – 3
Years
3 – 5
Years
More than
5 Years
Long-term debt obligations, including estimated interest (1) $ 390,896 $ 31,146 $ 171,932 $ 16,684 $ 171,134
Capital lease obligations 253 209 44 - -
Operating lease obligations 122,329 33,429 54,030 17,743 17,127
Purchase obligations (2) 107,503 107,503 - - -
Other long-term obligations (3) 30,205 6,786 6,613 2,760 14,046
Total $ 651,186 $ 179,073 $ 232,619 $ 37,187 $ 202,307
99
Quality of Disclosure
For every firm, there are “secrets” which business managers wish to hide must
investors and analysts seek to know. GAAP requires a certain amount of disclosure for
documents which are to be submitted to the SEC. However, there is still plenty of lee-
way for firms. Thus, if managers choose to only disclose what is required by regulation,
investors will have a difficult time in assuming a true company valuation. By comparing
the disclosure levels of HNI’s accounting policies with its competitors, we can determine
whether the firm is doing a responsible and creditable job of presenting information.
Low disclosure can lead to misinterpretations of earnings, asset values, and liabilities.
Firms that maximize the allowance of flexibility in accounting practices are generally
considered to have low disclosure while more conservative firms have a higher quality
of disclosure. Basically, quality of disclosure equates to the usefulness of a firm’s
financial statements. A low level of disclosure makes it harder for investors to accurate
derive a conclusion on company value and prospective returns in the future. If a firm
provides adequate levels of information, investors will feel more comfortable in
investing in the company. Evaluating disclosure can also lead us to potential
accounting red flags.
Goodwill
In HNI’s annual reports over the past five years provided an adequate level of
disclosure in regards to goodwill but not enough information was provided in how and
why goodwill was being impaired. HNI didn’t fully discuss how they performed tests at
the end of the year on goodwill to show why there was a need for impairment; this is a
cause for concern because the lack of this information makes it unclear to why
management hasn’t been impairing goodwill on a yearly basis. The ratio of goodwill to
plant, property and equipment shows how many long term intangible assets a company
has compared to their long term physical assets. If you have a high percentage of this
100
ratio it means that you have many assets on your balance sheet that aren’t helping in
the manufacturing of your product. As you can see from the graph below, the industry
as a whole has a relatively high percentage.
Goodwill to Plant, Property, and Equipment
2003 2004 2005 2006 2007
HNI 61.50% 72.12% 82.21% 83.19% 85.24%
Herman
Miller 15.91% 18.75% 20.01% 19.23% 19.89%
Steelcase 27.11% 29.45% 34.69% 40.22% 44.73%
Knoll, Inc. 29.16% 30.07% 31.89% 32.41% 52.62%
HNI has a staggering percentage compared to its competitors, almost 2 to 4
times bigger than its competitors, which is a major cause for concern. It seems that
the entire industry has implemented an aggressive accounting policy in efforts to boost
profits during the fiscal year. The low level of disclosure and high amounts of goodwill
for HNI raises speculation in the way management is conducting goodwill impairment.
By impairing goodwill at 20% over a 5 year period one can estimate that HNI’s current
financial picture is actually a lot worse off than what they have stated in their annual
reports. By not enclosing enough information on goodwill in their annual report, HNI
raises questions about goodwill impairment that has a direct effect on the validity of
their financial statements.
Research and Development
In the office furniture industry, research and development has very low levels of
disclosure. HNI has low amounts of disclosure. They do however provide great detail
101
on what they are doing with their research and development costs, in comparison to
top competitor Herman Miller. “The company draws great competitive strength from it
research, design and development programs. Accordingly, the company believes that
its research and design activities are of significant importance,” (Herman Miller 10-K).
Herman Miller stresses the importance of R&D but provides almost no detail on how it is
applied. The recorded expense or that expense as a percentage of net sales is all we
have to determine real numbers for investors. Companies in the office furniture
industry spend different amounts on research and development. Their focus on
operating efficiency, corporate development, or both, differs among the firms. These
reasons seem material to why research and development has low levels of disclosure.
Some of the firms stress product development as a very important element of their
production, which would make you think disclosure would be higher. The fact of the
matter is low levels do exist.
Pension/Post-Retirement Benefits
Overall, HNI Corporation does a less than adequate job of disclosing financial
information on its pension and other postretirement benefits when looking at top
competitor 10-K’s. Other competitors in the industry do a better job of discussing their
financials so the reader knows why the numbers are what they are. For instance,
Herman Miller provides a well written paragraph on plan assets and investment
strategies to make it clear to the investor exactly how and where the firm is investing
because percentages of plan assets in equity and debt can only tell the investor so
much. It is also odd that HNI completely got rid of plan assets in 2008 and all they have
to say about it is, “there are no plan assets invested” (HNI Corp. 10-K). This lack of
information might lead the investor to wonder what happened to this portion of assets
and where the money is being invested now.
102
Statistics for healthcare and growth rates in medical costs are nonexistent in
HNI’s financial statements. The 2008 10-K added a section not seen before pertaining
to its healthcare financials:
“The Corporation payment for these benefits has reached the maximum amounts per
the plan; therefore, healthcare trend rates have no impact on the Corporation’s
cost. Approximately $4.5 million of assets previously held in a voluntary employee
benefit association (VEBA) fund designated to pay retiree healthcare claims were
transferred into a VEBA fund designated to pay active healthcare claims during 2008”
(HNI Corp. 10-K).
The statement makes it clear that healthcare trend rates will not affect the
Corporation’s cost. According to this, the assumed growth rate of medical costs is
being accounted for, but without any hard numbers, it is difficult to assess the firm’s
position.
After reviewing HNI Corporation’s 10-K reports and comparing them to their
competitors, it is evident that the firm provides less sufficient information when
disclosing pension and other retirement benefits. If HNI were to discuss their financials
and intentions for the future as well as its competitors do, it would be much easier for
investors to draw conclusions based on their numbers.
Quantitative Analysis
Business managers utilize financial statistics present the current status of the
firm. By using these numbers as a means of valuation, companies may be analyzed
and compared in like terms with competitors. Additionally, quantitative analysis
provides corporate decision makers with measures to determine firm progression.
Potential investors and security analysts use this disclosed information to make
observations about the firm. GAAP provides managers with flexibility in reporting
financials of the company. Therefore, managers can variably choose what information
103
to disclose and in what format, all depending on public perception goal. “Big Bath”
scenarios aside, managers generally wish to display their firm as a profitable,
succeeding company.
They are heavily influenced by incentive laden contracts which give them
benefits when the meet certain criteria. These situations are known as agency costs.
Agency dilemmas arise when firm managers do not make decisions in the best interest
of shareholders. Understanding financials and being ability to identify deceptive
accounting techniques enables investors to more appropriately calculate firm value.
Red flags in operations can potentially be recognized through carefully calculated
diagnostic ratios.
Quantitative measures may be divided into two groups: sales manipulation
diagnostics and the expense aspects of accounting. Sales manipulation ratios all center
around net sales. These ratios divide net sales by other accounting figures such as
cash from sales and accounts receivable. On the other hand, the rest of quantitative
measures search reported expenses for discrepancies. Red flags are raised when
variances can’t be justified. These ratios test the validity, correctness, and
accountability of a firm’s financial statements.
Sales Manipulation Diagnostics
Sales Manipulation Diagnostics allow us to analyze relationships between a firm’s
net sales and significant items on its balance sheet. These ratios can be compared to
similar firms in an industry to help validate the credibility of a firm’s accounting
methods. A five-year period gives great insight into company trends, and by analyzing
these one can search for red flags. Red flags are abnormalities in the firm’s financial
statements. For example, if HNI has a ratio significantly different from the rest of the
industry, there may be cause for concern if there is not a proper explanation.
104
Net Sales/ Cash From Sales
Nets sales over cash from sales shows the relationship between a firm’s sales
during a period and the amount of those sales that were purchased with cash.
Normally, it is a concern if a firm’s ratio is considerably higher than competitive firms in
the industry because that would indicate the firm is exposing itself to debt collection
risk higher than the industry average. Deviations from the ideal ratio of 1:1 indicate a
firm is either recognizing too much net sales (higher than 1:1) or not enough net sales
(lower than 1:1). A sale which garners cash also negates the customary credit waiting
period and allows the firm to instantly utilize the revenue from the sale. Since money
has time value, it essential to collect cash from sales as quickly as possible. Cash from
sales can be derived from take the net sales and subtracting the change in net account
receivable over the years. A significant drop in this ratio could result from an
aggressive accounting strategy in recognizing accounts receivable. The ratio could
potentially increase if a firm decided to issue more strict credit terms, hoping to steer
customers towards purchasing with cash. Overall, we should expect this ratio to remain
consistent; a red flag may be present if otherwise.
0.960
0.970
0.980
0.990
1.000
1.010
1.020
1.030
2003 2004 2005 2006 2007
Net Sales/Cash From Sales (RAW)
HNI
Herman Miller
Steelcase
Knoll Inc.
105
Over the past several years, HNI has managed to main a ratio competitive with
other firms in the industry. Specifically, the firm has seen its ratio decline since 2004,
even dipping to .989 in 2007. Lowering this ratio indicates that HNI is more effectively
collecting cash for its sales, which allows it to immediately use such funds if necessary
to stimulate additional firm growth. The change graph below serves as first derivative
test which further indicates whether HNI’s sales are supported by collect cash. The
positive change indicates that the ratio has risen in the past few years (meaning sales
are becoming less supported by cash collections). Meanwhile, firms that their lines
below 0 in the change graph saw a decrease in their ratio for the respective year. As of
this time, we are only slightly concerned with the trend of this ratio for HNI because it
appears to follow the trend of the industry; if in the next few years, however, HNI’s
ratio continued to drop while competitors in the office furniture industry maintained net
sales/cash from sales numbers slightly above one, we would want to analyze the firm’s
accounting practices to look for any distortions. Currently, it appears HNI has suffered a
decrease in its ability to quickly garner cash from sales.
-1.500
-1.000
-0.500
0.000
0.500
1.000
1.500
2.000
2.500
3.000
2003 2004 2005 2006 2007
Net Sales/Cash From Sales (CHANGE)
HNI
Herman Miller
Steelcase
Knoll Inc.
106
Net Sales/Accounts Receivable
The ratio of net sales to accounts receivable shows how a firm’s accounts
receivable supports its sales. Firms that collect more quickly on their accounts
receivable will have a lower ratio than those who have a prolonged process. A higher
net sales/accounts receivable ratio indicates a firm has received payment for the service
it has performed. Delaying collection of accounts receivable can challenge firm liquidity.
As a company’s sales increase over the years, the expectation is that its accounts
receivable will rise as well at a proportional rate. Before calculating the ratio, doubtful
accounts should be deducted from receivables to give a better assumption of the actual
sales on account which may be possible collected.
The office furniture industry has several means of distribution in terms of getting
products to their customers, and this is reflected in its net sales/accounts receivable
ratio. Since many products are done through direct transactions, storefronts are less
involved than products any industry such as food products. With this in addition to the
fact that many sales are of high dollar quantity (millions of dollars) many sales in this
industry are done on credit. Office furniture industry firms stress collecting on these
0.000
2.000
4.000
6.000
8.000
10.000
12.000
2003 2004 2005 2006 2007
Nets Sales/Accounts Recievable (RAW)
HNI
Herman Miller
Steelcase
Knoll Inc.
107
accounts receivable as quickly as possible in order to enhance liquidity and be able to
use cash for reinvestment purposes. Thus, a higher ratio is strived for. As the graph
shows, all firms within the industry have a good net sales/accounts receivable ratio.
HNI specifically has enjoyed the second highest average ratio over the five year span.
The firm has been very effective in the cash collection process, and by increasing their
liquidity lowers their riskiness to potential creditors. By maintaining similar credit terms
throughout the years, HNI has managed to have accounts receivable correlate
accordingly in any given year. The change graph below further exemplifies the fact that
HNI has maintained the least volatile ratio since 2004. This coupled with HNI having the
second highest ratio indicates that the firm is doing a great job of limiting its
outstanding accounts receivables. A contributing factor here is the company’s credit
policy (which was revamped in 2003 and as such is indicated by the 170% increase in
the change graph) which allows the company to quickly collect on accounts. Incentives,
such as no interest if paid in thirty days, speed up the collection process.
Net Sales/Inventory
The net sales over inventory ratio gives a great glimpse into how inventory
supports a firm’s sales. Firms that properly manage and utilize their inventory will have
-100.000
-50.000
0.000
50.000
100.000
150.000
200.000
2003 2004 2005 2006 2007
Net Sales/Accounts Recievable (CHANGE)
HNI
Herman Miller
Steelcase
Knoll Inc.
108
a high ratio. A low ratio indicates a firm does not efficiently turn inventory into sales
and may often have inventory sitting in a warehouse rather than being quickly sold
after its production. This could occur when improper sales forecasts are used as a base
for inventory maintenance. In addition, systematic factors such as the economy can
affect this ratio. Firms with higher net sales/inventory know how to market their
product and get it to buyers fast. All things being equal, high inventory levels are not
desired because they represent an investment which is returning nothing to the firm.
Inventory produces profit only once it is sold; therefore business managers must
constantly search for new ways to move inventory swiftly.
Firms in the industry vary greatly in terms of their net sales/inventory ratios.
Steelcase, the number one office-furniture firm in the United States, has had one of the
lower ratios in the past few years but has slowly risen to HNI’s level. HNI has dropped
from over thirty-five in 2003 to less than twenty-five in 2007. This indicates that the
company is doing a less effective job at managing their costs and avoiding excess
quantities of unsold product to build up than it has been in the past. By looking at the
firm’s 10-K, we can easily observe why HNI’s net sales/inventory has dropped so much.
Over the past few years, the company’s inventory levels have doubled while their sales
have only increased at a moderate rate. An explanation for this may be that since HNI
0.000
5.000
10.000
15.000
20.000
25.000
30.000
35.000
40.000
2003 2004 2005 2006 2007
Net Sales/ Inventory (RAW)
HNI
Herman Miller
Steelcase
Knoll Inc.
109
has aggressively been trying to expand into new market segments, they have built up
inventories faster than they can acquire customers. As a result, they have unsold higher
amounts of unsold inventory; this is reflected in the firm’s decreasing ratio. To combat
this ongoing dilemma, HNI may want to slow down its expansion until it has a better
grasp of consumer demand in its newer markets. Again, a large portion of sales are
from a small number of buyers, so this problem could be solved by gaining several
large-order office-furniture buyers. Although HNI’s net sales/inventory has steadily
dropped, there is no red flag to report because the firm still remains at the industry
average. The change graph below highlights the company’s recent inability to turn
inventory into sales with a near -50% change in 2007. A red flag to report for the
industry is Herman Miller, which saw its ratio rise sharply in one year. Its rate of change
for 2005 was higher than 150% and therefore off the change graph
Net Sales/Warranty Liabilities
The ratio of Net Sales/Warranty Liabilities allows us to see if the firm’s sales are
supported by their warranty liabilities. Assuming a firm is adequately supplying
warranties for its products, we expect its warranty liabilities to increase proportionally
-150.000
-100.000
-50.000
0.000
50.000
100.000
150.000
2003 2004 2005 2006 2007
Net Sales/Inventory (CHANGE)
HNI
Herman Miller
Steelcase
Knoll Inc.
110
with its increased sales. Red flags arise when these two accounting numbers do not
move coherently.
Overall, the office furniture industry has a very high net sales/warranty liabilities
ratio. This may be explained by the fact that furniture products have very low failure
and return rates. Low rates allow for firms limit their warranty obligations. As the graph
above shows, HNI has a much higher ratio than other firms in the industry. This means
that HNI is not properly supporting its products with warranties liabilities at the rate
competitors do. Furthermore, as the change graph indicates, HNI alarmingly has
exceedingly not supported its increased sales accordingly with warranty liabilities in the
past few years. In 2005, for example, HNI’s ratio had a rate of change of 1500%. This
raises a red flag because by limiting warranty liabilities, the firm is able to present
inflated profit levels. Inflated profits leads to misleading investors into believing the firm
is doing as well as it really is. In addition, although warranty liabilities are relatively
small when compared to total liabilities, HNI is affecting the way creditors view them in
terms of their debt to equity ratio. Having lower debt makes them appear less risky for
potential loans. However, it’s important to remember that warranty liabilities encompass
only a small percentage of firm sales and thus do not have a major effect on company
finances.
0.000
50.000
100.000
150.000
200.000
250.000
300.000
2003 2004 2005 2006 2007
Nets Sales/Warranty Liabilities (RAW)
HNI
Herman Miller
Steelcase
Knoll Inc.
111
Sales Manipulation Diagnostics Conclusion
Overall, HNI performs similarly to competitors in terms of sales manipulation
diagnostics. The only concern we have relates to the firms net sales/warranty liabilities
ratio. Our concern stems from the fact that in years that net sales see incremental
gains from the previous year, the warranty liabilities either remains the same or only
increases minutely. This leads us to believe that HNI may be understating its warranty
liabilities. However, this still is not too critical of a flaw for two reasons. First, the
office-furniture industry is continually making strides in product quality, and this leads
to less importance for warranties. By ensuring that products are manufactured
correctly and for the long-term at company production plants, HNI as well as its
competitors may effectively limit their product liabilities. In addition, warranty liabilities
as a whole are only a small percentage of total liabilities. Therefore, even the impact of
disregarding the proper amount for warranty liabilities has remote impact on important
financial measurements such as debt to equity ratio. For instance, in 2008, HNI’s
warranty liability accounted for less than 1% of their total liabilities. Since the company
has ratios which for the most part follow standard trends in relation to the industry, we
surmise that HNI’s reported sales are believable.
-1000.000
-500.000
0.000
500.000
1000.000
1500.000
2003 2004 2005 2006 2007
Net Sales/ Warranty Liabilities (CHANGE)
HNI
Herman Miller
Steelcase
Knoll Inc.
112
Expense Manipulation Diagnostics
As the name implies, expense manipulation diagnostics help determine if a firm
has altered their value by manipulating expenses on their financial statements. This can
mislead investors into believing a firm is more profitable than it really is. Distorted
numbers as well as visible irregularities in the industry may hint at inaccurate firm
valuation. A comparison with competitors of HNI will allow us to identify possible red
flags which could lead to invalid firm valuation. These diagnostics take us more deeply
into the dynamics of a firm, not just their mere cash to cash cycles.
Asset Turnover
Asset turnover ratio offers a great means to compare companies of different
sizes on equal terms. It accomplishes this by demonstrating the relationship between a
firm’s assets and its sales. Generally, firms who possess higher asset/turnover ratios
experience more success than those who have lower ratios. Asset turnover is
computed by simply dividing a firm’s net sales over total assets. This ratio is useful to
determine the amount of sales that are generated from each dollar of assets. Assets
have been acquired through monetary investments of a firm and therefore we expect
them to generate return. If assets are not adequately equating to sales, either
reconfigured business operations or new company direction must be enforced. Proper
asset management is key to thriving firms. New activities and an expansion of assets
are characteristics of growing firms. Major deviations in this ratio may indicate that a
firm is not properly writing off their assets. For example, failure to impair goodwill will
result in a higher asset turnover ratio
113
From the graphs we may interpret that HNI effectively generates sales from its
assets. With an asset turnover ratio above two, the firm has remained at the forefront
of the industry standards. Although the ratio has lessened in the past two years, we
see no cause for concern because this drop was relatively small. As HNI continues to
partake in acquiring other companies, it is imperative that it continue to effective create
sales from new assets. It must be noted that HNI’s ratio would be much higher if not
for its vast amount of goodwill which contributes to its asset base. Therefore, by
depreciating goodwill, an even more accurate read of HNI’s performance may be
gained. As long as a firm keeps a ratio higher than one, it is maintaining profitable
production efficiency. The change graph illustrates that HNI’s asset turnover ratio is
becoming less sloped, as seen by its rate of change significantly dropping in 2004.
0.000
0.500
1.000
1.500
2.000
2.500
3.000
3.500
2003 2004 2005 2006 2007
Asset Turnover (RAW)
HNI
Herman Miller
Steelcase
Knoll Inc.
114
CFFO/OI
An effective method used to analyze a firm's earnings is by measuring the
relationship between a firm’s cash flow from operations and its operating income. The
CFFO/OI ratio links together two major financial statements: the income statement and
the statement of cash flows. By correlating these two statements into one ratio, we
can observe how cash is handled throughout a firm. The ratio describes the amount of
cash received from operations in relation to the actual operating income which is
reported on the income statement. An understatement of expenses by a firm will cause
this ratio to unjustifiably increase.
-150.000
-100.000
-50.000
0.000
50.000
100.000
2003 2004 2005 2006 2007
Asset Turnover (CHANGE)
HNI
Herman Miller
Steelcase
Knoll Inc.
115
Competitors in the office-furniture industry have had CFFO/OI ratios near or
below 1 for the past five years. This indicates that firms heavily depend on their
earnings from operations for cash flow. A sudden spike in HNI’s ratio for 2007 may be
attributed to from doubling its cash flow from operation from 2006 to 2007. Further
analysis of the cash flow statements shows this rise came from a substantial increase in
cash flow from receivables and a decrease in accounts payable and accrued expenses.
This raises a red flag because for the previous five years, the firm had endured
“negatives” for these to portions of cash flows; yet in 2007 they gained nearly seventy
million in additional cash flows from the management of these two items. Aggressive
accounting methods may have been introduced present reports on the accounts
payable and receivables in more favorable terms. There is nothing in HNI’s 10-k which
offers an explanation for these sudden changes.
0.000
0.200
0.400
0.600
0.800
1.000
1.200
1.400
1.600
2003 2004 2005 2006 2007
CFFO/OI (RAW)
HNI
Herman Miller
Knoll Inc.
116
CFFO/NOA
Cash flows from operations over net operating assets is a great way to analyze a
firm’s depreciating practices. Since net operating assets include plant, property, and
equipment, how a firm chooses to depreciate these assets has a significant impact on
this ratio. An overstatement of depreciation leads to a higher CFFO/NOA. However, in
general a higher ratio is seen as a positive because it dictates that a firm is utilizing
their assets to successful garner cash proceeds. The larger this ratio is, the better the
company is making use of their PP&E. A firm may skew their accounting numbers
(PP&E or cash flows) in order to create a more presentable CFFO/NOA ratio. The graph
below shows the ratios for HNI and three of its top competitors for the last five years.
Firms have made great strides in increasing this ratio over the past five years, largely in
part to their depreciating of assets.
-12.000
-10.000
-8.000
-6.000
-4.000
-2.000
0.000
2.000
4.000
6.000
2003 2004 2005 2006 2007
CFFO/OI (CHANGE)
HNI
Herman Miller
Steelcase
Knoll Inc.
117
Since 2003, firms in the industry have all seen a rise in their CFFO/NOA ratio.
This makes perfect since; firms have vehemently stressed new methods to improve
production efficiency in recent years. In addition, while there have been several minor
acquisitions by HNI, property and plant depreciation have far exceeded any additions to
operating assets. Thus, as indicated by the change graph, CFFO for firms has increase
at a faster rate than NOA. Overall, HNI has remained above the industry average in
terms of effectively obtaining cash flows from its operating assets.
0.000
0.200
0.400
0.600
0.800
1.000
1.200
2003 2004 2005 2006 2007
CFFO/NOA (RAW)
HNI
Herman Miller
Steelcase
Knoll Inc.
-60.000
-50.000
-40.000
-30.000
-20.000
-10.000
0.000
10.000
2003 2004 2005 2006 2007
CFFO/NOA (CHANGE)
HNI
Herman Miller
Steelcase
Knoll Inc.
118
Total Accruals/Sales
To calculate the total accruals/sales ratio, one must take the firms cash flows
from operations and subtract out the net earnings of that period. Then, that
amount is divided by the company’s total sales for that year.
As the graphs indicates, firms within the office furniture industry have fairly
erratic ratios. Thus, it is hard to identify any trends among past data. Furthermore,
office furniture firms have very low total accruals/sales ratios. Ironically, there seems
to be no time period where all firms share a similar ratio movements, rather it be
positive or negative. When looking at HNI in particular, it had a substantial increase in
2007. Although sales were relatively close to sales in 2006, accruals in 2007 jumped
considerably. This in turn leads to an increase in total accruals/sales. This information
coincides with HNI’s CFFO/NOA ratio. Since in 2007 the firm increased its receivables
and paid off liabilities, this leads to the conclusion that fewer sales are completed
through accruals.
0.000
0.010
0.020
0.030
0.040
0.050
0.060
0.070
2003 2004 2005 2006 2007
Total Accruals/Sales (RAW)
HNI
Herman Miller
Steelcase
Knoll Inc.
119
Expense Diagnostics Conclusion
As mentioned earlier when discussing key success factors, firms in the office
furniture industry compete in a cost conscious environment, and thus must operate as
efficiently as possible. By doing this, firms provide themselves with the opportunity to
sufficiently meet investors demands for returns. In relation to other firms in the
industry, HNI performs accordingly in terms of expense diagnostics. For the four ratios
we analyzed, in no instance did HNI’s ratio differ greatly from those of its competitors.
However two of the ratios, both of which concerned CFFO, presented us with an
abnormal observation for 2007. Further investigation showed that HNI has distinctly
increased cash flows thanks to an increase in receivables and paying off liabilities.
Since this practice has not been used in the past, it creates a possible misleading of
firm information/outlook for 2007. For example, having a higher CFFO/NOA ratio
implies that HNI is more effectively utilizing operating assets to produce positive cash
flows, something that would be positively looked upon by investors. Given our analysis,
there is a slight concern that HNI has been understating expenses, which could lead
investors into thinking firm value is higher than its true value.
-2.000
-1.500
-1.000
-0.500
0.000
0.500
1.000
2003 2004 2005 2006 2007
Total Accruals/Sales (CHANGE)
HNI
Herman Miller
Steelcase
Knoll Inc.
120
Potential Red Flags
Red flags are indicators within a company’s annual report that suggest that the
validity of the financial statements is in question. These indicators can range from
unexplained changes in accounting to unusual increases in inventories in relation to
sales increases. There are many indicators that may be potential red flags but not all of
them are; it’s the job of an analyst to decide whether there is a need to restate the
firm’s statements due to distorted numbers. HNI has potential red flags that might
have contributed to misleading financial statements. Goodwill and operating leases are
two indicators that are a cause for concern when discussing HNI’s financial statements.
Goodwill
Goodwill is a potential red flag due to the substantial amount recorded on HNI’s
balance sheet as well as the fact they have only impaired goodwill twice (both were
relatively insignificant in relation to the size of goodwill) over the past five years, 2003-
2007. HNI’s goodwill to long term assets ranges from 34 to 38 percent over the past
five years; while goodwill to plant, property, and equipment is in the 80 percentile over
this period. These are very large numbers that suggest that a lot of the company’s
assets are not directly involved to the operating income of the company. This is a
major red flag that needs to be addressed in further detail to realize the actual financial
picture of HNI over this period of time.
121
Operating and Capital Leases
Another area of questionable accounting that we were alerted to was the amount
of funds spent on operating leases by HNI. As of 2008 HNI has a total of $122,329,000
worth of operating leases. Essentially, HNI is understating its assets and liabilities when
they use the operating lease, over capital leases. This is an ambiguous accounting
strategy that sets off an alert for a red flag because they continuously leave a
substantial amount of liabilities off of their balance sheet. This practice can
dramatically affect HNI’s liquidity and debt to equity ratios which would potentially
mislead investors and creditors. The use of this accounting strategy also affects the
Firm’s income statement because interest is not classified properly and depreciation is
not accounted for. All in all, HNI’s heavy use of operating leases triggers a red flag.
Undo Accounting Distortions
Identifying red flags within financial statements is a key to understanding if a
company has distorted their financials to show they are conducting business better than
they actually are. If the analyst believes these red flags are too skewed, than the next
step is to undo the distortions. This step is crucial to understanding the actual financial
picture of a company. By undoing the distortions within a company’s financial
statements an analyst can gain a better perspective on a company’s actual financial
performance; as well as, what numbers were affected by the distortion. We believe
HNI’s two red flags, goodwill and operating leases, affected their financial statements
so unfavorably that we have decided to undo the appropriate distortions to gain a
better point of view on their actual financial performance.
122
123
HNI CorporationIncome Statement
Fiscal Year 2003 2004 2005 2006 2007 2008(Amounts in thousands, except for per share data)Statement of Income Data:Net sales 1,755,728 2,093,447 2,450,572 2,679,803 2,570,472 2,477,587 Cost of products sold 1,116,513 1,342,143 1,562,654 1,752,882 1,664,697 1,648,975 Gross profit 639,215 751,304 887,918 926,921 905,775 828,612 Selling and administrative expenses 480,744 572,006 668,910 717,676 702,329 717,870 Restructuring related and impairment charges 8,510 886 3,462 2,829 9,788 25,859 Operating income 149,961 178,412 215,546 206,416 193,658 84,883 Interest income 3,940 1,343 1,518 1,139 1,229 1,172 Interest expense 2,970 886 2,355 14,323 18,161 16,865 Earnings from continuing operations before income taxes and minority interest 150,931 178,869 214,709 193,232 176,726 69,190 Income taxes 52,826 65,287 77,295 63,670 57,141 23,634 Earnings from continuing operations before minority interest 98,105 113,582 137,414 129,562 119,585 45,556 Minority interest in earnings (losses) of subsidiary N/A N/A (6) (110) (279) 106 Income from continuing operations N/A N/A N/A 129,672 119,864 45,450 Discontinued operations, less applicable income taxes N/A N/A N/A (6,297) 514 - Net income 98,105 113,582 137,420 123,375 120,378 45,450
HNI's Income Statement (in thousands)
124
HNI Corporation Balance Sheet
Fiscal Year 2003 2004 2005 2006 2007 2008AssetsCurrent Assets Cash and cash equivalents 138,982 29,676 75,707 28,077 33,881 39,538 Short-term investments 65,208 6,836 9,035 9,174 9,900 9,750 Receivables, net 181,459 234,731 278,515 316,568 288,777 238,327 Inventories 49,830 77,590 91,110 105,765 108,541 84,290 Deferred income taxes 14,329 14,639 15,831 15,440 17,828 16,313 Prepaid expenses and other current assets 12,314 11,107 16,400 29,150 30,145 29,623 Total Current Assets 462,122 374,579 486,598 504,174 489,072 417,841 Property, Plant, and Equipment 312,368 311,344 294,660 309,952 305,431 315,606 Goodwill 192,086 224,554 242,244 251,761 256,834 268,392 Other Assets 55,250 111,180 116,769 160,472 155,639 163,790 Total Long Term Assets 559,704 647,078 653,673 722,185 717,904 747,788 Total Assets 1,021,826 1,021,657 1,140,271 1,226,359 1,206,976 1,165,629 Liabilities and Shareholders EquityCurrent Liabilities Accounts payable and accrued expenses 211,236 253,958 307,952 328,882 367,320 313,431 Income Taxes 5,958 6,804 1,270 N/A N/A N/A Note payable and current maturities of LT debt and Capital lease obligations 26,658 646 40,350 26,135 14,715 54,494 Current maturities of other long-term obligations 1,964 4,842 8,602 3,525 2,426 5,700 Total Current Liabilities 245,816 266,250 358,174 358,542 384,461 373,625 Long Term Liabilities: Long-Term Debt 2,690 2,627 103,050 285,300 280,315 267,300 Capital Lease Obligations 1,436 1,018 819 674 776 43 Other Long-Term Liabilities 24,262 40,045 48,671 56,103 55,843 50,399 Deferred Income Taxes 37,733 42,554 35,473 29,321 26,672 25,271 Minority Interest in Subsidiaries - - 140 500 1 158 Commitments and ContingenciesTotal Long Term Liabilities 66,121 86,244 188,153 371,898 363,607 343,171 Total Liabilities 311,937 352,494 546,327 730,440 748,068 716,796 Shareholders EquityPreferred stock - $1 par value - - - - - - Authorized: 2,000Issued: NoneCommon stock - $1 par value 58,239 55,303 51,849 47,906 44,835 44,324 Authorized: 200,000Issued and outstanding: 2008-44,324;2007-44,835; 2006-47,906Additional paid-in capital 10,324 6,879 941 2,807 3,152 6,037 Retained earnings 641,732 606,632 540,822 448,268 410,075 400,379 Accumulated other comprehensive (loss) income (406) 349 332 (3,062) 846 (1,907) Total Shareholders Equity 709,889 669,163 593,944 495,919 458,908 448,833 Total Liabilities and Shareholders Equity 1,021,826 1,021,657 1,140,271 1,226,359 1,206,976 1,165,629
HNI's Balance Statement (in thousands)
125
Fiscal Year 2002 2003 2004 2005 2006 2007 2008
Net Sales 1,692,622 1,755,728 2,093,447 2,450,572 2,679,803 2,570,472 2,477,587 Cost of products sold 1,092,743 1,116,513 1,342,143 1,562,654 1,752,882 1,664,697 1,648,975 Gross Profit 599,879 639,215 751,304 887,918 926,921 905,775 828,612 Selling and Administrative Expenses 454,189 480,744 572,006 668,910 717,676 702,329 717,870 Restructuring related and Impairment charges 3,000 8,510 886 3,462 2,829 9,788 25,859 Goodwill Impairment - 38,417 44,911 48,449 45,486 49,780 10 Operating Income 142,690 111,544 133,501 167,097 160,930 143,878 84,873 Interest Income 2,578 3,940 1,343 1,518 1,139 1,229 1,172 Interest Expense 4,714 2,970 886 2,355 14,323 18,161 16,865 Income Before Taxes 140,554 112,514 133,958 166,260 147,746 126,946 69,180 Income Taxes at 34.5% 48,491 38,817 46,216 57,360 50,972 43,796 23,867 Net Income 92,063 73,697 87,742 108,900 96,774 83,150 45,313
HNI's Restated Income Statement (in thousands)
126
2002 2003 2004 2005 2006 2007 2008Current Assets
Cash and cash equivalents 139,165 138,982 29,676 75,707 28,077 33,881 39,538 Short-term investments 16,378 65,208 6,836 9,035 9,174 9,900 9,750 Receivables, net 181,096 181,459 234,731 278,515 316,568 288,777 238,327 Inventories 46,823 49,830 77,590 91,110 105,765 108,541 84,290 Deferred income taxes 10,101 14,329 14,639 15,831 15,440 17,828 16,313 Prepaid expenses and other current assets 11,491 12,314 11,107 16,400 29,150 30,145 29,623
Total Current Asset 405,054 462,122 374,579 486,598 504,174 489,072 417,841 Long Term Assets:
Property, Plant, Equipment 353,270 312,368 311,344 294,660 309,952 305,431 315,606 Goodwill 192,395 153,669 141,226 110,467 74,498 29,792 41,340 Other Assets 69,833 55,250 111,180 116,769 160,472 155,639 163,790
Total Long Term Assets 615,498 521,287 563,750 521,896 544,922 490,862 520,736 Total Assets 1,020,552 983,409 938,329 1,008,494 1,049,096 979,934 938,577
Liabilities:Total Current Liabilities 298,680 245,816 266,250 358,174 358,542 384,461 373,625 Long term Liabilities 74,979 66,121 86,244 188,153 371,898 363,607 343,171 Total Liabilities 373,659 311,937 352,494 546,327 730,440 748,068 716,796
Stockholder's EquityTotal Common Stock 58,374 58,239 55,303 51,849 47,906 44,835 44,324 Additional paid-in capital 549 10,324 6,879 941 2,807 3,152 6,037 Retained Earnings 587,731 603,315 523,304 409,045 271,005 183,033 173,327 Accum. other comprehensive income 239 (406) 349 332 (3,062) 846 (1,907)
Total Stockholder's Equity 646,893 671,472 585,835 462,167 318,656 231,866 221,781
Total Liabilities and Stockholder's Equity 1,020,552 983,409 938,329 1,008,494 1,049,096 979,934 938,577
HNI's Restated Balance Sheet (in thousands)
127
Goodwill to Total Assets
2003 2004 2005 2006 2007
HNI 18.80% 21.98% 21.24% 21.03% 21.57%
Herman
Miller 5.16% 5.47% 5.52% 5.85% 5.87%
Steelcase 8.93% 8.91% 8.89% 9.00% 8.89%
Knoll, Inc. 8.04% 7.91% 7.78% 7.06% 10.54%
As you can see in the table above, HNI has a substantial portion of goodwill in
relation to total assets. HNI’s percentage is a lot larger than their competitors within the
industry and is why we believe we needed to undo possible distortions so that we can
gain a better viewpoint of HNI’s financial picture. Over the period of 2002 to 2008, HNI
impaired goodwill four times; three of the four times were for very insignificant
numbers. Our first step in undoing HNI’s distorted numbers was to write off goodwill
over a five year period at 20 percent. This is an important step because it shows how
goodwill would look on the balance sheet if HNI amortized goodwill on an annual basis.
As you can see below, there is a significant change in goodwill before and after
impairment.
HNI’s impairment of Goodwill (in thousands)
2003 2004 2005 2006 2007 2008
Goodwill Before
Impairment 192086 224554 242244 257844 260339 289854
Goodwill After
Impairment 153669 141226 110467 74498 29792 41340
128
After impairing goodwill, we need to find the long term asset value after the
impairment in order to recognize the accumulated impairment of goodwill over this
period of time. Since goodwill is an intangible long term asset stated on the balance
sheet; one can infer that impairing goodwill would have a direct effect on the long term
asset value. Our next step is to subtract the long term asset value before the
impairment by the new long term asset value after impairment. The difference is the
accumulated goodwill impairment expense over the six years. This is important to
understand because the accumulated impairment expense is what you subtract retained
earnings by to find retained earnings after impairment. As you can see in the table
below, goodwill represented a substantial amount of long term assets before
impairment.
HNI’s Long Term Asset Value (in thousands)
2003 2004 2005 2006 2007 2008
Before
Impairment 559704 647078 653673 722185 717904 747788
After
Impairment 521287 563750 521896 544922 490862 520736
HNI’s Accumulated Goodwill Impairment Expense (in thousands)
2003 2004 2005 2006 2007 2008
Dollar
Amount 38417 83328 131777 177263 227042 227052
Our last step updated the asset side of the balance sheet by showing how long
term assets were affected after the impairment of goodwill. In order to complete the
balance sheet we must impair retained earnings for each year by the accumulated
impairment expense for that given year, so that Assets = Liabilities+ Shareholders’
129
Equity. The table below shows the decline in retained earnings due to the impairment
expense.
HNI’s Retained Earnings (in thousands)
2003 2004 2005 2006 2007 2008
Before
Impairment 641732 606632 540822 448268 410075 400379
After
Impairment 603315 523304 409045 271005 183033 173327
To determine the changes in the income statement, we need to find out the
impairment expense for each individual year. In order to determine the annual
impairment expense, we took HNI’s amortized goodwill amount for a given year and
subtract any impairment HNI had for goodwill in that year. For example, in 2006 the
amortized amount of goodwill (20% of goodwill) was $53,285,000, which we then
subtracted by $6,083,000 (the impairment that HNI had disclosed in their 10K). In the
broadest terms, we subtracted what HNI did impair for goodwill by what HNI should
have impaired (the 20% amortization). The table below states the annual impairment
expense from 2003 to 2008.
HNI’s Annual Goodwill Impairment Expense (in thousands)
2003 2004 2005 2006 2007 2008
Dollar
Amount 38417 44911 48449 45486 49780 10
By finding our annual impairment expense we are now closer to determining how
goodwill impairment has affected net income. Next, we were able to find our taxable
income by expensing our impairment costs over the six year period. After that, we
found a corporate tax rate of 34.5% by averaging the corporate tax rates over the six
130
year period. The table below shows our income before taxes as well as the income tax
for the subsequent years.
HNI’s Tax Table (in thousands)
2003 2004 2005 2006 2007 2008
Earnings
Before
Taxes 112514 133958 166260 147746 126946 69180
Taxes 38817 46216 57360 50972 43796 23867
Estimated
Tax Rate 34.5% 34.5% 34.5% 34.5% 34.5% 34.5%
Once we determine our income tax, we can finally understand the effect the
goodwill impairment had on net income. The table below states net income before and
after the impairment of goodwill. As you can see net income was significantly smaller
after the goodwill impairment than before. Also, since 2005 net income after
impairment has been on the decline.
HNI’s Net Income (in thousands)
2003 2004 2005 2006 2007 2008
Before
Impairment
Expense 98105 113582 137420 123375 120378 45450
After
Impairment
Expense 73697 87742 108900 96774 83150 45313
131
Conclusion
After restating the financials of HNI, we have determined that the aggressive
accounting strategy shown in regards to goodwill has adversely affected their financial
picture. By not impairing goodwill, HNI was able to overstate their net income so that it
seems that they are netting a lot more money than they actually are. It seems that this
aggressive accounting strategy is standard within the office furniture industry and we
believe that the net income within the industry is a lot lower than advertised. By
impairing goodwill we believe the financial statements shown above are a more precise
view of HNI’s financial picture.
Capitalized Operating Leases
Operating Leases
Interest Expense
PMT Change in Balance
Depreciation Capital Lease
Expense
Understated Assets and Liabilities
2003 50,750,000 3,400,250 7,582,750 4,182,500 2,030,000 5,430,250 45,319,750
2004 61,733,000 4,136,111 5,609,889 1,473,778 2,469,320 6,605,431 55,127,569
2005 71,479,000 4,789,093 64,961,907 60,172,814 2,859,160 7,648,253 63,830,747
2006 141,230,000 9,462,410 5,280,410 (4,182,000) 5,649,200 15,111,610 126,118,390
2007 145,412,000 9,742,604 32,825,604 23,083,000 5,816,480 15,559,084 129,852,916
2008 122,329,000 8,196,043 41,625,043 33,429,000 4,893,160 13,089,203 109,239,797
Totals 592,933,000 39,726,511 157,885,603 118,159,092 23,717,320 63,443,831 529,489,169
• We used a 6.7 discount rate
• To determine the payment we took the (beginning operating lease + Interest –
Ending Operating lease)
• We found depreciation by dividing the operating leases by 25 years, which we
figured would be an appropriate length of a leased facility.
132
Financial Analysis, Forecast Financials, and Cost of Capital Estimation
A three step process must be completed by a financial analyst to accurately and
successfully evaluate a firm. These three steps consist of a ratio analysis, the
forecasting of financial statements, and determining the cost of capital of the firm. The
ratio analysis is helpful in providing parallels between companies and figuring out the
typical industry averages and trends to provide better predictions of where the
company is headed. Liquidity, profitability, and capital structure ratios will be analyzed
to forecast HNI Corporation’s balance sheet, income statement, and statement of cash
flows. These financial statements will be forecasted out 10 years based on the firm’s
historical records of the past 5 years. After an accurate evaluation of these procedures,
the information may then be assessed to predict the firm’s future performance in the
industry.
Financial Analysis
Comparisons of financial statements of companies across a particular industry
are often used by creditors, investors, and financial analysts to help them draw
conclusions. The ratios used by these analysts are not complex and provide simplicity
for them when assessing and interpreting these numbers across the board. The
evaluation of a firm, its competitors, and the industry are easier for an analyst to
conduct via these ratios. Creditors, investors, and financial analysts will use these
liquidity, profitability, and capital structure ratios to compare HNI Corporation’s
financials to its competitors over many years. The financial worth of HNI will then be
smoothly comparable to its competitors in the industry.
133
Liquidity Ratios
Liquidity ratios are calculations that firms use to measure their cash availability
and are useful for comparing sales to different items on the balance sheet. These
ratios are used to measure how well a firm can easily convert their assets into cash to
cover their short term liabilities. The firm should be focused on achieving high liquidity
ratios to show the analyst that the firm will not have trouble meeting their current
obligations. On the other hand, too high of results might indicate that the firm is not
adequately investing back into the company to grow and expand. Ratios used in
analyzing the liquidity of a firm include the current ratio, quick asset ratio, working
capital turnover, accounts receivable turnover, days’ sales outstanding, inventory
turnover, days’ supply inventory, and cash to cash cycle.
Current Ratio
The current ratio is equivalent to current assets divided by current liabilities. A
current ratio exceeding 1 is generally good representative number that the company
can pay their bills and meet their short term obligations. The current ratio chart and
table shows that although HNI’s current ratio has slipped to their lowest is has in the
past 5 years, it remains above 1 at a relatively sturdy 1.27. HNI’s purchase of a large
Chinese manufacturer and marketer of office furniture in 2006 is not the reason for this
10% drop; long term assets are usually financed through long term debt or equity and
would not affect the firm’s current ratio. The recently acquired Chinese company,
Lamex, is reported bring in revenues exceeding $70 million per year in the $3 billion
and growing Chinese office furniture industry. This investment may very well raise
HNI’s current ratio in the future if it performs as expected and helps globalize the firm.
An increase in cash produce will lead to a higher current ratio. With the exception of
Steelcase, which has had a volatile liquidity ratio in the recent years, HNI looks to be on
134
par with its other competitors in the industry. Although HNI has fallen beneath the
industry average in the past 2 years, they should not have a problem meeting their
short term obligations.
Current Ratio 2003 2004 2005 2006 2007
HNI 1.88 1.41 1.36 1.41 1.27
Herman Miller 1.81 1.52 1.30 1.35 1.59
Steelcase 1.73 1.73 1.35 1.91 1.37
Knoll Inc. 0.85 1.59 1.48 1.45 1.49
Industry Average 1.57 1.56 1.37 1.53 1.43
Quick Asset Ratio
The quick asset ratio, also known as the acid-test ratio, is similar to the current
ratio. The difference between the two inventories is subtracted out of current assets
when dividing them by current liabilities. By excluding the firm’s inventory from the
equation, the ratio is helpful in allowing the firm to focus on their more liquid assets
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2003 2004 2005 2006 2007
Current Ratio
HNI
Herman Miller
Steelcase
Knoll Inc.
Industry Average
135
that can be easily converted to cash to cover their current liabilities if sales ceased.
One can clearly see when comparing the quick asset ratio graph to the current ratio
graph that the two ratios seem to have similar trends across the industry. This
indicates that the changes in the ratios are not to do so much with inventories as they
are to changes in accounts receivable and payable. Since a company’s inventory is the
least liquid of all current assets, too large of an inventory compared to other current
assets is frowned upon by creditors because they do not want to find a firm trying to
get rid its inventory to cover short term costs. Quick asset ratios can vary greatly
depending on the industry and the office furniture industry looks to have an acid-test
ratio hovering right around one the past few years. Even though HNI’s has dropped
about 13% from last year, it should not be too great of a concern when considering
their recent large acquisition of Lamex. If HNI’s quick asset ratio does not increase
back to the industry average in the next few years, a re-assessment of their current
ratio should be taken into consideration since their inventory has remained stable.
0.60
0.80
1.00
1.20
1.40
1.60
2003 2004 2005 2006 2007
Quick Asset Ratio
HNI
Herman Miller
Steelcase
Knoll Inc.
Industry Average
136
Quick Asset Ratio 2003 2004 2005 2006 2007
HNI 1.57 1.02 1.01 0.99 0.86
Herman Miller 1.44 1.19 0.99 0.99 1.22
Steelcase 1.14 1.19 0.96 1.42 0.97
Knoll Inc. 0.57 1.01 0.99 0.93 0.92
Industry Average 1.18 1.10 0.99 1.08 0.99
Working Capital Turnover
Working capital turnover compares a firm's sales to its working capital, which are
current assets minus current liabilities. This ratio allows the firm to measure how
effectively they are using their money to fund their operations to generate sales
revenue. Keeping this in mind, a high ratio of sales over working capital is a good
indication that the company is efficiently using its working capital to produce high
revenues. After showing a steady working capital turnover from 2004 to 2006, HNI
Corporation’s turnover increased a whopping 33.5% in 2007. When looking at the
industry averages, one can see that they are very sporadic. HNI finds themselves in a
good position since they have the highest turnover out of all their competitors. The
increase in working capital turnover was not due to HNI’s sales increasing, but rather
their working capital decreasing. This means that HNI did a better job of using their
money for short term obligations to create sales than they did in the two previous
years. Overall, 24.5 turns is a very high working capital turnover for this industry and
the investor should not expect the firm to continue at this pace.
137
Working Capital Turnover 2003 2004 2005 2006 2007
HNI 8.12 19.32 19.08 18.40 24.57
Herman Miller 6.92 10.15 19.13 19.15 11.01
Steelcase 5.88 5.84 9.83 5.29 13.59
Knoll Inc. -24.69 11.27 12.63 12.73 12.21
Industry Average -0.94 11.65 15.17 13.89 15.35
Accounts Receivable Turnover
The accounts receivable turnover is calculated by dividing the net sales by the
net accounts receivable on the balance sheet. A firm uses accounts receivable to offer
credit to their customers which allows them to pay at a later date. This ratio allows the
firm to measure how efficiently they are collecting their accounts outstanding. A low
ratio shows a firm is having trouble making collections and that should consider re-
-10.00
-5.00
0.00
5.00
10.00
15.00
20.00
25.00
2003 2004 2005 2006 2007
Working Capital Turnover
HNI
Herman Miller
Steelcase
Knoll Inc.
Industry Average
138
assessing their credit policies. Lower ratios could indicate that the firm has large sums
of money caught up in their accounts receivable balance and payments will not be
recognized for long periods of time. High ratios are preferred because speedy
collections ensure a continuous cash flow for the company and increase their liquidity.
A/R Turnover 2003 2004 2005 2006 2007
HNI 9.68 8.92 8.80 8.47 8.90
Herman Miller 9.40 8.93 10.03 10.20 9.63
Steelcase 6.56 6.91 7.51 8.78 8.62
Knoll Inc. 7.64 7.64 7.12 7.39 7.71
Industry Average 8.32 8.10 8.36 8.71 8.71
HNI Corporation’s accounts receivable turnover has been relatively steady over
the past 5 years and rose just above the industry in 2007. Herman Miller and Knoll
Incorporated deviate only one turn from the industry average either way which shows
that the accounts receivable turnover for the office furnishings industry is fairly stable.
There are no dramatic spikes in the accounts receivable turnover for any of HNI’s
competitors so the industry average has stayed solid. Conclusively, HNI has done an
adequate job of regulating their credit policies to hold a secure accounts receivable
turnover in comparison to their competition.
139
As they should, the accounts receivable turnover and the days’ sales outstanding
graphs act as reflections of one another. If a firm has a high account receivable
turnover, it will conversely have low days’ sales outstanding. This may be observed
between the accounts receivable graph and the following days’ sales outstanding graph.
6.00
7.00
8.00
9.00
10.00
11.00
2003 2004 2005 2006 2007
Accounts Recievable Turnover
HNI
Herman Miller
Steelcase
Knoll Inc.
Industry Average
30.00
35.00
40.00
45.00
50.00
55.00
60.00
2003 2004 2005 2006 2007
Days' Sales Outstanding
HNI
Herman Miller
Steelcase
Knoll Inc.
Industry Average
140
Days’ Sales Outstanding
The days’ sales outstanding ratio simply puts the accounts receivable turnover in
a measurement of days instead of turns. Thus, a firm can acquire an average collection
time, or period, that it takes for sales revenue to come into circle and be invested back
into the company. This can be calculated by dividing 365, the number of days in a
year, by the company’s accounts receivable turnover. Since the accounts receivable
turnover ratio and the days’ sales outstanding ratio are directly correlated, a higher
accounts receivable turnover will inevitably lead to a fewer amount of days between
collections. Days’ sales outstanding can vary greatly depending on the industry. For
instance, a retailer of office furniture will have a higher accounts receivable turnover
than a wholesaler of office furniture because many sales are made on credit every day
as opposed to a wholesaler whose business comes mainly from bulk orders.
Days Sales Outstanding 2003 2004 2005 2006 2007
HNI 37.72 40.93 41.48 43.12 41.01
Herman Miller 38.84 40.89 36.39 35.78 37.91
Steelcase 55.66 52.80 48.59 41.55 42.36
Knoll Inc. 47.78 47.77 51.29 49.42 47.36
Industry Average 45.00 45.60 44.44 42.47 42.16
141
Inventory Turnover
When analyzing how effectively a firm replenishes its inventory as sales are
made, the calculation of inventory turnover serves very helpful. The ratio is drawn by
taking the firm’s cost of goods sold and dividing it by their inventory. A high inventory
turnover suggests the firm either has high sales for that period or they are ineffectively
purchasing inventory. Low inventory turnover signifies that the firm’s sales are
struggling and they are having trouble flipping their inventory. The company may find
themselves in a pickle if sales start to fall while they have a large inventory on hand.
The ratio can differ significantly across industries and should be compared to the
industry average.
5.00
10.00
15.00
20.00
25.00
2003 2004 2005 2006 2007
Inventory Turnover
HNI
Herman Miller
Steelcase
Knoll Inc.
Industry Average
142
Inventory Turnover 2003 2004 2005 2006 2007
HNI 22.41 17.30 17.01 16.57 15.33
Herman Miller 24.22 21.97 24.68 22.73 23.84
Steelcase 14.76 13.99 13.45 14.78 15.65
Knoll Inc. 12.02 9.39 9.49 8.73 7.50
Industry Average 18.35 15.66 16.16 15.70 15.58
According to the inventory turnover table, HNI and Knoll are well below the
industry average while Herman Miller is well above. The reasoning for this is HNI has
been holding almost twice as much inventory as Herman Miller has been over past
several years. Knoll’s inventory turnover is significantly lower than the industry average
because they are a much smaller company than HNI and its competitors so they have
much lower cost of goods sold while holding high levels of inventory in comparison.
Seeing that HNI’s inventory turnover has been steadily decreasing over the past 4 years
and has just fallen below the industry average for the first time in 5 years, they need to
be cautious when determining their inventory levels in the future. Despite HNI’s
superior sales and cost of goods sold to Herman Miller’s, it is obvious that HNI has not
been managing their inventory as effectively. Steelcase’s inventory turnover has been
steadily increasing over the past 4 years and if HNI does not re-assess their buying
habits, they will find themselves well below the industry norm in future years.
Days’ Supply of Inventory
The days’ supply of inventory is the amount of time (in days) that it takes a firm
to turnover its inventory. It can be calculated by taking the amount of days in a year,
365, and dividing it by the firm’s inventory turnover. Because days’ supply of inventory
directly correlated to inventory turnover ratio, the two graphs are almost mirror images
143
of one another with the exception of the industry average. Since a high inventory
turnover is generally what firms are trying to attain and the two ratios are reflections of
one another, a low days’ supply of inventory is normally sought after. This ratio is also
subject to the industry and its trends as well.
It is clear that Knoll’s high days’ supply of inventory is responsible for bringing
the industry average above their competitors in the past 2 years. HNI’s days’ supply of
inventory over the past 4 years has been constantly increasing at low rate while
Steelcase’s has been decreasing at a similar pace. It is not a huge difference that an
investor should be too concerned with, but the ratio should be watched to make sure it
does not get out of hand in the future. Herman Miller is the industry leader by 8 days.
It may not seem like much, but it leads to 8 more times they turn their inventory than
Steelcase who has recently jumped into second place in terms of inventory turnover. In
order for HNI to regain a strong position in days’ supply of inventory like they had in
10.00
20.00
30.00
40.00
50.00
2003 2004 2005 2006 2007
Days Supply of Inventory
HNI
Herman Miller
Steelcase
Knoll Inc.
Industry Average
144
2004, they must first raise their inventory turnover. By accomplishing this goal, they
may then lower their days’ supply of inventory which will help strengthen the firm.
Days Supply of Inventory 2003 2004 2005 2006 2007
HNI 16.28 21.1 21.46 22.03 23.81
Herman Miller 15.07 16.62 14.79 16.06 15.31
Steelcase 24.74 26.08 27.14 24.70 23.33
Knoll Inc. 30.37 38.89 38.48 41.79 48.66
Industry Average 21.62 25.67 25.47 26.14 27.78
Cash to Cash Cycle
The cash to cash cycle is used to calculate the number of days it takes to convert
an input dollar into actual cash flows. The ratio comes from the summation of the
firm’s days’ sales outstanding and the days’ supply of inventory. By adding these two
ratios, the firm is essentially measuring the amount of time it takes to sell their
inventory and collect their accounts receivable. Like the ratios that the cycle to cash
cycle is made up of, a lower number is what a firm is seeking. A firm can increase their
liquidity by reducing the amount of time is takes to flip their inventory and make
collection of their outstanding receivables. A firm will be deemed more credit worthy if
they have a low cash to cash cycle in comparison to their other competitors in the
industry.
145
It is not a surprise that Herman Miller has the lowest cash to cash cycle in the
office furnishings industry considering their dominant numbers in the days’ liquidity
ratios. HNI’s cash to cash cycle is about 5 days lower than the industry average.
Although this ratio has been increasing every year since 2003, they were able to reduce
it in 2006. Based on the graph and table provided, Herman Miller’s cash to cash cycle
has been increasing over the past 2 years. If HNI can continue to remain under the
industry average and decrease the amount of time is takes them convert their
resources into cash flows, they can narrow the gap that separates them from the
industry leader. Overall, they hold a strong position in the office furnishings industry
and seem to have things under control.
40.00
50.00
60.00
70.00
80.00
90.00
100.00
2003 2004 2005 2006 2007
Cash to Cash Cycle
HNI
Herman Miller
Steelcase
Knoll Inc.
Industry Average
146
Cash to Cash Cycle 2003 2004 2005 2006 2007
HNI 54.01 62.02 62.94 65.15 64.82
Herman Miller 53.91 57.51 51.18 51.84 53.23
Steelcase 80.40 78.88 75.72 66.25 65.69
Knoll Inc. 78.15 86.66 89.77 91.21 96.03
Industry Average 66.62 71.27 69.90 68.61 69.94
Conclusion
After calculating and analyzing these liquidity ratios, it is now possible to
evaluate the firm’s position in the office furnishing industry. HNI Corporation’s current
ratio and quick asset ratio were the worst in the industry but not too much below the
industry average. Again, this could be due to their recent acquisition of Lamex in China
but should be watched carefully in the years to come. HNI’s working capital was well
above their competition but is extremely high for this industry and should not expect
this enormous growth rate every year. As for the turnover ratios, HNI has been fairly
average over the past 5 years with an improvement in their cash to cash cycle while the
industry average increased. Overall, HNI Corporation’s liquidity efficiency can be
ranked average. The table on the following page displays HNI’s relationship concerning
liquidity ratios with industry averages.
147
Liquidity Ratio Performance Trend
Current Ratio Below Downward
Quick Asset Ratio Below Downward
Working Capital Turnover Above Upward
Accounts Receivable Turnover Average Stable
Days' Sales Outstanding Average Stable
Inventory Turnover Average Downward
Days' Supply of Inventory Average Upward
Cash to Cash Cycle Average Downward
Overall Average Stable
Profitability Ratios
In order to successfully build a business, an adequate coverage of expenses with
revenues is necessary. To analyze this relationship, we utilize profitability ratios.
Profitability ratios essentially provide key statistics which aid in determining a firm’s
ability to generate profit. For these ratios, higher numbers are desired. For example, an
ROA of 25% is much more preferable than 5%. With this in mind, we will carefully
select important monetary reported accounting numbers from a firm’s balance sheet,
income statement, and statement of cash flows. Trends in profitability ratios help
create expectations for the future as well as a way to compare like firm in a given
industry. The profitability ratios analyzed are as follows: gross profit margin, operating
expense ratio, operating profit margin, net profit margin, asset turnover, return on
assets, return on equity, sustainable growth rate, internal growth rate, and a firm’s z-
148
score. Many of the profitability ratios have been restated for HNI to indicate a more
transparent view of company operations.
Gross Profit Margin
The gross profit margin relates a firm’s gross profit to its total sales. The gross
profit margin is calculated by subtracting cost of goods from net sales and then dividing
that resulting number by net sales. The higher the ratio, the more adequate a firm
operates in terms of covering its fixed costs and overhead expenses. In addition, gross
profit (after several deductions) deductively leads to net income; therefore a higher
gross profit margin allows the opportunity for more net income. Information provided
by the gross profit margin gives insight into company profit generating before
accounting for non-production costs.
24.0%
26.0%
28.0%
30.0%
32.0%
34.0%
36.0%
38.0%
2003 2004 2005 2006 2007
Gross Profit Margin
HNI
Herman Miller
Steelcase Inc.
Knoll Inc.
Industry Average
149
Gross Profit Margin 2003 2004 2005 2006 2007
HNI 36.4% 35.9% 36.2% 34.6% 35.2%
Herman Miller 31.1% 32.3% 33.1% 33.7% 34.7%
Steelcase Inc. 26.2% 28.5% 29.5% 30.6% 32.9%
Knoll Inc. 33.9% 34.1% 33.7% 32.5% 34.6%
Industry Average 31.9% 32.7% 33.1% 32.8% 34.4%
As the graph indicates, HNI has done an excellent job in maintaining a high
gross profit margin. In fact, HNI has had the highest gross profit margin in the office
furniture industry from 2003-2007. However, the gap between HNI and its competitors
has shrunk. This shrinkage is not due to HNI losing hold on its margin but rather than
other firms have become more efficient in generating sales relative to production costs.
For example, Steelcase Inc. has seen its gross profit margin increase a rate of twice the
industry average, going from 26.2% in 2003 to 32.9% in 2007. As long as HNI keeps its
gross profit margin in the 30%-40% range, we can classify the firm as adequate
managing its cost of goods.
Operating Expense Ratio
The operating expense ratio shows how high a firm’s selling and administrative
expenses are relative to its sales. Ideally, a firm will maintain a low operating expense
ratio in relation to competitors in its industry. A firm will see its operating expense ratio
rise if it begins to disregard cost control procedures. To calculate this ratio, divide
selling and administrative expenses by sales. The resulting percentages indicate the
amount of selling and administrative expenses that account for every dollar of sales.
150
Operating Expense Ratio 2003 2004 2005 2006 2007
HNI 0.2738 0.2732 0.2730 0.2678 0.2732
HNI (Restated) 0.2683 0.2738 0.2732 0.2730 0.2678
Herman Miller 0.2272 0.2156 0.2151 0.2063 0.1967
Steelcase Inc. 0.2889 0.2763 0.2642 0.2685 0.2698
Knoll Inc. 0.2148 0.2402 0.2218 0.2058 0.2112
Industry Average 0.2546 0.2558 0.2495 0.2443 0.2437
All firms in the office furniture industry have done an adequate job of upholding
reasonable operating expense ratios (considering the industry). A large part of selling
multi-million dollar furniture deals with customers comes from the establishment of
relationships with consumers. Therefore, minimizing these costs can greatly benefit a
firm. HNI specifically has had a stable rate over the past five years, having only
witnessed a ½% change in a five year span. Still, we would like to see HNI lower its
operating expense ratio so that it is at least at the industry average. As the graph
entails, HNI has consistently been above the industry average. This indicates the firm is
0.1800
0.2000
0.2200
0.2400
0.2600
0.2800
0.3000
2003 2004 2005 2006 2007
Operating Expense Ratio
HNI
Herman Miller
Steelcase Inc.
Knoll Inc.
Industry Average
HNI (Restated)
151
sacrificing possible net income gains. By re-evaluating administrative costs, HNI could
provide additional value to the shareholder.
Operating Profit Margin
Operating profit margin results from dividing a company’s operating income
(gross profit minus selling and administrative expenses) by total sales. The lower the
percentage of sales that operating income accounts for, the less profitable a firm is
after taking operating expenses out. Thus, as is the case concerning gross profit
margin, a higher margin is desired.
Operating Profit Margin 2003 2004 2005 2006 2007
HNI 8.5% 8.5% 8.8% 7.7% 7.5%
HNI (Restated) 6.4% 6.4% 6.8% 6.0% 5.6%
Herman Miller 4.6% 8.0% 9.1% 10.3% 12.3%
Steelcase Inc. ‐3.1% 0.7% 2.9% 3.7% 5.9%
Knoll Inc. 12.4% 10.1% 11.5% 11.9% 13.5%
Industry Average 5.8% 6.7% 7.8% 7.9% 9.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
2003 2004 2005 2006 2007
Operating Profit Margin
HNI
Herman Miller
Steelcase Inc.
Knoll Inc.
Industry Average
HNI (Restated)
152
The graph shows that HNI has seen its operating profit margin slowly decline
over the years as well as sinking to below the industry average. This is a result of the
firm not adequately generating sales off of its operating expenses. We would like to see
HNI reassess some of its business practices because low operating profit margins
indicate a firm is burdening itself with inefficient operations. Knoll Inc. continues to lead
the industry in terms of operating profit margin with a margin of 13.5% in 2007.
Meanwhile, HNI’s was only 7.5% in the same year.
Net Profit Margin
Net profit margin is one of the most widely recognized and important financial
profitability ratios. Thankfully, it is quite simple to compute. To calculate a firm’s net
profit margin, one divides net income by net sales. This ratio indicates the amount
which for every dollar of sales results into end-use profit; this profit may be used either
to pay shareholder dividends or re-invest in company projects. A high net profit margin
signifies a firm’s strong grasp of controlling company expenses. This ratio can only
increase if profits are increasing at a faster rate than expenses. Therefore, simply
concentrating on garnering additional revenue does not necessarily result in a higher
net profit ratio.
Net Profit Margin 2003 2004 2005 2006 2007
HNI 5.6% 5.4% 5.6% 4.6% 4.7%
HNI (Restated) 4.2% 4.2% 4.4% 3.6% 3.2%
Herman Miller 3.2% 4.5% 5.7% 6.7% 7.6%
Steelcase Inc. ‐1.0% 0.5% 1.7% 3.5% 3.9%
Knoll Inc. 5.2% 3.8% 4.4% 6.0% 6.8%
Industry Average 3.4% 3.7% 4.4% 4.9% 5.2%
153
No firm can sustain a long period of negative net profit margins. The graph
shows that firms in the office furniture industry have an average net profit margin of
about 4.4% with a standard deviation of 1%. The trends of firms in the industry are all
upwards moving except for HNI, which raises a concern. While the industry average
increased 2.5% from 2003-2007, HNI actually saw a decrease in net profit margin of
.9%. This provides us with the insight that HNI is not properly adapting with the
industry in terms of managing costs. A decrease in net profit margin means that HNI
will have less money to re-invest with and spend as they please for future growth. Since
net profit margin is so strongly tied to company growth, it is essential to value this ratio
when analyzing a firm.
Asset Turnover
Another exceedingly important profitability ratio is asset turnover, which is the
key ratio in linking a firm’s income statement to its balance sheet when forecasting. A
firm with a higher asset turnover ratio is successfully generating sales from its assets. A
maximization of generating revenues from assets is especially important to industries
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
2003 2004 2005 2006 2007
Net Profit Margin
HNI
Herman Miller
Steelcase Inc.
Knoll Inc.
Industry Average
HNI (Restated)
154
which have expensive long-term fixed assets. The asset turnover is calculated by
dividing net sales by the previous year’s assets. A turnover of less than one indicates a
firm is not properly utilizing its assets.
Asset Turnover 2003 2004 2005 2006 2007
HNI 1.72 2.05 2.15 2.19 2.13
HNI (Restated) 1.79 2.23 2.43 2.55 2.62
Herman Miller 1.74 2.12 2.46 2.87 3.02
Steelcase Inc. 1.00 1.11 1.21 1.32 1.43
Knoll Inc. 1.18 1.26 1.43 1.69 1.67
Industry Average 1.49 1.75 1.94 2.12 2.17
As an industry, asset turnover increased from 1.41 in 2003 to 2.06 in 2007. This
designates that firms in the industry have successfully generated sales from their
assets. Obviously, have a turnover ratio of greater than one is vital to company success.
Herman Miller has experience the largest gain in asset turnover, nearly doubling from
2003-2007. HNI has seen its asset turnover ascend to over 2. Statistics from 2007
indicated that for every dollar invested in assets, HNI generated $2.13 in sales. An
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
3.00
2003 2004 2005 2006 2007
Asset Turnover
HNI
Herman Miller
Steelcase Inc.
Knoll Inc.
Industry Average
HNI (Restated)
155
explanation for the observed rise in asset turnover ratios may be that early in the
decade firms invested a lot of money in assets but since then have tried to find ways to
generate more sales with pre-existing facilities and equipment.
Return on Assets
One of the primary components of finance is that people expect to be
compensated for delaying their consumption of money. This is why interest is awarded
to bank accounts and business managers expect a substantial return on their assets.
They surmise that investing in an asset is only plausible if that asset will generate a
return greater than that of other possible projects and especially higher than the risk-
free rate. For this reason, return on assets is a greatly value financial ratio. To calculate
return on assets, we divide net income by the previous year’s total assets. The reason
that we use the previous year’s total assets instead of the current one is that it is last
year’s assets that are being implemented in producing the current year’s income.
Return on Assets 2003 2004 2005 2006 2007
HNI 9.6% 11.1% 12.1% 10.1% 10.0%
HNI (Restated) 8.9% 7.2% 8.9% 11.6% 9.6%
Herman Miller 5.5% 9.5% 14.1% 19.3% 22.9%
Steelcase Inc. ‐1.0% 0.5% 2.1% 4.6% 5.6%
Knoll Inc. 6.2% 4.8% 6.3% 10.1% 11.3%
Industry Average 5.8% 6.6% 8.7% 11.1% 11.9%
156
The graph above indicates that over the past five years HNI’s return on assets as
been slightly volatile. By this we mean the firm’s ROA has risen up and down and has
not followed any distinct recognizable trend. However, the industry as a whole has
experienced an upward trend of return on assets. In fact, the ROA rose 245% from
2003-2007, quite a significant jump to its current status of 12.2%. The reason HNI
hasn’t enjoyed the same gains in ROE stems from its problem of operating expenses.
The firm’s high operating expense ratio leads to the firm to having lower net income,
which is a direct component of the return on asset ratio. Remember, the industry saw a
significant investment in long-term assets in the early decade; sometimes it is hard to
effectively utilized newly acquired assets because a firm may not be familiar in
maximizing the output of the assets at the lowest possible cost. The graphs seem to
show that firms have gained knowledge in how to maximize their assets.
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
2003 2004 2005 2006 2007
Return on Assets
HNI
Herman Miller
Steelcase Inc.
Knoll Inc.
Industry Average
HNI (Restated)
157
Return on Equity
Return on Equity is measured by taking the current year’s net income and
dividing it by the previous year’s total equity. This ratio shows how efficiently a firm is
using shareholder capital to generate returns for the firm. It goes without saying that
this ratio is very important to investors. Return on equity shares an interesting
relationship with a firm’s capital structure (financial leverage). A firm which shifts to a
higher debt to equity ratio but maintains its net income levels will see a jump in its
return on equity. Since return on equity impacts shareholder wealth, it is imperative for
current and potential investors alike to compare this profitability ratio with others within
an industry. By comparing return on equity and the cost of equity, we can establish
if the firm is properly utilizing its assets (some acquired by means of equity funding) to
generate profit.
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
2003 2004 2005 2006 2007
Return on Equity
HNI
Herman Miller
Steelcase Inc.
Industry Average
HNI (Restated)
158
Return on Equity 2003 2004 2005 2006 2007
HNI 13.8% 17.0% 23.1% 24.9% 26.2%
HNI (Restated) 8.5% 11.2% 13.1% 18.6% 20.9%
Herman Miller 22.1% 34.9% 58.2% 93.3% 98.1%
Steelcase Inc. ‐1.8% 1.1% 4.1% 8.9% 10.8%
Industry Average 10.7% 16.0% 24.6% 36.4% 39.0%
Firms in the office furniture industry appear to have adapted a similar strategy in
respect to how they manage their stock issuances. Several firms have aggressively
repurchased stock within the past few years; this can significantly affect ratios which
deal with firm equity (debt to equity ratio, ROE). This fact may be observed in the
graph of firm ROE’s from 2003 to 2007. Knoll Inc. was excluded from comparison for
this ratio due to the fact that they had a shareholder deficit (negative equity) in 2003
and 2004. Using their numbers would drastically throw off industry averages and
prevent us from having a viable means of assessment. As one can see, all firms in the
industry have seen major, almost fantasy-like, jumps in their return on equity ratios. In
a five-year span, HNI return on equity doubled, Herman Miller return on equity
quadrupled, and Steelcase Inc. return on equity increased more than tenfold. Each firm
should be carefully evaluated on a case-by-case basis to identify the quantitative reason
for such extreme gains. Asset turnover, profit margin, and firm capital structure
all impact return on equity. Having a higher return on equity attracts shareholders,
especially when it significantly eclipses an investor’s expected rate of return on their
investment into a firm.
159
Internal Growth Rate
Measuring a firm’s internal growth rate is one of the two methods preferred in
predicting firm potential growth for the future. This growth rate evaluates firm
potential growth on the assumption that no financing from outside sources will be uses.
That is, only funding from the firm’s cash flows will be used for firm growth projects. To
calculate the internal growth rate (IGR), a firm’s return on assets is multiplied by the
company plowback ratio. A plowback ratio, also recognized as retention rate, is the
amount of net income retained after paying dividends and can be found by the equation
(1-dividends/net income). If a company does not pay dividends, its IGR is simply its
return on assets.
IGR 2003 2004 2005 2006 2007
HNI 9.0% 8.0% 10.2% 7.6% 6.8%
HNI (Restated) 5.7% 4.6% 6.1% 7.3% 5.4%
Herman Miller 4.1% 6.7% 11.2% 16.2% 19.7%
Steelcase Inc. ‐2.5% ‐1.0% 0.0% 1.7% ‐8.4%
Industry Average 4.1% 4.6% 6.9% 8.2% 5.9%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
2003 2004 2005 2006 2007
IGR
HNI
Herman Miller
Steelcase Inc.
Industry Average
HNI (Restated)
160
In comparison to the industry average IGR, HNI has performed adequately. Even
after restatement, HNI remains close to the industry average. Knoll Inc. was excluded
from this graph due to significant abnormalities in their accounting statements. As the
graph indicates, Herman Miller has done an exceptional job in the past few years of
providing itself with the opportunity for internally funded company growth. Since HNI’s
plowback ratio has remained at a consistently stable rate, we would expect its IGR
trends to follow its ROA movement trends, which it does.
Sustainable Growth Rate
The other popular measure of prospective company growth is known as the
sustainable growth rate (SGR). The sustainable growth rate is similar to the internal
growth rate but precedes one step further by incorporating the firm’s capital structure.
To calculate SGR, we multiply IGR by (1+total liabilities/shareholder equity). This
allows us to analyze how much the firm can grow while both investing and managing
debt proportionally. Basically, sustainable growth rate measures a firm’s growth
potential if it is to remain at its current debt to equity ratio. Thus, drastic changes to
capital structure can have a large effect on SGR.
-50.0%
0.0%
50.0%
100.0%
150.0%
200.0%
2003 2004 2005 2006 2007
SGR
HNI
Herman Miller
Steelcase Inc.
Industry Average
HNI (Restated)
161
4% 6
SGR 2003 2004 2005 2006 2007
HNI 11.5% 12.2% 19.5% 18.9% 18.0%
HNI (Restated) 6.9% 7.3% 13.4% 24.0% 22.8%
Herman Miller 20.8% 18.9% 29.6% 31.2% 180.6%
Steelcase Inc. 8.1% 13.2% 21.8% 31.5% 45.9%
Industry Average 11.8% 12.9% 21.1% 26.4% 66.8%% 8% Quite frankly, SGR’s of firms in the office furniture industry are very hard to
evaluate due to recent drastic shifts in company capital structures. For example, the
equity for Herman Miller in 2006 was 153 million. However, the very next year,
shareholder equity dropped to 23 million. This drop allows for a much higher SGR since
a prime component the formula is (1+total liabilities/equity). By reducing equity, a firm
will have a much higher value. Firms in the industry have made concentrated efforts to
alter their capital structures through such methods as share repurchasing. By increasing
debt to equity, a firm can manage its agency costs better. This means that business
managers must spend earning more to pay off debt rather than make risky decisions
that may lead to personal benefit and not towards the best interest of shareholders.
However, problems occur in years that firm’s can’t meet their debt obligations; in such
times they often must borrow at high rates to pay off their lower rate debts.
Conclusion
The profitability ratios we analyzed allow us to observe the profitability efficiency
of HNI as well as other competitive firms in the industry. Profitability, a core concept of
business strategy, stresses how well a company operates within its means. As a whole,
HNI performs decently but could improve on several fronts. The following table
summarizes HNI’s profitability ratio performance with industry averages. Although HNI
162
overall is still above market performance in profitability, recent signs of downward
trends present a concern for the company.
Profitability Ratio Performance Trend
Gross Profit Margin Above Stable
Operating Expense Ratio Above Stable
Operating Profit Margin Above Downward
Net Profit Margin Above Downward
Asset Turnover Above Upward
Return on Assets Above Downward
Return on Equity Average Upward
Internal Growth Rate Above Downward
Sustainable Growth Rate Above Downward
Overall Profitability Above Downward
Capital Structure Ratios
Capital structure ratios are used by firms to help provide insight on how risky the
firm is. A firms’ capital structure is the configuration of liabilities or can be referred to
simply as the right side of the balance sheet. These ratios help determine how much
debt is used to finance assets or operations. This financing shows exactly why capital
structure ratios determine leverage. Leverage is borrowing money to complement
existing funds for investment purposes in a way that future outcomes can be magnified.
Firms that are greatly leveraged might be at risk of going bankrupt if they cannot make
payments on their liabilities. However, leverage can increase stockholders’ return on
investments and tax advantages can be acquired through borrowing. It is essential
when using financial leverage to increase benefits to shareholders while trying to
minimize risk. Ratios used in determining a firms’ capital structure are the debt to
equity ratio, times interest earned ratio, and debt service margin ratio.
163
Debt to Equity
The debt to equity ratio can be calculated by taking total liabilities and dividing it
by owner’s equity. It shows how much money of debt financing the firm is applying for
every dollar that the shareholders have invested. The debt to equity ratio is a strong
indicator in determining a firm’s financial leverage. Most firms use only the long term
portion of debt or liabilities. In fact, some quoted ratios tend to leave out the current
portion of long term debt. Other subjective decisions are whether to include preferred
shares as part of debt or equity. If this ratio is greater than 1, it means assets are
primarily financed through debt. This could cause revenue to be volatile because of the
additional interest costs. In contrast, if the ratio is smaller than 1, assets are financed
mostly through equity. When a firm has a high debt to equity ratio they are seen as
risky, especially in periods with high interest rates. In these time periods, high interest
rates will cause extra interest to be paid out of debt. HNI over the past 5 years has
been under the industry average. Not necessarily a bad thing but their debt to equity
was below 1 for several years. However, the ratio has been increasing slightly annually.
Restated numbers show strong growth for HNI, because these numbers also have been
increasing annually. This shows HNI’s ability to control their financial leverage unlike
Herman Miller, whose debt to equity ratio has been exceedingly volatile as of late.
Debt to Equity Ratio 2003 2004 2005 2006 2007
HNI 0.44 0.53 0.92 1.47 1.63
HNI (Restated) 0.46 0.60 1.18 2.29 3.23
Herman Miller 2.67 3.14 3.83 3.29 32.47
Steelcase 0.95 0.98 0.95 0.94 1.33
Industry Average 1.51 1.75 2.29 2.66 12.89
Knoll Inc N/A N/A N/A N/A N/A
164
Times Interest Earned
A useful tool in measuring a firm’s ability to meet its debt obligations is the times
interest earned ratio. It is also known as the interest coverage ratio or fixed-charged
coverage. The ratio is calculated by using a company’s operating income and dividing it
by total interest payable or the interest expense on contractual debt. This ratio shows
how many times a firm can cover its interest expenses by taking money out of earnings.
If a firm is unable to meet these contractual debt obligations, filing for chapter 11 could
be a relevant issue. Making sure interest payments can be made to appease debt
holders and stopping bankruptcy depends highly on firm’s ability to generate sufficient
income. A high times interest earned ratio can often indicate a firm has a displeasing
amount of debt or possibly is paying too much debt with income that could be useful in
other projects. The philosophy is that firms would receive greater returns by investing
income into different projects and financing at a lower cost of capital then what is
presently expensed for the current debt to meet debt obligations. HNI’s times interest
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
2003 2004 2005 2006 2007
Debt to Equity Ratio
HNI
Herman Miller
Steelcase
Industry Average
HNI (Restated)
165
earned ratio is decreasing annually and the restated numbers show that they have
come to drop below the industry average in the last two years. Historically, they are
much higher than the industry average. This high average can be correlated with HNI’s
operations. They have been able to sustain earnings with such efficiency, that they are
able to pay back investors at a good rate. They are paying off high debts with
significant amounts of earnings because innovation is less important now than it will be
in the future or it has been in the past.
-20.00
0.00
20.00
40.00
60.00
80.00
100.00
2003 2004 2005 2006 2007
Times Interest Earned
HNI
Herman Miller
Steelcase
Knoll Inc
Industry Average
HNI (Restated)
166
Times Interest Earned 2003 2004 2005 2006 2007
HNI 50.49 201.37 91.53 14.41 10.66
HNI (Restated) 37.56 150.68 70.95 11.24 7.92
Herman Miller 4.34 8.71 11.26 14.46 13.12
Steelcase -3.97 0.87 4.56 6.15 12.00
Knoll Inc 4.28 3.67 3.92 4.93 5.78
Industry Average 23.17 91.32 45.56 12.80 12.37
Debt Service Margin
The debt service margin ratio can be computed by taking total available cash
flow and dividing it by the current notes payable. This measures the ability of a
business to meet its regular debt obligations. The cash flow available for debt
repayment to its total debt service indicates a margin of safety available if the business
makes a profit, and its cash flows temporarily decrease. Any smart investor will insist
on having a debt service margin ratio greater than 1. The higher the ratio is, the easier
it is to finance projects through borrowing. If the ratio is below 1, that means there is
negative cash flow which is a serious problem for any firm looking to be successful. For
example, if a firm has a DSMR of .85, it would mean the firm only has enough operating
revenue to cover 85% of debt payments. The ratio can also be used to find the
minimal amount that a lender is willing to accept. This ratio is seen as a useful
indicator of financial strength. Knoll’s debt service margin ratio has the most
fluctuation, which can be seen easily on the line graph. Herman Miller is typically above
the industry average. Their operating income is higher than Knoll or Steelcase and their
current debt is much lower than HNI. This shows Herman Miller has very healthy
operating procedures because high cash flow means good daily operations. HNI is the
167
lowest in the industry. Their restated numbers are the same as the original numbers
because restating goodwill has nothing to do with cash flow or notes payable. This
ratio shows an area that HNI as a successful firm should look to improve.
Debt Service Margin 2003 2004 2005 2006 2007
HNI 3.42 7.29 311.16 3.96 11.14
HNI (Restated) N/A 7.29 311.16 3.96 11.14
Herman Miller 6.08 8.41 11.57 45.90 71.20
Steelcase 2.93 3.33 2.60 1.07 48.96
Knoll Inc 1.24 0.74 717.05 29.83 34.10
Industry Average 3.42 6.76 338.38 21.18 44.14
0.00
100.00
200.00
300.00
400.00
500.00
600.00
700.00
800.00
2003 2004 2005 2006 2007
Debt Service Margin
HNI
Herman Miller
Steelcase
Knoll Inc
Industry Average
HNI (Restated)
168
Altman’s Z-Score
There are numerous models to predict distress. Of these models, Altman’s Z-
score is an accurate and robust way of computing bankruptcy scores. When buying
stock, risk adverse shareholders could effectively use this model to ensure there is no
risk of possible bankruptcy. The model is also used in indicating the credit score for
individuals interested in comparing credit risk among other firms. The lower the score,
the higher chances are for bankruptcy. If a firm has a Z-score below 1.81, the model is
predicting high chances of bankruptcy. If a score is between 1.81 and 2.67, the firm is
in the “gray area”. Anything above 2.67 is considered to be a healthy credit rating.
When a firm has a higher Z-score than its competitors, you can assume they are paying
lower interest rates. The Z-score can be found by using the equation below.
1.2(Net Working Capital/Total Assets)
+1.4(Retained Earnings/Total Assets)
+ 3.3(Earnings before Interest and Taxes/Total Assets)
+ 0.6(Market Value of Equity/Book Value of Liabilities)
+ 1.0(Sales/Total Assets) = Altman’s Z-Score
169
Z-score 2004 2005 2006 2007 2008
HNI 7.65 6.69 5.11 4.45 3.83
HNI Restated 9.67 3.61 4.98 4.38 3.43
Herman Miller 5.20 5.58 6.62 6.80 4.53
Steelcase 2.03 2.41 2.74 2.98 2.79
Knoll 2.71 3.08 3.47 3.09 2.93
Industry Avg. 5.45 4.27 4.58 4.34 3.50
The industry average is above bankruptcy and gray area levels. Individually,
Steelcase and Knoll have been in and out of the gray area for years, which gives them
the worst rating in the office furniture industry. They will be paying higher interest
rates than any of their competitors. Herman Miller leads the industry, which will enable
them to borrow money at lower interest rates to finance their projects. HNI has a
strong credit rating over their history, even though they have been slightly decreasing
0.00
2.00
4.00
6.00
8.00
10.00
12.00
2004 2005 2006 2007 2008
HNI
HNI Restated
Herman Miller
Steelcase
Knoll
Industry Avg.
170
over recent years. Originally, HNI is above the industry average but after restating
financials because of large amounts in goodwill, restated numbers show we are below
the industry average.
Conclusion
One can effectively measure the capital structure of a firm using the debt to
equity ratio; the times interest earned ratio, and debt service margin ratio. HNI over
the last five years have had a fairly low debt to equity ratio. The firm had the lowest
but in the last two years have risen slightly above Steelcase. This shows HNI’s ability to
keep more equity then debt, which is a good sign. Their times interest earned ratio is
higher than the industry average. Although they have had strong amounts of income
before interests and taxes, high interest rates have forced them to transfer large
amounts of income to pay off debt obligations. HNI over the last three years has been
able to lower their times interest earned ratio to levels similar to the industry
competition. Their debt service margin ratio has been almost identical to the industry
average. Lately, it is starting to decline but HNI has always had enough operating
income to satisfy current liabilities.
HNI has a good credit score above the industry average. They are second
behind competitor Herman Miller for the highest score which enables them to attract
risk adverse investors. They show a very healthy capital structure and a good credit
rating which should ensure their success in the future even in times of an economic
recession.
171
Capital Structure Ratio Performance Trend
Debt to Equity Below Upward
Times Interest Earned Above Volatile
Debt Service Margin Average Upward
Z - Score Above Downward
Estimating the Cost of Capital
Cost of Equity
When purchasing a firm’s stock potential stockholders and investors require a
certain level of return that corresponds to two things; the risk that they bear and the
amount of time waiting for returns. The cost of equity is the minimum return required
by stockholders when investing in a firm’s stock. The cost of equity is higher than the
cost of debt because it costs more to finance equity. We calculated HNI’s cost of equity
by using the Capital Asset Pricing Model (CAPM). When using CAPM, the cost of equity
is calculated by taking the estimated beta of the firm and multiplying it by the market
risk premium and then adding the risk free rate.
Cost of Equity = Beta of the firm (return of the market – risk free rate) + risk free rate
Ke = β*(RM-RF) + RF
The Beta of a firm is a coefficient that measures the amount of systematic risk of
a firm and determines the amount of un-diversifiable risk that a firm shares in the
market. We ran a linear regression analysis in order to find the appropriate Beta for
HNI. We multiplied the beta by the market risk premium, which is the return for the
market (S&P 500) minus the risk free rate. The risk free rate was found on the St. Louis
172
Federal Reserve Website and was the same rate as the current Treasury bill rates. The
current risk free rate was 2.87% and we concluded that the market risk premium was
6.8%.
When we performed the regression analysis, we took 80 historical monthly stock
prices for HNI, and then we located the 3 month, 1 year, 2 year, 7 year, and 10 year
risk free rates to find the five points on the yield curve. Then we found the average
return of the S&P 500. We then ran the Regressions for five investment horizons, 24,
36, 48, 60 and 72 months, for each point on the yield curve. The purpose of this was to
test the stability of Beta over time. We broke down the results and looked for the
highest Adjusted R-Squared because the higher the Adjusted R-squared, the higher the
explanatory power of the estimated Beta. Our Highest Adjusted R-Squared was 25.39%
and was at the three month point and the 60 slice. The Beta for that slice was found to
be 1.47, which we believe to be relatively accurate because Beta remained relatively
stable over the time frame, but our low R-Squared shows poor exploratory power.
Slice BETA ADJUSTED R SQUARED LOWER 95% UPPER 95%
RISK PREMIUM
RISK FREE RATE
ESTIMATED Ke LOW Ke HIGH Ke
72 1.37 0.250 0.823 1.92 6.8 2.87 12.21 8.47 15.96
60 1.47 0.253 0.829 2.11 6.8 2.87 12.86 8.51 17.22
48 1.44 0.231 0.696 2.19 6.8 2.87 12.69 7.61 17.77
36 1.37 0.216 0.518 2.22 6.8 2.87 12.20 6.39 18.02
24 1.40 0.208 0.308 2.50 6.8 2.87 12.43 4.96 19.89
After finding all of the variables needed, we calculated HNI’s cost of equity (Ke),
using the CAPM model, to be 12.87%. We concluded that this was a decent estimate
because the estimated Ke for all points and slices, on the yield curve, remained
relatively constant, but with an almost historically low Risk Free Rate, we felt that it
could be a little higher. Using a 95% confidence interval, we calculated our upper and
lower bounds of cost of equity. The lower bound was 8.51% and the upper bound was
17.23%.
Cost of Equity
173
2.87 + 1.47 * (6.8) = Ke = 12.87
Cost of Equity With 95% CI
Upper Ke: 17.23%= 2.11*(6.8) +2.87
Lower Ke: 8.51%= .83*(6.8) + 2.87
Size Adjusted
While the Capital Asset Pricing Model is one of the most commonly used methods
for finding the cost of equity, some financial analysts debate that the model is not
perfect. It is a known fact that smaller firms tend to generate higher returns than larger
firms in the market. There is no proven explanation as to why this is true but one might
be able draw the conclusion that several factors are involved. We believe that this “size
effect” could be possible because smaller firms might have the tendency of being
undervalued or underpriced. Larger firms are also known to be less of a risk, than
smaller firms. When taking size into account, when calculating the cost of equity, the
best method to use is the CAPM model with the addition of a size premium. With HNI
having a market value of 443.24 million, we found their size premium to be 2.7%. With
this size premium accounted for, we found our size adjusted cost of equity to be
15.56%.
Size Adjusted CAPM
Ke = Rf + β*(RM-RF) + Size Premium (Palepu Healy)
2.87 + (1.47 * (6.8)) + 2.7 = 15.56%
174
Alternative Cost of Equity
For an alternative approach to finding the cost of equity, we used the back door
method. By using the back door method, we calculated two different costs of equity for
our current and revised financial statements. Using our current financial statements the
back door cost of equity was 14.99%. We found this figure to be accurate because it is
very close to our size adjusted number and falls in between the upper and lower
bounds of our regression. We also felt that it was more accurate because the risk free
rate used in the CAPM model is at an almost historical low. Our back door cost of equity
from our revised financial statements was computed to be 19.25%. We found this
number to be inaccurate for several reasons. First it does not fall within our regression
lower and upper bounds. It also was derived from a high P/B ratio because a
substantial amount of goodwill had to be impaired during the revision of our balance
sheet which in turn lowered our Owner’s Equity drastically. All in all, we found that the
backdoor cost of equity to be an accurate calculation when determining the risk
associated with investing in HNI.
Back Door Cost of Equity
ROE Growth Rate P/B Cost of Equity
HNI 15.85% 8.82% 1.14 14.99%
HNI Restated 23.26% 9.19% 2.31 19.25%
175
Cost of Debt
The make up a Firm’s value consists of two things, debt and equity. Debt and
equity both have costs associated with them and it is important to take these certain
costs into account. The cost of debt is calculated by finding a weighted average of a
firm’s liabilities and applying the interest rates that pertain to each one individually. The
cost of debt for a firm is usually always lower than the cost of equity for a firm. This is
because when a firm defaults, or goes bankrupt, debt holders get paid before the
equity holders. This increases the risk of being an equity holder and in return equity
holders require higher return rates for the extra risk that they take on.
The table below represents the cost of debt for HNI. Each of the liabilities,
from the balance sheet, is represented with the proper interest rates next to them.
Interest rates came from HNI’s 10K, the St. Louis Federal Reserve, or were estimated.
Accounts Payable and accrued expenses used the St. Louis Federal reserve Non-
Financial 3 month commercial paper rate and was .48%. For Notes Payable and current
maturities of long-term debt and Capital lease obligations and long term portion of
Capital lease obligations we used 6.7% that we estimated and used to capitalize
operating leases. For Current maturities of other long-term obligations, minority interest
in subsidiaries, and long term debt we used our defined pension plan interest rate of
6.4%, found in HNI’s 10k. For Deferred income taxes we used 2.87%, which is the St.
Louis Federal reserve 10yr risk free Treasury bill rate. We calculated the Weighted
Average Cost of Debt (WACD) of the liabilities by dividing the individual liabilities by the
sum of total liabilities and then multiplying each of these weights by their proper
interest rates. We then added each of these together and found the WACD of 3.82%.
176
Weighted Average Cost of Capital (WACC)
As previously stated, companies are financed by debt and equity. The weighted
average cost of capital is used to find the appropriate interest rate to finance the firm.
To calculate WACC you must first find the weighted average cost of debt and cost of
equity. WACC is the market value of liabilities divided by the market value of assets
multiplied by the WACD and then added to the Market Value of Equity divided by the
Market Value of Assets multiplied by the cost of Capital (Ke). We found before tax
WACC for our current financial statements and our revised statements. WACCbt for our
current statements was 7.3% and WACCbt for our revised statements was 5.96%.
WACCbt for our revised statements was lower because we impaired Goodwill, which in
turn reduced the amount of market value of equity more than it reduced the market
value of assets. This caused the weight of MVE/MVA to be lower and MVL/MVA to be
higher. We felt that WACCbt was low, so we also calculate WACCbt using our backdoor
Ke and size adjusted Ke. We found that our size adjusted WACC and Backdoor WACC
was more accurate because most large companies have a WACC between 8%-12%.
The following are displayed below.
(Amounts in thousands) 2008 Average Interest rate Source of interest rate WACD
Current Liabilities
Accounts Payable and accrued expenses 313,431 0.48% St. Louis Fed 3M NF Commercial
Paper 0.20989% Note payable and current maturities of long‐term debt and capital lease obligations 54,494 6.70%
Estimated Capital Lease Interest Rate 0.50936%
Current maturities of other long‐term obligations 5,700 0.064 Defined Pension Plan Rate HNI 10‐
k 0.0508931%
Long Term Debt 267,300 6.40% Defined Pension Plan Rate HNI 10‐
k 2.3866205%
Capital Lease Obligations 43 6.70% Estimated Capital Lease Interest
Rate 0.00040193%
Other Long‐Term Liabilities 50,399 6.40% Defined Pension Plan Rate HNI 10‐
k 0.44999358%
Deferred Income Taxes 25,271 2.87% St. Louis Fed 10yr RF rate 0.1011833%
Minority Interest In Subsidiaries 158 6.40% Defined Pension Plan Rate HNI 10‐
k 0.00141072%
Total Liabilities 716,796
Before‐Tax Weighted Average Cost of Debt 3.8216%
177
Cost of Debt MVL/MVA Ke MVE/MVA WACCWACCbt 3.82% 61.49% 14.99% 38.51% 8.12%
WACCbt revised 3.82% 76.37% 19.25% 23.63% 7.47%
Weighted Average Cost of Capital Using Back Door Ke
Cost of Debt MVL/MVA Ke MVE/MVA WACCWACCbt 3.82% 61.49% 15.56% 38.51% 8.34%
WACCbt revised 3.82% 76.37% 15.56% 23.63% 6.59%
Weighted Average Cost of Capital Using Size Adjusted Ke
Weighted Average Cost of Capital
Cost of Debt MVL/MVA Ke MVE/MVA WACC
WACCbt 3.82% 61.49% 12.87% 38.51% 7.30%
WACCbt Revised 3.82% 76.37% 12.87% 23.63% 5.96%
178
Three Month 60 Slice Highest Adjusted R-Squared
Financial Statements Forecasting
In order to better understand how a firm will fair in the future you must conduct
a financial statements forecast. When forecasting HNI, we made assumptions and
found trends using ratios and growth rates over the last five years to predict what
might happen to certain line items in the future. We also found trends within the
industry and current economic situations to help us form a more accurate picture of
financials over the next ten years. This means forecast analysis isn’t just a separate
analysis but you use your assumptions from previous analysis’s to forecast future
financials. Due to the difficulty of finding financials and trends within the hearth
industry; we focused more on the office furniture industry when discussing industry
assumptions and trends. We believe this is the best possible method to find HNI’s
future financial performance.
SUMMARY OUTPUT
Regression Statistics Multiple R 0.516289269 R Square 0.266554609 Adjusted R Square 0.253908999 Standard Error 0.098917953 Observations 60
ANOVA
df SS MS F Significance
F Regression 1 0.206251276 0.206251276 21.07882539 2.41571E‐05Residual 58 0.567516158 0.009784761Total 59 0.773767434
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95%
Intercept 0.00330719 0.013093408 0.252584362 0.801482438‐
0.022902114 0.029516494X Variable 1 1.470372441 0.320261071 4.591168194 2.41571E‐05 0.829300262 2.11144462
179
Income Statement
Most analysts start with forecasting the income statement due to the fact that
the other financial statements are directly affected by the assumptions and trends used
when forecasting the income statement. This is why the income statement is the most
important financial statement to forecast. Due to the income statements importance, an
accurate forecast of the income statement is significant to the accuracy of the firms
overall future financial performance.
The first step in forecasting the income statement is to forecast future sales. This
is the most important step in the whole forecasting process because many of the ratios
used in determining future financials has to deal with the forecast of sales. Due to
future sales growth being so important, many assumptions and trends must be taken
into consideration to produce the most accurate sales growth percentage possible. The
current recession must be taken into consideration when trying to form an accurate
sales growth. Two assumptions must be made to be able to find an accurate sales
growth during a recession; HNI’s sales growth during the last recession as well as the
office furniture industry sales growth average over that time. We found out that during
the early 2000s recession, HNI’s sales growth was -14%, -6%, and 3.7% from 2001-
2003. We found the industry sales growth average from the Business and Institutional
Furniture Manufacturers Association website, bifma.org, to be -17.4%, -19.0%, and -
4.3% over the same period (bifma.org). We have decided that the recession will last
until 2011 because we think that the new economic policies provided by the new
president will come into effect after the 2011 year. Taking all of this information into
account we can now provide assumptions for the sales growth during the recession.
During 2009 to 2011 we assume that the sales growth will be -14%, -7%, and -3%
over that time period. To find the sales growth for 2012 to 2018, we found HNI’s
average sales growth from 2002-2008 as well as the industries average sales growth
during non recession years from 1991 to 2008. Both of these percentages were very
close to 7%, so we decided to use a 7% sales growth for the years 2012 to 2018.
180
The next step in forecasting the income statement is to find cost of goods sold.
To make an assumption on future cost of goods sold we must find the cost of goods
sold as a percentage of sales over the last six years. Over this time period we found
that cost of goods sold represents a very steady relationship to sales of about 65%. We
decided to use 65% to forecast cost of goods sold due to the stability shown over this
time. We now multiply the sales for each forecasted year by 65% to find the future
cost of goods sold from 2009 to 2018.
The third step in forecasting the income statement is to find gross profit. To find
gross profit we used the accounting assumption that Sales – Cost of Goods Sold =
Gross Profit. We performed this step for the years 2009 to 2018 to find our forecast
gross profit. To double check this method we found gross profit as a percentage of
sales from 2003 to 2008. We found that during this period there was definite stability of
gross profit around 35%. Next, we multiplied sales by 35% to double check our gross
profit and it was the same as Sales – Cost of Goods Sold. This makes sense because if
you add the percentages of gross profit and cost of goods sold to sales it equals 100%;
which represents total sales.
Forecasting operating income is the next step in forecasting the income
statement. According to the rules of accounting, operating income is found by
subtracting selling, administrative expenses and impairment charges from gross profit.
Due to the uncertainty of future expenses and charges we must find operating income
using a different method. We found the operating profit margin from 2003 to 2008 to
better understand the stability of operating income over this time. Other than the
operating profit margin of 2008 there was a fairly level figure between 8% and 7%. We
decided to use 7.5% as the forecast percentage of operating income. We multiplied the
forecasted net sales by 7.5% to find operating income for the time period of 2009-
2018.
Our last step in forecasting the income statement is to find out the forecasted
net income. Generally, the rule of thumb to find net income is to subtract interest
181
expense and income taxes from operating income. This method cannot be used due to
the uncertainty of future tax rates and interest expenses. In order to find net income
we found the net profit margin over the last 6 years. In 2008 net profit margin was
relatively low compared to the other years so we used the other years to find an
adequate average. We decided upon a net profit margin of 4.5% to be able to forecast
net income. We multiplied the forecasted net sales by 4.5% to find the forecasted net
income over the next years.
182
HNI CorporationIncome Statement
Fiscal Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018(Amounts in thousands, except for per share data)Statement of Income Data:Net sales 1,755,728 2,093,447 2,450,572 2,679,803 2,570,472 2,477,587 2,130,725 1,981,574 1,922,127 2,056,676 2,200,643 2,354,688 2,519,516 2,695,882 2,884,594 3,086,516 Cost of products sold 1,116,513 1,342,143 1,562,654 1,752,882 1,664,697 1,648,975 1,384,971 1,288,023 1,249,382 1,336,839 1,430,418 1,530,547 1,637,686 1,752,324 1,874,986 2,006,235 Gross profit 639,215 751,304 887,918 926,921 905,775 828,612 745,754 693,551 672,744 719,837 770,225 824,141 881,831 943,559 1,009,608 1,080,280 Selling and administrative expenses 480,744 572,006 668,910 717,676 702,329 717,870 575,296 535,025 518,974 555,302 594,174 635,766 680,269 727,888 778,840 833,359 Restructuring related and impairment charges 8,510 886 3,462 2,829 9,788 25,859 Operating income 149,961 178,412 215,546 206,416 193,658 84,883 159,804 148,618 144,160 154,251 165,048 176,602 188,964 202,191 216,345 231,489 Interest income 3,940 1,343 1,518 1,139 1,229 1,172 Interest expense 2,970 886 2,355 14,323 18,161 16,865 Earnings from continuing operations before income taxes and minority interest 150,931 178,869 214,709 193,232 176,726 69,190 Income taxes 52,826 65,287 77,295 63,670 57,141 23,634 Earnings from continuing operations before minority interest 98,105 113,582 137,414 129,562 119,585 45,556 Minority interest in earnings (losses) of subsidiary N/A N/A (6) (110) (279) 106 Income from continuing operations N/A N/A N/A 129,672 119,864 45,450 Discontinued operations, less applicable income taxes N/A N/A N/A (6,297) 514 - Net income 98,105 113,582 137,420 123,375 120,378 45,450 95,883 89,171 86,496 92,550 99,029 105,961 113,378 121,315 129,807 138,893
HNI's Income Statement (in thousands) HNI's Forecasted Income Statement (in thousands)
183
Fiscal Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Statement of Income Data:Sales Growth Percent 19.24% 17.06% 9.35% -4.08% -3.61% -14.00% -7.00% -3.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00%Net sales 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%Cost of goods sold (1) 63.59% 64.11% 63.77% 65.41% 64.76% 66.56% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00%Gross profit 36.41% 35.89% 36.23% 34.59% 35.24% 33.44% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00%Selling, general and administrative expenses 27.38% 27.32% 27.30% 26.78% 27.32% 28.97% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00%Restructuring related and impairment charges 0.48% 0.04% 0.14% 0.11% 0.38% 1.04%Operating Income 8.54% 8.52% 8.80% 7.70% 7.53% 3.43% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50%Interest income 0.22% 0.06% 0.06% 0.04% 0.05% 0.05%Interest expense, net 0.17% 0.04% 0.10% 0.53% 0.71% 0.68%Income before income taxes and minority interest 8.60% 8.54% 8.76% 7.21% 6.88% 2.79%Income Taxes 3.01% 3.12% 3.15% 2.38% 2.22% 0.95%Net income 5.59% 5.43% 5.61% 4.60% 4.68% 1.83% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50%
HNI's Common Size Income Statement HNI's Forecasted Common Size Income Statement
184
Restated Income Statement
HNI’s actual income statement is very similar to the income statement we
restated in our accounting analysis except for the goodwill impairment expense in our
restated income statement. Our restated income statement shows how net income is
affected if HNI had impaired goodwill regularly over the last six years. As you can see in
the restated income statement below that net income was significantly affected by this
goodwill impairment. Due to the significant decrease in net income, we must find a new
net profit margin for the past six years before we start forecasting net income for our
restated income statement. Except for 2008, the net profit margin was pretty stable
between 5% and 3% over the past six years; so we averaged net income from 2003 to
2007. We found a net profit margin average of 3.8% over this time period. We decided
to use 3.6% as an adequate net profit margin to forecast our restated net income. We
multiplied our forecasted sales by 3.6% to find our net income for our restated income
statement.
Also, our restated income statement shows how goodwill impairment affects
operating income. Due to the significantly lower operating income in our restated
income statement we must perform a new operating profit margin ratio with our
restated operating income over the past 6 years. Other than in 2008 we found a fairly
stable operating profit margin of 6.8% to 5.6%. We averaged the other years and
found an average operating profit margin of 6.24%. We used 6.2% to forecast
operating income for the next ten years and multiplied the forecasted sales by 6.2% to
find the forecasted operating income for the next ten years.
185
Fiscal Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Net Sales 1,692,622 1,755,728 2,093,447 2,450,572 2,679,803 2,570,472 2,477,587 2,130,725 1,981,574 1,922,127 2,056,676 2,200,643 2,354,688 2,519,516 2,695,882 2,884,594 3,086,516 Cost of products sold 1,092,743 1,116,513 1,342,143 1,562,654 1,752,882 1,664,697 1,648,975 1,384,971 1,288,023 1,249,383 1,336,839 1,430,418 1,530,547 1,637,685 1,752,323 1,874,986 2,006,235 Gross Profit 599,879 639,215 751,304 887,918 926,921 905,775 828,612 745,754 693,551 672,744 719,837 770,225 824,141 881,831 943,559 1,009,608 1,080,281 Selling and Administrative Expenses 454,189 480,744 572,006 668,910 717,676 702,329 717,870 575,296 535,025 518,974 555,303 594,174 635,766 680,269 727,888 778,840 833,359 Restructuring related and Impairment charges 3,000 8,510 886 3,462 2,829 9,788 25,859 Goodwill Impairment - 38,417 44,911 48,449 45,486 49,780 10 Operating Income 142,690 111,544 133,501 167,097 160,930 143,878 84,873 132,105 122,858 119,172 127,514 136,440 145,991 156,210 167,145 178,845 191,364 Interest Income 2,578 3,940 1,343 1,518 1,139 1,229 1,172 Interest Expense 4,714 2,970 886 2,355 14,323 18,161 16,865 Income Before Taxes 140,554 112,514 133,958 166,260 147,746 126,946 69,180 Income Taxes at 34.5% 48,491 38,817 46,216 57,360 50,972 43,796 23,867 Net Income 92,063 73,697 87,742 108,900 96,774 83,150 45,313 76,706 71,337 69,197 74,040 79,223 84,769 90,703 97,052 103,845 111,115
HNI's Restated Income Statement (in thousands) HNI's Restated Income Statement Forecast (in thousands)
186
Common Size Income Statement
Fiscal Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Sales Growth 3.73% 19.24% 17.06% 9.35% -4.08% -3.61% -14.00% -7.00% -3.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00%Net Sales 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%Cost of products sold 64.56% 63.59% 64.11% 63.77% 65.41% 64.76% 66.56% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00%Gross Profit 35.44% 36.41% 35.89% 36.23% 34.59% 35.24% 33.44% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00%Selling and Administrative Expenses 26.83% 27.38% 27.32% 27.30% 26.78% 27.32% 28.97% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00%Restructuring related and Impairment charges 0.18% 0.48% 0.04% 0.14% 0.11% 0.38% 1.04%Goodwill Impairment 0.00% 2.19% 2.15% 1.98% 1.70% 1.94% 0.00%Operating Income 8.43% 6.35% 6.38% 6.82% 6.01% 5.60% 3.43% 6.20% 6.20% 6.20% 6.20% 6.20% 6.20% 6.20% 6.20% 6.20% 6.20%Interest Income 0.15% 0.22% 0.06% 0.06% 0.04% 0.05% 0.05%Interest Expense 0.28% 0.17% 0.04% 0.10% 0.53% 0.71% 0.68%Income Before Taxes 8.30% 6.41% 6.40% 6.78% 5.51% 4.94% 2.79%Income Taxes at 34.5% 2.86% 2.21% 2.21% 2.34% 1.90% 1.70% 0.96%Net Income 5.44% 4.20% 4.19% 4.44% 3.61% 3.23% 1.83% 3.60% 3.60% 3.60% 3.60% 3.60% 3.60% 3.60% 3.60% 3.60% 3.60%
HNI's Restated Common Size Income Statement HNI's Restated Common Size Income Statement Forecast
187
Balance Sheet
The balance sheet is the next financial statement that needs to be forecasted. A
forecasted balance sheet helps show a firm how assets, liabilities and equity are
affected in their future performance. By forecasting the firm’s balance sheet you can
find out how retained earnings will fair in the future. In order to provide an accurate
forecast of the balance sheet, the forecasted sales must be accurate due to the fact
that it is the base of many of the ratios used to forecast important line items on the
balance sheet.
The first line item to be forecasted on the balance sheet is total assets. To
forecast total assets you must use the asset turnover ratio, which is the link between
the income statement and balance sheet. To be able to forecast total assets we found
the asset turnover over the last six years as well as the average asset turnover over this
time period. We found a pretty steady average of 2.1 over this time period. We decided
to use 2.1 as an accurate forecast of asset turnover. To find forecasted total assets we
divided 2.1 by the forecasted sales for the next ten years. As you can see the accuracy
of the forecasted sales is quite significant in finding an accurate forecast of total assets.
Our next step in forecasting the balance sheet is to forecast the line item long
term or non-current assets. To forecast long term assets we must find long term assets
as a percentage of total assets over the last six years. This ratio is very stable over this
time period with an average of 59.7% of long term assets to total assets. We decided
to round up and use 60% as an accurate forecast of long term assets. We multiplied
the forecasted total assets by 60% to find an accurate view of long term assets over
the next ten years.
The next line item to be forecasted on the balance sheet is current assets. This is
a pretty easy line item to forecast due to the two items we forecasted above. According
to the rules of accounting, total assets minus long term assets equal current assets. We
used this rule of thumb to forecast our current assets over the next ten years. To
188
double check this line item we found the average of current assets to total assets over
the past 6 years was 40%. We multiplied total assets by 40% over the next ten years
and it was the same as total assets minus long term assets. This makes sense because
the percentage we used for long term assets added to the 40% of current assets equals
100%; which represents total assets.
After we found current assets we can now begin to start forecasting the liabilities
section of the balance sheet. Our first liability to be forecasted on the balance sheet is
current liabilities. In order to find forecasted current liabilities, we found out our current
ratio over the last six years as well as the average over this period. Over the last six
years the current ratio was fairly stable and had an average of 1.4. We used the
average of 1.4 as an accurate base to forecast current liabilities. We divided 1.4 from
our forecasted current assets to find our current liabilities over the next ten years.
Our next step in forecasting the balance sheet takes us to the stockholder’s
equity portion of the balance sheet. First, we must forecast retained earnings before we
are able to forecast total stockholder’s equity. When forecasting retained earnings the
following method is used: beginning balance of retained earnings + net income –
dividends paid. We followed this method for the next ten years to be able to provide an
accurate forecast of retained earnings. To find stockholders equity we basically used the
same method used to find forecasted retained earnings. The method we used to find
total stockholder’s equity is: beginning balance of stockholders equity + net income –
dividends paid. Basically, this represents the change in the previous year’s retained
earnings added into stockholders equity. We used our method to forecast stockholders
equity for the next ten years.
After finding total assets and total stockholder’s equity we are now able to
forecast total liabilities for the next ten years. By using the accounting equation, Assets
= Liabilities + Stockholders Equity, we are now able to find total liabilities. We
subtracted our forecasted total stockholder’s equity from our forecasted total assets to
find our total liabilities for the next ten years. After we found total liabilities we can now
189
forecast our long term liabilities. Once again we use the accounting rule of total
liabilities minus current liabilities to find our long term liabilities. We followed this
method for the next ten years to find our forecasted long term liabilities. Due to the fact
that we are performing a fundament equity valuation of HNI, liabilities tend to be
distorted. As you can see our forecasted long term liabilities are significantly decreasing
over the next ten years which is to be expected when performing an equity valuation.
After we finished the preceding steps we can now focus on forecasting other line
items of the balance sheet. The key to forecasting these different line items is to find
trends over the past six years that can be used to forecast in the future. Net account
receivables, inventory, and plant, property and equipment (PP&E) were all line items we
decided to forecast based on the trends we found over the last six years. We found the
account receivables turnover the past six years in order to forecast net receivables. We
threw out 2008 figure and used the average over the other years of 9 as an accurate
figure to forecast net receivables. We divided our forecasted sales by 9 to find our
forecasted net receivables for the next ten years. To find our future inventory figures
we found our inventory turnover for the past six years. Other than in 2003 we found a
stable inventory turnover figure in between 15 and 19. We threw out 2003s figure and
found an average of inventory turnover of 17.2. We divided our forecasted sales by
17.2 to find our inventory figures for the next ten years. In order to find our PP&E, we
took the percentage of PP&E to total assets over the past six years. Over this period we
found fluctuations from 30% to 25% of PP&E to total assets. We decided upon
throwing out the 30% totals in 2003 and 2004 and averaged the remaining years. We
found an average of 25.875% and decided to round up to a 26% figure for our forecast
of PP&E. We multiplied our forecasted total assets by 26% to find our forecasted PP&E
over the next ten years. Forecasting these line items can be beneficial to a firm in order
to understand what may happen in future budgeting decisions.
190
191
Fiscal Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018AssetsCurrent Assets Cash and cash equivalents 138,982 29,676 75,707 28,077 33,881 39,538 Short-term investments 65,208 6,836 9,035 9,174 9,900 9,750 Receivables, net 181,459 234,731 278,515 316,568 288,777 238,327 3,652,671 3,396,984 3,295,075 3,525,730 3,772,531 4,036,608 4,319,171 4,621,513 4,945,018 5,291,170 Inventories 49,830 77,590 91,110 105,765 108,541 84,290 6,980,660 6,492,014 6,297,254 6,738,061 7,209,726 7,714,407 8,254,415 8,832,224 9,450,480 10,112,013 Deferred income taxes 14,329 14,639 15,831 15,440 17,828 16,313 Prepaid expenses and other current assets 12,314 11,107 16,400 29,150 30,145 29,623 Total Current Assets 462,122 374,579 486,598 504,174 489,072 417,841 852,290 792,630 768,851 822,670 880,257 941,875 1,007,806 1,078,353 1,153,838 1,234,606 Property, Plant, and Equipment 312,368 311,344 294,660 309,952 305,431 315,606 553,988 515,209 499,753 534,736 572,167 612,219 655,074 700,929 749,994 802,494 Goodwill 192,086 224,554 242,244 251,761 256,834 268,392 Other Assets 55,250 111,180 116,769 160,472 155,639 163,790 Total Long Term Assets 559,704 647,078 653,673 722,185 717,904 747,788 1,278,435 1,188,944 1,153,276 1,234,005 1,320,386 1,412,813 1,511,710 1,617,529 1,730,756 1,851,909 Total Assets 1,021,826 1,021,657 1,140,271 1,226,359 1,206,976 1,165,629 2,130,725 1,981,574 1,922,127 2,056,676 2,200,643 2,354,688 2,519,516 2,695,882 2,884,594 3,086,516 Liabilities and Shareholders EquityCurrent Liabilities Accounts payable and accrued expenses 211,236 253,958 307,952 328,882 367,320 313,431 Income Taxes 5,958 6,804 1,270 N/A N/A N/A Note payable and current maturities of LT debt and Capital lease obligations 26,658 646 40,350 26,135 14,715 54,494 Current maturities of other long-term obligations 1,964 4,842 8,602 3,525 2,426 5,700 Total Current Liabilities 245,816 266,250 358,174 358,542 384,461 373,625 608,779 566,164 549,179 587,622 628,755 672,768 719,862 770,252 824,170 881,862 Long Term Liabilities: Long-Term Debt 2,690 2,627 103,050 285,300 280,315 267,300 Capital Lease Obligations 1,436 1,018 819 674 776 43 Other Long-Term Liabilities 24,262 40,045 48,671 56,103 55,843 50,399 Deferred Income Taxes 37,733 42,554 35,473 29,321 26,672 25,271 Minority Interest in Subsidiaries - - 140 500 1 158 Commitments and ContingenciesTotal Long Term Liabilities 66,121 86,244 188,153 371,898 363,607 343,171 1,015,349 857,761 769,581 816,574 866,476 919,304 975,076 1,033,812 1,095,534 1,160,265 Total Liabilities 311,937 352,494 546,327 730,440 748,068 716,796 1,624,128 1,423,925 1,318,760 1,404,196 1,495,231 1,592,072 1,694,938 1,804,064 1,919,704 2,042,127 Shareholders EquityPreferred stock - $1 par value - - - - - - Authorized: 2,000Issued: NoneCommon stock - $1 par value 58,239 55,303 51,849 47,906 44,835 44,324 Authorized: 200,000Issued and outstanding: 2008-44,324;2007-44,835; 2006-47,906Additional paid-in capital 10,324 6,879 941 2,807 3,152 6,037 Retained earnings 641,732 606,632 540,822 448,268 410,075 400,379 458,143 509,195 554,913 604,026 656,958 714,162 776,125 843,364 916,436 995,935 Accumulated other comprehensive (loss) income (406) 349 332 (3,062) 846 (1,907) Total Shareholders Equity 709,889 669,163 593,944 495,919 458,908 448,833 506,597 557,649 603,367 652,480 705,412 762,616 824,579 891,818 964,890 1,044,389 Total Liabilities and Shareholders Equity 1,021,826 1,021,657 1,140,271 1,226,359 1,206,976 1,165,629 2,130,725 1,981,574 1,922,127 2,056,676 2,200,643 2,354,688 2,519,516 2,695,882 2,884,594 3,086,516
HNI's Balance Statement (in thousands) HNI's Forecasted Balance Sheet (in thousands)
192
Fiscal Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018AssetsCurrent Assets Cash and cash equivalents 30.07% 7.92% 15.56% 5.57% 6.93% 9.46% Short-term investments 14.11% 1.82% 1.86% 1.82% 2.02% 2.33% Receivables, net 39.27% 62.67% 57.24% 62.79% 59.05% 57.04% 58.33% 58.33% 58.33% 58.33% 58.33% 58.33% 58.33% 58.33% 58.33% 58.33% Inventories 10.78% 20.71% 18.72% 20.98% 22.19% 20.17% 30.52% 30.52% 30.52% 30.52% 30.52% 30.52% 30.52% 30.52% 30.52% 30.52% Deferred income taxes 3.10% Prepaid expenses and other current assetsTotal Current Assets 45.23% 36.66% 42.67% 41.11% 40.52% 35.85% 40.00% 40.00% 40.00% 40.00% 40.00% 40.00% 40.00% 40.00% 40.00% 40.00%Property, Plant, and Equipment 30.57% 30.47% 25.84% 25.27% 25.31% 27.08% 26.00% 26.00% 26.00% 26.00% 26.00% 26.00% 26.00% 26.00% 26.00% 26.00%Goodwill 18.80% 21.98% 21.24% 20.53% 21.28% 23.03%Other Assets 9.87% 17.18% 17.86% 22.22% 21.68% 21.90%Total Long Term Assets 54.77% 63.34% 57.33% 58.89% 59.48% 64.15% 60.00% 60.00% 60.00% 60.00% 60.00% 60.00% 60.00% 60.00% 60.00% 60.00%Total Assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%Liabilities and Shareholders EquityCurrent Liabilities Accounts payable and accrued expenses 85.93% 95.38% 85.98% 91.73% 95.54% 83.89% Income Taxes 2.42% 2.56% 0.35% 0.00% 0.00% 0.00% Note payable and current maturities of LT debt and Capital lease obligations 10.84% 0.24% 11.27% 7.29% 3.83% 14.59% Current maturities of other long-term obligations 0.80% 1.82% 2.40% 0.98% 0.63% 1.53%Total Current Liabilities 78.80% 75.53% 65.56% 49.09% 51.39% 52.12% 57.06% 69.85% 83.84% 85.60% 87.41% 89.32% 91.36% 93.58% 96.02% 98.72%Long Term Liabilities: Long-Term Debt 4.07% 3.05% 54.77% 76.71% 77.09% 77.89% Capital Lease Obligations 2.17% 1.18% 0.44% 0.18% 0.21% 0.01% Other Long-Term Liabilities 36.69% 46.43% 25.87% 15.09% 15.36% 14.69% Deferred Income Taxes 57.07% 49.34% 18.85% 7.88% 7.34% 7.36% Minority Interest in Subsidiaries 0.00% 0.00% 0.07% 0.13% 0.00% 0.05%Commitments and ContingenciesTotal Long Term Liabilities 21.20% 24.47% 34.44% 50.91% 48.61% 47.88% 42.94% 30.15% 16.16% 14.40% 12.59% 10.68% 8.64% 6.42% 3.98% 1.28%Total Liabilities 30.53% 34.50% 47.91% 59.56% 61.98% 61.49% 50.07% 40.90% 34.08% 33.38% 32.68% 31.99% 31.27% 30.53% 29.76% 28.94%Shareholders EquityPreferred stock - $1 par valueAuthorized: 2,000Issued: NoneCommon stock - $1 par value 8.20% 8.26% 8.73% 9.66% 9.77% 9.88%Authorized: 200,000Issued and outstanding: 2008-44,324;2007-44,835; 2006-47,906Additional paid-in capital 1.45% 1.03% 0.16% 0.57% 0.69% 1.35%Retained earnings 90.40% 90.66% 91.06% 90.39% 89.36% 89.20% 90.44% 91.31% 91.97% 92.57% 93.13% 93.65% 94.12% 94.57% 94.98% 95.36%Accumulated other comprehensive (loss) income -0.06% 0.05% 0.06% -0.62% 0.18% -0.42%Total Shareholders Equity 69.47% 65.50% 52.09% 40.44% 38.02% 38.51% 49.93% 59.10% 65.92% 66.62% 67.32% 68.01% 68.73% 69.47% 70.24% 71.06%Total Liabilities and Shareholders Equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
HNI's Common Size Balance Sheet HNI's Forecasted Common Size Balance Sheet
193
Restated Balance Sheet
Due to the goodwill impairment we conducted in the accounting analysis portion
of our valuation, we must forecast a restated balance sheet for the next ten years.
Since goodwill in an intangible asset stated on the balance sheet, we must conduct a
new asset turnover ratio for the past five years using our restated financials. We found
some volatility within our new asset turnover figures so we threw out our 2003 and
2004 figures and averaged the other years to find an accurate asset turnover figure.
The average asset turnover ratio is 2.5625 so we decided to round down and use the
figure 2.56 as an accurate asset turnover ratio. It makes sense that our restated asset
turnover is more than our 2.1 asset turnover using our 10k financials due to the fact
that total assets decreased over this time because of the 20% goodwill impairment we
conducted over the last 5 years. Now we must divided forecasted sales by our new
asset turnover figure 2.56 to find the forecasted total assets for the next ten years.
Our next step in forecasting our restated balance sheet is to find our forecasted
long term assets. Since goodwill is an intangible asset stated under the long term
portion of assets we can conclude that our percentage of long term assets to total
assets will decrease. We used our restated long term assets as a percentage of total
assets over the past six years to find an accurate average to forecast long term assets.
We found some volatility within these figures and threw those numbers out and
average the remaining years. We found an average of 52.46% and decided upon a
52% figure to forecast out our long term assets. We multiplied our forecasted total
assets by 52% to find our long term asset numbers for the next ten years.
Next, we must forecast plant, property and equipment for the restated balance
sheet. As we have discussed above the impairment of goodwill has decreased total
assets the past 6 years. This means the percentage found above will be slightly lower
than the percentage we will use for our restated financials. Similar to our actual balance
sheet, we must find the percentage of PP&E to total assets for the past six years. These
194
figures remain relatively steady over this period of time with an average near 32%. We
decided upon 32% and multiplied our forecasted total assets by 32% to find our
forecasted PP&E.
After finding our restated total asset and long term asset forecast we can now
perform the steps described in our balance sheet section above to find our other
forecasted line items. Each step is performed identical to the steps performed in our
non-restated balance sheet in order to ensure proper accuracy of our restated figures.
Since the goodwill impairment expense in our restated income statement decreased our
net income, we can conclude that our retained earnings and stockholder’s equity will be
a lot lower than what we projected in our balance sheet above. We believe that the
forecasted numbers in our restated balance sheet represent a more accurate picture of
HNI’s future financial performance due to the effect the goodwill impairment had upon
net income and total assets. Basically, by using our restated financials we can now
assume what would happen in the future if goodwill was impaired over the past five
years.
195
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Current Assets
Cash and cash equivalents 139,165 138,982 29,676 75,707 28,077 33,881 39,538 Short-term investments 16,378 65,208 6,836 9,035 9,174 9,900 9,750 Receivables, net 181,096 181,459 234,731 278,515 316,568 288,777 238,327 3,595,598 3,343,906 3,243,589 3,470,640 3,713,585 3,973,536 4,251,684 4,549,301 4,867,753 5,208,495 Inventories 46,823 49,830 77,590 91,110 105,765 108,541 84,290 6,871,588 6,390,576 6,198,859 6,632,779 7,097,074 7,593,869 8,125,440 8,694,221 9,302,816 9,954,013 Deferred income taxes 10,101 14,329 14,639 15,831 15,440 17,828 16,313 Prepaid expenses and other current assets 11,491 12,314 11,107 16,400 29,150 30,145 29,623
Total Current Asset 405,054 462,122 374,579 486,598 504,174 489,072 417,841 1,697,922 1,579,067 1,531,695 1,638,914 1,753,637 1,876,392 2,007,739 2,148,281 2,298,661 2,459,567 Long Term Assets:
Property, Plant, Equipment 353,270 312,368 311,344 294,660 309,952 305,431 315,606 266,341 247,697 240,266 257,084 275,080 294,336 314,940 336,985 360,574 385,814 Goodwill 192,395 153,669 141,226 110,467 74,498 29,792 41,340 Other Assets 69,833 55,250 111,180 116,769 160,472 155,639 163,790
Total Long Term Assets 615,498 521,287 563,750 521,896 544,922 490,862 520,736 432,803 402,507 390,432 417,762 447,006 478,296 511,777 547,601 585,933 626,949 Total Assets 1,020,552 983,409 938,329 1,008,494 1,049,096 979,934 938,577 2,130,725 1,981,574 1,922,127 2,056,676 2,200,643 2,354,688 2,519,516 2,695,882 2,884,594 3,086,516
Liabilities:Total Current Liabilities 298,680 245,816 266,250 358,174 358,542 384,461 373,625 285,365 265,389 257,428 275,448 294,729 315,360 337,435 361,056 386,330 413,373 Long term Liabilities 74,979 66,121 86,244 188,153 371,898 363,607 343,171 1,584,991 1,422,599 1,342,694 1,428,620 1,520,180 1,617,582 1,721,048 1,830,817 1,947,144 2,070,302 Total Liabilities 373,659 311,937 352,494 546,327 730,440 748,068 716,796 1,870,356 1,687,988 1,600,122 1,704,068 1,814,909 1,932,942 2,058,483 2,191,873 2,333,474 2,483,675
Stockholder's EquityTotal Common Stock 58,374 58,239 55,303 51,849 47,906 44,835 44,324 Additional paid-in capital 549 10,324 6,879 941 2,807 3,152 6,037 Retained Earnings 587,731 603,315 523,304 409,045 271,005 183,033 173,327 211,914 245,132 273,551 304,154 337,280 373,292 412,579 455,556 502,666 554,387 Accum. other comprehensive income 239 (406) 349 332 (3,062) 846 (1,907)
Total Stockholder's Equity 646,893 671,472 585,835 462,167 318,656 231,866 221,781 260,368 293,586 322,005 352,608 385,734 421,746 461,033 504,010 551,120 602,841
Total Liabilities and Stockholder's Equity 1,020,552 983,409 938,329 1,008,494 1,049,096 979,934 938,577 2,130,725 1,981,574 1,922,127 2,056,676 2,200,643 2,354,688 2,519,516 2,695,882 2,884,594 3,086,516
HNI's Restated Balance Sheet (in thousands) HNI's Restated Balance Sheet Forecast (in thousands)
196
Common Size Balance SheetFiscal Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Current Assets
Cash and cash equivalents 34.36% 30.07% 7.92% 15.56% 5.57% 6.93% 9.46% Short‐term investments 4.04% 14.11% 1.82% 1.86% 1.82% 2.02% 2.33% Receivables, net 44.71% 39.27% 62.67% 57.24% 62.79% 59.05% 57.04% 59.26% 59.26% 59.26% 59.26% 59.26% 59.26% 59.26% 59.26% 59.26% 59.26% Inventories 11.56% 10.78% 20.71% 18.72% 20.98% 22.19% 20.17% 31.01% 31.01% 31.01% 31.01% 31.01% 31.01% 31.01% 31.01% 31.01% 31.01% Deferred income taxes 2.49% 3.10% 3.91% 3.25% 3.06% 3.65% 3.90% Prepaid expenses and other current assets 2.84% 2.66% 2.97% 3.37% 5.78% 6.16% 7.09%
Total Current Asset 39.69% 46.99% 39.92% 48.25% 48.06% 49.91% 44.52% 48.00% 48.00% 48.00% 48.00% 48.00% 48.00% 48.00% 48.00% 48.00% 48.00%Long Term Assets:
Property, Plant, Equipment 34.62% 31.76% 33.18% 29.22% 29.54% 31.17% 33.63% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00% 32.00%Goodwill 18.85% 15.63% 15.05% 10.95% 7.10% 3.04% 4.40%Other Assets 6.84% 5.62% 11.85% 11.58% 15.30% 15.88% 17.45%
Total Long Term Assets 60.31% 53.01% 60.08% 51.75% 51.94% 50.09% 55.48% 52.00% 52.00% 52.00% 52.00% 52.00% 52.00% 52.00% 52.00% 52.00% 52.00%Total Assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Liabilities:Total Current Liabilities 79.93% 78.80% 75.53% 65.56% 49.09% 51.39% 52.12% 49.89% 55.24% 60.03% 61.10% 62.19% 63.32% 64.50% 65.76% 67.11% 68.57%Long term Liabilities 20.07% 21.20% 24.47% 34.44% 50.91% 48.61% 47.88% 50.11% 44.76% 39.97% 38.90% 37.81% 36.68% 35.50% 34.24% 32.89% 31.43%Total Liabilities 36.61% 31.72% 37.57% 54.17% 69.63% 76.34% 76.37% 68.72% 62.07% 57.11% 56.11% 55.13% 54.15% 53.16% 52.14% 51.09% 50.00%
Stockholder's EquityTotal Common StockAdditional paid‐in capitalRetained Earnings 57.59% 61.35% 55.77% 40.56% 25.83% 18.68% 18.47% 81.39% 83.50% 84.95% 86.26% 87.44% 88.51% 89.49% 90.39% 91.21% 91.96%Accum. other comprehensive income
Total Stockholder's Equity 63.39% 68.28% 62.43% 45.83% 30.37% 23.66% 23.63% 31.28% 37.93% 42.89% 43.89% 44.87% 45.85% 46.84% 47.86% 48.91% 50.00%
Total Liabilities and Stockholder's Equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
HNI's Restated Common Size Balance Sheet HNI's Restated Common Size Balance Sheet Forecast
197
Statement of Cash Flows
The statement of cash flows is the last financial statement to be forecasted. The
statement of cash flows states the cash flows from operating activities (CFFO),
investing activities (CFFI), and financing activities (CFFF). The statement of cash flows
is predominately forecasted last due to the fact that it is the hardest financial statement
to forecast. It is the hardest financial statement to forecast because there is not one
line item that can be linked to the two other financial statements. Due to this difficulty
and volatility of most of the line items on the statement of cash flow, only a few line
items can be forecasted.
Our first step in forecasting the statement of cash flows involves forecasting cash
flows from operating activities. Basically, the cash flows from operating activities are the
cash flows generated from annual business operations. Since there has been a lot of
volatility in the cash flow from operations over the past six years we have conducted
three different ratios in order to find the best possible way to forecast this line item.
The ratios include CFFO/Net Income, CFFO/Sales, and CFFO/Operating Income. We
performed each of these ratios for the past six years and found that CFFO/Sales would
be the best ratio to forecast cash flows from operations. We found some volatility from
these figures so we threw out 2007 and 2008 and averaged the remaining years. We
found an average of 8.1425% and decided upon an 8% figure for our forecast. From
there we multiplied our forecasted sales by 8% to find our forecasted cash flows from
operations for the next ten years.
After we have forecasted cash flows from operations the next step is to forecast
cash flows from investing activities. Forecasting cash flows from investing activities
turned out to be a tougher challenge than predicted. Due to the volatility of the figures
that make up cash flows from investing over the past six years, we were very uncertain
on applying a growth rate based on our assumptions. Due to this predicament, we
decided to grow cash flows from investing activities by 6.5%, a growth rate slightly
198
smaller than the growth rate we found for cash flows from operations. This may not be
indicative of future CFFI but we believe that this growth rate is the best possible
method to forecast future CFFI.
The last step in forecasting the statement of cash flows is to forecast dividends
under the cash flows from financing activities. In order to forecast dividends we had to
look at HNI’s past dividends per share for the last six years. We found an average
increase of six cents per year over this time period. As of 2008, HNI was paying 21.5
cents per share in dividends which equals to 86 cents of dividends per share paid for
that year. We decided for 2009 and 2010 to pay out the same 86 cents of yearly
dividends per share due to the effect that the recession had on HNI. After that we grew
the yearly dividends per share by six cents each year until 2018. To find the amount of
dividends paid for the next ten years, we multiplied each year’s dividend per share by
the amount of shares outstanding stated on HNI’s 2008 10k. The graph below states
our dividend forecast for the next ten years.
Dividend Forecast
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Dividends/share 0.215 0.215 0.23 0.245 0.26 0.275 0.29 0.305 0.32 0.335 Yearly Dividends/Share 0.86 0.86 0.92 0.98 1.04 1.1 1.16 1.22 1.28 1.34 Shares outstanding (in thousands) 44324 44324 44324 44324 44324 44324 44324 44324 44324 44324 Dividends Paid (in thousands) 38119 38119 40778 43438 46097 48756 51416 54075 56735 59394
199
For the Years 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Net Cash Flows From (To) Operating Activities:Net income 98,105 113,582 137,420 123,375 120,378 45,450 95,883 89,171 86,496 92,550 99,029 105,961 113,378 121,315 129,807 138,893 Noncash items included in net income:Depreciation and amortization 72,772 66,703 65,514 69,503 68,173 70,155 Other postretirement and post-employment benefits 2,166 1,874 2,002 2,109 2,132 1,509 Stock-based compensation 3,219 3,603 1,616 Excess tax benefits from stock compensation (865) (808) (11) Deferred income taxes (3,314) 708 (8,933) (3,712) (4,935) 2,600 Net loss on sales, retirements and impairments 5,415 1,394 1,029 4,639 1,662 22,691 of long-lived assets and intangiblesStock issued to retirement plan 4,678 5,990 6,199 7,948 6,611 6,592 Other net 391 1,947 1,664 1,733 (1,162) (3,908) Changes in working capital, excludingacquisition and disposition:Receivables 1,006 (26,960) (25,654) (24,059) 39,941 58,570 Inventories (3,004) (9,409) (10,488) (7,123) 20,380 31,842 Prepaid expenses and other current assets 1,508 (145) (4,207) (9,541) 2,264 306 Accounts payable and accrued expenses (35,288) 25,990 36,809 (2,794) 30,944 (59,145) Income taxes 2,218 846 (5,534) (2,088) 1,169 (1,255) Increase (decrease) in other liabilities (5,379) 11,736 5,188 (2,742) 835 (2,643) Net cash flows from (to) operating activities 141,274 194,256 201,009 159,602 291,187 174,369 170,458 158,526 153,770 164,534 176,051 188,375 201,561 215,671 230,768 246,921 Net Cash Flows From (To) Investing Activities:Capital expenditures (34,842) (32,417) (38,912) (58,921) (58,568) (70,083) Proceeds from sale of PPE 1,808 2,968 317 5,952 12,145 6,191 Capitalized software (2,666) (3,383) (2,980) (1,003) (346) (1,413) Acquisition spending, net of cash acquired (5,710) (134,848) (33,804) (78,569) (41,696) (75,479) Short-term investments net (49,326) 60,949 2,400 926 - (250) Purchase of long-term investments (5,742) (24,496) (34,495) (13,600) (24,427) (10,650) Sales or maturities of long-term investments 15,000 16,858 32,505 8,250 20,576 20,158 Other net (350) (68) - 294 - Net cash flows from (to) investing activities (81,478) (114,719) (74,947) (136,965) (92,022) (131,526) (123,582) (114,931) (111,483) (119,287) (127,637) (136,572) (146,132) (156,361) (167,306) (179,018)
Free Cash Flow 59,796 79,537 126,062 22,637 199,165 42,843 FCF/CFFO 0 0 1 0 1 0 Net Cash Flows From (To) Financing Activities:Purchase of HNI Corporation common stock (21,512) (145,604) (202,217) (203,646) (147,675) (28,553) Proceeds from long-term debt 761 199,000 515,157 289,503 359,500 Payments of note and long-term debt and other financing (20,992) (26,795) (57,970) (352,401) (309,297) (334,200) Proceeds from sale of HNI Corporation common stock 12,063 15,579 14,997 5,786 9,708 4,151 Excess tax benefits from stock compensation 865 808 11 Dividends paid (30,299) (32,023) (33,841) (36,028) (36,408) (38,095) 38,119 38,119 40,778 43,438 46,097 48,756 51,416 54,075 56,735 59,394 Net cash flows from (to) financing activities (59,979) (188,843) (80,031) (70,267) (193,361) (37,186)
HNI's Statement of Cash Flows (in thousands) HNI's Forecasted Statement of Cash Flows (in thouands)
200
For the Years 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Net Cash Flows From (To) Operating Activities:Net income 69.44% 58.47% 68.37% 77.30% 41.34% 26.07% 56.25% 56.25% 56.25% 56.25% 56.25% 56.25% 56.25% 56.25% 56.25% 56.25%Noncash items included in net income:Depreciation and amortization 51.51% 34.34% 32.59% 43.55% 23.41% 40.23%Other postretirement and post-employment benefits 1.53% 0.96% 1.00% 1.32% 0.73% 0.87%Stock-based compensation 0.00% 0.00% 0.00% 2.02% 1.24% 0.93%Excess tax benefits from stock compensation 0.00% 0.00% 0.00% -0.54% -0.28% -0.01%Deferred income taxes -2.35% 0.36% -4.44% -2.33% -1.69% 1.49%Net loss on sales, retirements and impairments 3.83% 0.72% 0.51% 2.91% 0.57% 13.01%of long-lived assets and intangiblesStock issued to retirement plan 3.31% 3.08% 3.08% 4.98% 2.27% 3.78%Other net 0.28% 1.00% 0.83% 1.09% -0.40% -2.24%Changes in working capital, excludingacquisition and disposition:Receivables 0.71% -13.88% -12.76% -15.07% 13.72% 33.59%Inventories -2.13% -4.84% -5.22% -4.46% 7.00% 18.26%Prepaid expenses and other current assets 1.07% -0.07% -2.09% -5.98% 0.78% 0.18%Accounts payable and accrued expenses -24.98% 13.38% 18.31% -1.75% 10.63% -33.92%Income taxes 1.57% 0.44% -2.75% -1.31% 0.40% -0.72%Increase (decrease) in other liabilities -3.81% 6.04% 2.58% -1.72% 0.29% -1.52%Net cash flows from (to) operating activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%Net Cash Flows From (To) Investing Activities:Capital expenditures 42.76% 28.26% 51.92% 43.02% 63.65% 53.28%Proceeds from sale of PPE -2.22% -2.59% -0.42% -4.35% -13.20% -4.71%Capitalized software 3.27% 2.95% 3.98% 0.73% 0.38% 1.07%Acquisition spending, net of cash acquired 7.01% 117.55% 45.10% 57.36% 45.31% 57.39%Short-term investments net 60.54% -53.13% -3.20% -0.68% 0.00% 0.19%Purchase of long-term investments 7.05% 21.35% 46.03% 9.93% 26.54% 8.10%Sales or maturities of long-term investments -18.41% -14.70% -43.37% -6.02% -22.36% -15.33%Other net 0.00% 0.31% 0.09% 0.00% -0.32% 0.00%Net cash flows from (to) investing activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Net Cash Flows From (To) Financing Activities:Purchase of HNI Corporation common stock 35.87% 77.10% 252.67% 289.82% 76.37% 76.78%Proceeds from long-term debt -1.27% 0.00% -248.65% -733.14% -149.72% -966.76%Payments of note and long-term debt and other financing 35.00% 14.19% 72.43% 501.52% 159.96% 898.73%Proceeds from sale of HNI Corporation common stock -20.11% -8.25% -18.74% -8.23% -5.02% -11.16%Excess tax benefits from stock compensation 0.00% 0.00% 0.00% -1.23% -0.42% -0.03%Dividends paid 50.52% 16.96% 42.28% 51.27% 18.83% 102.44%Net cash flows from (to) financing activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
HNI's Common Size Statement of Cash Flows HNI's Forecasted Common Size Statement of Cash Flows
201
Restated Statement of Cash Flows
The restated statement of cash flows is nearly identical to the statement of cash
flows discussed above. The only difference between the two is that we used the
restated net income from the restated income statement. This net income was
significantly lower than the net income used above due to the goodwill impairment
expense. Since there is a lower net income, the cash flows from operations must be
lower. To find the cash flow from operations we found the change in each year’s net
income and subtracted the change from the cash flow from operations. Now the cash
flow from operations is indicative of the goodwill impairment expense expressed in the
restated net income. To forecast CFFO we used the same figure of 8% to forecast for
the next ten years. The other statement of cash flows forecasts are not affected and
were conducted using the same process as above.
202
For the Years 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Net Cash Flows From (To) Operating Activities:Net income 73,697 87,742 108,900 96,774 83,150 45,313 76,706 71,337 69,197 74,040 79,223 84,769 90,703 97,052 103,845 111,115 Noncash items included in net income:Depreciation and amortization 72,772 66,703 65,514 69,503 68,173 70,155 Other postretirement and post-employment benefits 2,166 1,874 2,002 2,109 2,132 1,509 Stock-based compensation 3,219 3,603 1,616 Excess tax benefits from stock compensation (865) (808) (11) Deferred income taxes (3,314) 708 (8,933) (3,712) (4,935) 2,600 Net loss on sales, retirements and impairments 5,415 1,394 1,029 4,639 1,662 22,691 of long-lived assets and intangiblesStock issued to retirement plan 4,678 5,990 6,199 7,948 6,611 6,592 Other net 391 1,947 1,664 1,733 (1,162) (3,908) Changes in working capital, excludingacquisition and disposition:Receivables 1,006 (26,960) (25,654) (24,059) 39,941 58,570 Inventories (3,004) (9,409) (10,488) (7,123) 20,380 31,842 Prepaid expenses and other current assets 1,508 (145) (4,207) (9,541) 2,264 306 Accounts payable and accrued expenses (35,288) 25,990 36,809 (2,794) 30,944 (59,145) Income taxes 2,218 846 (5,534) (2,088) 1,169 (1,255) Increase (decrease) in other liabilities (5,379) 11,736 5,188 (2,742) 835 (2,643) Net cash flows from (to) operating activities 116,866 168,416 172,489 133,001 253,959 174,232 170,458 158,526 153,770 164,534 176,051 188,375 201,561 215,671 230,768 246,921 Net Cash Flows From (To) Investing Activities:Capital expenditures (34,842) (32,417) (38,912) (58,921) (58,568) (70,083) Proceeds from sale of PPE 1,808 2,968 317 5,952 12,145 6,191 Capitalized software (2,666) (3,383) (2,980) (1,003) (346) (1,413) Acquisition spending, net of cash acquired (5,710) (134,848) (33,804) (78,569) (41,696) (75,479) Short-term investments net (49,326) 60,949 2,400 926 - (250) Purchase of long-term investments (5,742) (24,496) (34,495) (13,600) (24,427) (10,650) Sales or maturities of long-term investments 15,000 16,858 32,505 8,250 20,576 20,158 Other net (350) (68) - 294 - Net cash flows from (to) investing activities (81,478) (114,719) (74,947) (136,965) (92,022) (131,526) (123,582) (114,931) (111,483) (119,287) (127,637) (136,572) (146,132) (156,361) (167,306) (179,018)
Net Cash Flows From (To) Financing Activities:Purchase of HNI Corporation common stock (21,512) (145,604) (202,217) (203,646) (147,675) (28,553) Proceeds from long-term debt 761 199,000 515,157 289,503 359,500 Payments of note and long-term debt and other financing (20,992) (26,795) (57,970) (352,401) (309,297) (334,200) Proceeds from sale of HNI Corporation common stock 12,063 15,579 14,997 5,786 9,708 4,151 Excess tax benefits from stock compensation 865 808 11 Dividends paid (30,299) (32,023) (33,841) (36,028) (36,408) (38,095) 38,119 38,119 40,778 43,438 46,097 48,756 51,416 54,075 56,735 59,394 Net cash flows from (to) financing activities (59,979) (188,843) (80,031) (70,267) (193,361) (37,186)
HNI's Restated Statement of Cash Flows (in thousands) HNI's Restated Statement of Cash Flows Forecast (in thousands)
203
For the Years 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Net Cash Flows From (To) Operating Activities:Net income 63.06% 52.10% 63.13% 72.76% 32.74% 26.01% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00%Noncash items included in net income:Depreciation and amortization 62.27% 39.61% 37.98% 52.26% 26.84% 40.27%Other postretirement and post-employment benefits 1.85% 1.11% 1.16% 1.59% 0.84% 0.87%Stock-based compensationExcess tax benefits from stock compensationDeferred income taxes -2.84% 0.42% -5.18% -2.79% -1.94% 1.49%Net loss on sales, retirements and impairments 4.63% 0.83% 0.60% 3.49% 0.65% 13.02%of long-lived assets and intangiblesStock issued to retirement plan 4.00% 3.56% 3.59% 5.98% 2.60% 3.78%Other net 0.33% 1.16% 0.96% 1.30% -0.46% -2.24%Changes in working capital, excludingacquisition and disposition:Receivables 0.86% -16.01% -14.87% -18.09% 15.73% 33.62%Inventories -2.57% -5.59% -6.08% -5.36% 8.02% 18.28%Prepaid expenses and other current assets 1.29% -0.09% -2.44% -7.17% 0.89% 0.18%Accounts payable and accrued expenses -30.20% 15.43% 21.34% -2.10% 12.18% -33.95%Income taxes 1.90% 0.50% -3.21% -1.57% 0.46% -0.72%Increase (decrease) in other liabilities -4.60% 6.97% 3.01% -2.06% 0.33% -1.52%Net cash flows from (to) operating activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%Net Cash Flows From (To) Investing Activities:Capital expenditures 42.76% 28.26% 51.92% 43.02% 63.65% 53.28%Proceeds from sale of PPE -2.22% -2.59% -0.42% -4.35% -13.20% -4.71%Capitalized software 3.27% 2.95% 3.98% 0.73% 0.38% 1.07%Acquisition spending, net of cash acquired 7.01% 117.55% 45.10% 57.36% 45.31% 57.39%Short-term investments net 60.54% -53.13% -3.20% -0.68% 0.00% 0.19%Purchase of long-term investments 7.05% 21.35% 46.03% 9.93% 26.54% 8.10%Sales or maturities of long-term investments -18.41% -14.70% -43.37% -6.02% -22.36% -15.33%Other net 0.00% 0.31% 0.09% 0.00% -0.32% 0.00%Net cash flows from (to) investing activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Net Cash Flows From (To) Financing Activities:Purchase of HNI Corporation common stock 35.87% 77.10% 252.67% 289.82% 76.37% 76.78%Proceeds from long-term debt -1.27% 0.00% -248.65% -733.14% -149.72% -966.76%Payments of note and long-term debt and other financing 35.00% 14.19% 72.43% 501.52% 159.96% 898.73%Proceeds from sale of HNI Corporation common stock -20.11% -8.25% -18.74% -8.23% -5.02% -11.16%Excess tax benefits from stock compensationDividends paid 50.52% 16.96% 42.28% 51.27% 18.83% 102.44%Net cash flows from (to) financing activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
HNI's Restated Common Size Statement of Cash Flows HNI's Restated Common Size Statement of Cash Flows Forecast
204
Valuation Analysis
Method of Comparables
The methods of comparables ratios are useful to financial analysts when
determining the value of the firm. The chief advantage when calculating the methods
of comparables is they generate relatively quick and simple results. However, some
ratios may be misleading and produce conflicting results if the analyst does not know
how to appropriately calculate and apply them. Using a margin of safety of 15% on
HNI’s share price as of April 1, 2009, an educated recommendation can be given on
each method determining whether the firm is undervalued, overvalued, or fairly valued.
HNI’s share price on April 1, 2009 was $10.50, thus the 15% margin of safety lies
between $8.93 and $12.08.
P/E Trailing
The trailing price to earnings ratio is defined as the market price of equity
divided by the last four quarters of earnings per share. The information in this method
can be found through www.yahoo.finance.com. Using this website we were able to
compute accurate information, which can be seen below.
205
P/E Trailing Comparables
Company PPS EPS P/E Trailing Industry Ave. HNI PPS
HNI 10.50 1.02 10.29 5.21 5.32
HNI Restated 10.50 1.63 6.44 5.21 8.49
Herman Miller 12.28 1.82 6.75
Steelcase 4.13 -0.09 N/A
Knoll Inc. 6.69 1.82 3.68
Some financial analysts believe that the price to earnings trailing ratio is more
accurate than the forward price earnings ratio because it uses the real earnings. The
method also makes the assumption that an industry average exists and firms move
closer to the average, which clearly ignores the individual business plans of each firm.
The inputs themselves in this case can also cause the ratio to be flawed because both
inputs are backward looking numbers.
We were unable to compute the ratio for Steelcase because of their inflated
negative earnings. This caused their ratio to be way out of the 15% range and thus we
know that they are not fairly priced. To get company value, we multiplied the average
industry trailing price earnings by HNI’s trailing earnings per share for the last 12
months. This computation shows HNI’s price per share to be $5.32, which is within
15% of the closing price. So we can assume that HNI is fairly priced.
Forecasted P/E
The forward price to earnings ratio is defined as the market price of equity
divided by the earnings per share in the next financial year. We were able to compute
the following date displayed below.
206
Forecasted P/E Comparables
Company PPS EPS 1 Year
Out P/E
Forecast Industry
Ave. HNI PPS
HNI 10.5
0 2.16 4.86 8.01 17.30 HNI Restated
10.50 1.73 6.07 8.01 13.86
Herman Miller
12.28 0.93 13.21 outlier
Steelcase 4.13 N/A N/A
Knoll Inc. 6.69 0.84 8.01
To get the estimated earnings per share for HNI we used our forecast; for their
competitors, we used information found on www.yahoo.finance.com. To get the
suggested price for HNI we calculated an industry average trailing price to earnings
ratio. We then took ratios from HNI’s competitors, taking HNI out of the average to
avoid any inaccurate or unnecessary computed towards HNI. To compute the
suggested price for HNI we took the industry average price to earnings ratio and set it
equal to HNI’s price to earnings ratio. We then added HNI’s earnings for next year,
which is EPS forward, to the equation and solved for P. P is the price HNI should be if
the industry moved towards an average price to earnings ratio. I would like to reiterate
that we are assuming a 15% on the stock price evaluation so we adjusted the
suggested price to be either plus or minus 15% giving us a reasonable price for HNI.
I said a reasonable price for HNI and not an accurate price because the
forecasted price to earnings ratio limits the forecast to one year in the future and
ignores the potential earnings growth beyond a 12 month period. Without any
additional data the forward and trailing price to earnings ratios will compute inaccurate
information for valuation estimates.
207
Price to Book Ratio
The price to book ratio is calculated in order to observe if the firm’s value is
justified by their book value of equity. It also is known to evaluate a stock’s market
value in comparison to its book value. We were able to compute the following results.
Price/Book Comparables
Company PPS BPS P/B Industry Ave. HNI PPS
HNI 10.50 10.13 1.04 2.58 26.09
HNI Restated 10.50 5.00 2.10 2.58 12.89
Herman Miller 12.28 0.91 13.56 outlier
Steelcase 4.13 5.29 0.78
Knoll Inc. 6.69 0.96 6.95
We started by calculating the book value of equity per share by dividing the book
value of equity by the number of shares outstanding. Price to book is computed by
dividing price per share by the book value of equity per share. After calculating the
price to book ratio for each firm, we then calculated the industry average. Then we
finally multiplied the industry average by HNI’s book value of equity per share. A share
price of $26.09 is much higher than the current share price $10.50, which tells us that
HNI is undervalued. Even when restating HNI’s share price, the company is still
undervalued.
This number computed for the price to book ratio is an important one for
investment analysis because a firm’s book value is a good measure of firm value that
can simply be compared to market value. This shows investors a much simpler
benchmark. Another reason for showing the high value in this computation is because
208
price to book is not affected by firms that experience negative earnings (a limitation in
P/E ratio). But, price to book is not without its own limits because the book value of a
firm in an accounting number which we know can be manipulated. If accounting
policies are different among firms in the industry, the ratio is less useful.
Dividends to Price Ratio
The dividend to price ratio is a useful tool used in the method of comparables.
However, not every company pays dividends, so not every firm is able to use this
method. HNI and its competitors in the office furniture industry all had dividend
payouts, which are shown in the following table.
Dividends/Price Comparables
Company PPS DPS D/P Industry Ave HNI PPS
HNI 10.50 0.88 0.0838 0.0595 14.79
HNI Restated 10.50 0.88 0.0838 0.0595 14.79
Herman Miller 12.28 0.36 0.0293
Steelcase 4.13 0.32 0.0775
Knoll Inc. 6.69 0.48 0.0717
To get the price, we took HNI’s dividends per share and divided it by the industry
average dividends over price to get the price of HNI which is $14.79. This shows that
HNI is overvalued compared to the price of $10.50.
209
Price Earnings Growth (P.E.G.)
The price earnings growth is used to determine whether a firm’s stock is
undervalued or overvalued. It can be calculated by taking the firm’s P/E and dividing it
by the forecasted growth rate in earnings. For consistency purposes, the growth rate
used should be in terms of earnings per share. Lower P.E.G. ratios indicate that the
firm might be undervalued, whereas high P.E.G. ratios give off the impression that the
firm is overvalued. If a firm’s P.E.G. differs too much from other competitors in the
industry, they should be excluded when calculating the industry average. The following
calculation shows precisely how the P/E and growth rate is calculated for this ratio.
P.E.G. = [(Price per share x shares outstanding)/(Net Income (ttm))] / [(NI13-NI09)/ (NI09)]
Price Earnings Growth (P.E.G.) Comparables
Company P/E Growth P.E.G. Industry Ave HNI PPS
HNI 12.75 3.28 3.89 2.45 9.50
HNI Restated 12.78 3.28 3.90 2.45 9.53
Herman Miller 13.17 3.2279 4.08
Steelcase N/A N/A N/A
Knoll Inc. 8.02 9.90 0.81 *Based on five year P.E.G.'s
The graph shows that HNI’s P.E.G. is 3.89, which is higher than the industry
average. Although Knoll’s P.E.G. is considerably lower than HNI’s and Herman Miller’s,
it is still taken into consideration when calculating the industry average because their
210
expected growth is higher than their competitors. HNI’s suggested price per share is
within our 15% margin of safety which suggests the firm is fairly valued.
Price/EBITDA
The price/EBITDA ratio is calculated by taking the firm’s current market
capitalization rate and dividing it by their earnings before interest, tax, depreciation and
amortization. The firm’s current market capitalization rate is calculated by taking the
firm’s current price per share and multiplying it by their number of shares outstanding.
Since a high EBITDA promotes strong operating cash flows, lower ratios indicate the
firm has profitable cash flow from operations. By comparing the firm’s market
capitalization rate to its EBITDA, the ratio attempts to validate the firm’s market value
of equity with their operating cash flows. One weakness in this ratio is that it does not
take taxes and debt management techniques into account. Poor management in these
areas could lead to profit losses so the ratio must be approached with caution.
Price/EBITDA Comparables
Company MKT Cap EBITDA P/EBITDA Industry Ave HNI PPS
HNI 465.4 156.10 2.98 2.97 10.46
HNI Restated 465.4 156.20 2.98 2.97 10.47
Herman Miller 650.27 240.90 2.70
Steelcase 552.02 126.20 4.37
Knoll Inc. 314.49 170.89 1.84 *MKT Cap and EBITDA in millions
211
The table above shows that HNI’s as-stated and restated Price/EBITDA is right
on par with the industry average. Based upon the industry average, Steelcase and
Knoll look to be overvalued and undervalued, respectively. HNI looks to be fairly valued
when compared to their other competitors in the industry and their suggested price per
share is within our 15% margin of safety. However, the investor must not forget that
the ratio does have weaknesses and should be carefully evaluated.
Enterprise Value/EBITDA
This ratio can be calculated by dividing the firm’s earnings before interest, tax,
depreciation and amortization into the firm’s enterprise value. The enterprise value is
calculated by adding the firm’s market value of equity with its book value of liabilities
and then subtracting its cash and investments from that. Unlike the price/book ratio,
the EV/EBITDA ratio is not affected by the firm’s capital structure. The same
weaknesses apply to this ratio as does the price/EBITDA ratio because taxes and debt
management are not taken into account.
Enterprise Value/EBITDA Comparables
Company EV EBITDA EV/EBITDA Industry Average HNI PPS
HNI 817.30 156.10 5.24 3.69 13.00
HNI Restated 817.30 156.20 5.23 3.69 13.00
Herman Miller 894.46 240.90 4.86
Steelcase 634.786 126.20 4.37
Knoll Inc. 645.45 170.89 1.84 *EV and EBITDA in millions
212
The table above shows that HNI’s EV/EBITDA is above the industry average.
This is due to the facts that HNI, compared within the industry, has a higher than
average enterprise value and lower than average EBITDA. When interpreting the
EV/EBITDA, a higher ratio generally means the firm is overvalued. Based upon HNI’s
stated and restated EV/EBITDA ratios, their suggested price per share is outside our
15% margin of safety. In comparison to this ratio, HNI’s current stock price is
undervalued.
Price to Free Cash Flows (P/FCF)
This model provides the investor with information to compare the firm’s market
price and value of operating cash flows. The price to free cash flows ratio is calculated
by dividing the firm’s market capitalization rate by their free cash flows. It should be
noted that if any competitor’s P/FCF numbers are negative or significantly differ from
other competitors in the industry that their ratio should be ignored when computing the
industry average. The equation for a firm’s price to free cash flow is provided below.
P/FCF = (Price per share x shares outstanding) (Cash flows from operations +/- Cash flows from investing)
P/FCF Comparables
Company MKT Cap FCF P/FCF Industry Ave HNI PPS
HNI 465.40 42.84 10.86 8.93 8.63
HNI Restated 465.4 42.71 10.90 8.93 8.61
Herman Miller 650.27 81.10 8.02
Steelcase 551.36 56.00 9.85
Knoll Inc. 314.49 3.82 82.33 outlier *MKT Cap and FCF in millions
213
According to this chart, HNI’s P/FCF is above the industry average and the
highest among their competitors in the office furnishing industry. Knoll is considered an
outlier because their P/FCF ratio differs significantly from other competitors in the
industry and would skew the industry average. The calculation shows that HNI’s
suggested P/FCF per share is below our 15% margin of safety which implies that HNI’s
current stock price is overvalued.
Conclusion
The method of comparables can be done in a relatively short time frame, and it
is difficult to rely on them for completely accurate results. The numbers that are made
for these comparables are pretty much based all on industry averages. This excludes
any chance for an analyst’s opinion and therefore, these methods are usually
inaccurate. All of the comparable ratios are based outside financial theory, which
means it is essential to exclude any outlier ratios or extraordinary ratios. For the most
part, the method of comparables ratios suggests that HNI is fairly valued.
Intrinsic Valuation Models
In comparison to the method of comparables, the different valuation models
offer analysts a more precise view of the valuation of a firm. Each model uses forecast
assumptions from the forecast analysis section to be able to find an accurate estimation
of current stock price performance. A sensitivity analysis is performed for each model
using growth rates and the cost of equity in order to find the value of a firm. The value
of the firm can be described in three ways; over-valued, fairly valued, or under-valued.
Each model is based on financial theory that provides an analyst an understanding of
how each stock estimation can provide a view of a firm’s value. The intrinsic valuation
models discussed below include: the dividend discount model, discounted free cash flow
model, residual income model, long-run residual income model, and the abnormal
214
earnings growth model. These models performed below show us a more accurate
picture of HNI’s value.
Discounted Dividends Model
The Discounted Dividends Model is the most simple equity valuation model, but
also the most unreliable. This model has the lowest explanatory power compared to the
other intrinsic valuation models. In this model, you simply find the present value of the
expected dividends to be paid in order to find the value of the stock. The two inputs for
this model are cost of equity and the expected forecasted dividends. The expected
forecasted dividends are found by using educated basic assumptions on payout ratios
and future earnings growth rates.
This model is formed by some of the most important financial theories, but there
are several draw backs to the model which can make it unreliable. The biggest problem
with the model is that it is very sensitive to growth rate inputs. The growth rate inputs
are estimated and are kept at a constant rate throughout the model. This is unrealistic
considering that a firm is not going to pay a constant dividend, grow dividends at the
same rate, or even pay a dividend every year forever. The second problem with the
model is that there is an assumption being made that the rate of return is going to be
held constant throughout time, in reality the required rate of return is going to change
year to year.
To value HNI’s stock using the dividend discount model we first found the total
dividends paid from our forecasted financial statements, we then divided them by the
number of shares outstanding in order to find the total amount of dividends per share.
We then multiplied each year’s dividend by the different present value factors, which
correspond to the time, in order to bring each year’s dividend into present value. We
then estimated the value of HNI’s 2019 dividends per share in perpetuity to be $1.41.
We found the terminal value of the perpetuity by discounting it back to year zero using
215
the cost of equity. We then summed these two numbers to find the implied model price
as of 12/31/08. We are valuing HNI’s price as of 4/1/09 so we calculated the time
consistent price by exponentially multiplying the implied model price by the fraction of
the year that has passed, which was (3/12). The time consistent price is then compared
to the actual closing price on 4/1/09 to determine if the price is considered to be under
or overvalued.
The above chart is the discounted dividend model’s sensitivity evaluation. Our
valuation price, of $7.88, was calculated using a 15.57% cost of equity and a 3%
growth rate. At the valuation price of $7.88 it is implied that HNI is overvalued when
compared to the 4/1/09 market price of $10.50. Dividends are very sensitive to growth
rates and we have found that this model might not give the most accurate picture of
the valuation of HNI’s stock price, but the dividend discount model suggests that HNI is
an overvalued company.
Discounted Free Cash Flow Model
The discounted free cash flow model determines the value of a firm’s equity by
summing the present value of forecasted cash flows and the present value of the free
cash flow continuing perpetuity. The two line items that are used to determine the
HNI's Discounted Dividends Sensitivity Analysis
Growth Rate
0.00 0.01 0.02 0.03 0.04 0.05 0.06
Cost of Equity
11.21% $10.61 $11.05 $11.58 $12.24 $13.09 $14.20 $15.7412.67% $8.26 $9.56 $9.91 $10.34 $10.86 $11.52 $12.3814.12% $8.20 $8.41 $8.66 $8.95 $9.29 $9.71 $10.2415.57% $7.35 $7.51 $7.68 $7.88 $8.12 $8.40 $8.7417.03% $6.65 $6.76 $6.89 $7.03 $7.20 $7.39 $7.6218.48% $6.07 $6.16 $6.25 $6.36 $6.48 $6.61 $6.7719.93% $5.58 $5.65 $5.72 $5.80 $5.88 $5.98 $6.10
overvalued < $8.93 $8.93 < fairly valued <
$12.08 undervalued > $12.08
216
evaluation are found on the statement of cash flows. They are cash flows from
operating (CFFO) and cash flows from investing (CFFI). The year by year cash flows are
found by taking the CFFO and subtracting CFFI. Each year is calculated this way and
then multiplied by the year’s present value factor. The present value of each year is
then summed and added to the present value of the free cash flow perpetuity. This
calculation equals the total market value of assets. The total market value of assets is
then divided by the number of total shares outstanding in order to find the price per
share for 4/1/09. Like the discounted dividends model, a time consistent price is used
as a benchmark to compare figures.
In this model the sensitivity analysis depends on the relationship of two things,
weighted average cost of equity and the growth rate. These rates are manipulated in
order to compare the outcome to the time consistent price. When compared to the time
consistent price, an analysis can determine if the outcome is under or overvalued. The
model requires that the growth rate will be greater than the cost of capital and a value
greater than one. The problem with this model is that it assumes that a firm can
continue to grow to infinity in the perpetuity. The truth of the matter is that a firm will
most likely grow to within a sustainable growth rate and then slow down.
217
0.01 0.015 0.02 0.025 0.03 0.035 0.046.67% $7.32 $8.81 $10.61 $12.86 $15.71 $19.46 $24.627.23% $4.99 $6.15 $7.54 $9.22 $11.29 $13.92 $17.367.79% $3.05 $3.98 $5.06 $6.35 $7.91 $9.83 $12.258.34% $1.42 $2.19 $3.06 $4.07 $5.27 $6.73 $8.518.90% $0.01 $0.62 $1.32 $2.12 $3.06 $4.18 $5.529.46% N/A N/A N/A $0.55 $1.30 $2.18 $3.23
10.02% N/A N/A N/A N/A N/A $0.50 $1.32Restated WACC 6.60% $7.64 $9.18 $11.05 $13.38 $16.36 $20.30 $25.75
HNI's Discounted Free Cash Flows Sensitivy Analysis
Weighted Average Cost of
Capital
Growth rate
overvalued < $8.93 $8.93 < fairly valued < $12.08 undervalued > $12.08
Above is the sensitivity analysis for the discounted free cash flows model. By
looking at this model it easy to see that HNI is overvalued. In our analysis the higher
costs of capital caused the outcome of the price to be negative for some of the lower
growth rates, this is because HNI has a substantial amount of debt that creates a
negative market value of equity. Overall, this model is considered to have very low
explanatory power because a large percentage of the prices are determined by the
perpetuity. This is a problem considering that the inputs of the perpetuity are in the
future where forecasted numbers tend to be highly distorted.
Residual Income
The residual income valuation model is an important valuation model due to the
fact that it has one of the highest explanatory powers in regards to all of the valuation
models we have computed. With respect to industries, the residual income model has a
90 percent explanatory power; while computing for firms its explanatory power is
anywhere between 40-70 percent. This is a very large explanatory power compared to
the 2-5 percent for discounted dividends and the 10-20 percent for discounted free
218
cash flows. The reason for such a greater explanatory power is due to the fact that this
model is less responsive to changes in the growth rate. Another reason for this models
higher explanatory power is because most of the valuation weight is in the firm’s
current financial picture rather than in the terminal value perpetuity. This means that
the stock estimation found when computing this model is based on more current
accurate values rather than the forecasted values used when calculating the terminal
value perpetuity. By using the firm’s current values the residual income model’s stock
estimation is not majorly influenced by the forecasted numbers that tend to be highly
distorted in the long run.
The residual income model focuses on the book value of equity as well as the
present value of the value added by the company. Annual residual income is
represented by the value added back into the company. To calculate annual residual
income you subtract the company’s net income for that year by the normal or
benchmark income. In order to find the benchmark income you multiply your cost of
equity by last year’s book value of equity. If annual residual income is positive than it
means that the company created value for that year; the company destroyed value if
their residual income for the year is a negative number. We performed this step for HNI
over the ten years of forecasted numbers to find our residual income over that time
period. We found that after 2010, HNI destroyed value over the next eight years. After
we calculated our annual residual income our next step was to put each residual income
figure in present value. To do so we performed a present value factor for the next ten
years by computing the inverse of one plus the cost of equity raised to the time period,
or 1/(1+Ke)t. After we found the present value factor for the 10 year time period, we
multiplied the annual residual income by the present value factor for each respective
year. This equals the year-by-year present value of residual income over the next ten
years.
Our next step is to find HNI’s terminal value perpetuity. In order to find the
perpetuity we must forecast another year’s residual income. For our as-stated residual
income model we decided to grow our 2018 residual income figure by 15 percent to
219
find our 2019 residual income. We decided to grow by 15 percent due to the fact that
we calculated the percent change of residual income over the 10 year time period and
found a steady percent around 15 percent growth. For our restated residual income
model we used a declining rate of around 1 percent due to the fact the percent change
in residual income over the ten years was steady around negative one percent. After we
found our 2019 figure for our perpetuity we must divide that number by the difference
of our cost of equity and growth rate. After that we must put our terminal value
perpetuity in current 2009 dollars. We then multiply our perpetuity by the present value
factor at time 10 to find the present value of our perpetuity.
Our next step is to find the market value of equity for HNI. For this step we
added the book value of equity for 2008 by the sum of all year-by-year present values
of residual income and the terminal value perpetuity. From there we found our model
price by dividing market value of equity by HNI’s number of shares outstanding. This
gives us a model price at the end of HNI’s 2008 fiscal year. To find a model price
consistent to our April 1, 2009 valuation date we multiplied our model price by one plus
the cost of equity raised to the three twelfths, or (1+Ke)3/12. This time consistent price
serves as a benchmark when comparing our model to our April 1st observed share price
of $10.50. In efforts to find the value of HNI, we decided upon a 15 percent margin of
acceptance, which means any figure between $8.93 and $12.08 means HNI is fairly
valued. Our last step is to perform a sensitivity analysis using different growth rates and
cost of equity figures in efforts to find the value of HNI. Our growth rates are negative
due to the fact that the theory of equilibrium states that over a long period of time
residual income will level out at zero. Below is our sensitivity analysis for our as-stated
and restated financials for HNI.
220
-10% -20% -30% -40% -50%11.21% $15.86 $15.43 $15.21 $15.08 $14.9812.67% $13.75 $13.57 $13.47 $13.41 $13.3714.12% $12.03 $12.01 $12.00 $11.99 $11.9915.57% $10.62 $10.70 $10.74 $10.77 $10.7917.03% $9.43 $9.57 $9.65 $9.71 $9.7418.48% $8.44 $8.62 $8.72 $8.79 $8.8419.93% $7.60 $7.80 $7.92 $8.00 $8.05
overvalued < $8.93 undervalued > $12.08
Growth RateHNI's As-Stated Residual Income Sensitivity Analysis
Cost of Equity
$8.93 < fairly valued < $12.08
-10% -20% -30% -40% -50%11.21% $12.83 $12.24 $11.94 $11.75 $11.6312.67% $11.31 $10.92 $10.72 $10.59 $10.5014.12% $10.06 $9.81 $9.67 $9.59 $9.5315.57% $9.01 $8.86 $8.77 $8.72 $8.6817.03% $8.11 $8.03 $7.98 $7.95 $7.9318.48% $7.36 $7.32 $7.30 $7.29 $7.2819.93% $6.71 $6.71 $6.70 $6.70 $6.70
overvalued < $8.93 undervalued > $12.08
Growth Rate
Cost of Equity
$8.93 < fairly valued < $12.08
HNI's Restated Residual Income Sensitivity Analysis
As you can see the sensitivity analysis shows that changes in growth rates and
cost of equity have a relatively small effect on the model price. Our as-stated and
restated sensitivity analysis shows us differing opinions of HNI. Our as-stated shows
HNI being fairly valued within a range of around 14-17 percent for cost of equity. A
lower cost of equity shows that HNI is undervalued while a higher cost of equity shows
HNI being overvalued. However, our restated sensitivity analysis shows us a different
way of looking at HNI. The restated sensitivity analysis shows that HNI is overvalued to
fairly valued compared to our observed share price of $10.50. Unlike the as-stated
analysis, the restated shows HNI being fairly valued using a lower cost of equity. A
221
modest to high cost of equity states that HNI is overvalued when using our restated
financials. This could mainly be due to the fact that the restatement of goodwill had
such a huge effect on all financial statements. The restatement of goodwill significantly
decreased net income and the book value of equity compared to our as-stated
financials which in turn leads to a lower market value of equity for our restated model.
This then yields to a lower model price and is a good reason why the restated analysis
has lower model prices for each cost of equity compared to our as-stated analysis. We
believe the significant impact on the restatement of goodwill shows us a better picture
of HNI’s current financial performance, so we are convinced that the restated sensitivity
analysis is more accurate in regards to valuing HNI. This means that we believe that
HNI is fairly valued to overvalued. Due to the high explanatory power of the residual
income model we are confident that our assumption of HNI’s value will be the same as
our final conclusion of HNI’s value.
Abnormal Earnings Growth Model
The abnormal earnings growth model (AEG) is an accounting based model
derived from financial theory. Similar to the residual income model, the AEG model uses
information strictly from financial statements. At the core of the AEG model is the
forecasted numbers we found for net income and dividends. Just like the residual
income model, the AEG model has a higher explanatory power than the discounted
dividend and discounted free cash flow model. This makes the AEG model very
important is determining the value of HNI.
Our first step in the AEG model is to find dividend reinvestment or DRIP. In order
to find DRIP we must multiply last year’s total dividend payment by the cost of equity
for the forecasted 10 year time period. DRIP is a principle based on the assumption that
investors will reinvest their dividends into a company’s stock based on the return from
the cost of equity. After we found DRIP for our forecasted ten years we must find the
222
cumulative dividend earnings. To find the cumulative dividend earnings we added the
dividend reinvestment to the net income for the same year. Our next step is to find the
normal or benchmark earnings for HNI over the next ten years. We perform this step by
multiplying a year lagged net income by one plus our cost of equity. These earnings
serve as a benchmark in which we can determine our abnormal earnings growth. To
find our abnormal earnings growth we then subtract our cumulative dividend earnings
by our normal earnings. After this step we must put our abnormal earnings growth in
current 2009 dollars. To make sure are abnormal earnings growth is in the present
value we have to multiply our abnormal earnings growth by each respective years
present value factor. To find our present value factor we find the inverse of one plus
our cost of equity raised to the time period, or 1/(1+Ke)t. This yields the year-by-year
present value of abnormal earnings growth.
Our next step in the AEG model is to find the terminal value perpetuity. Before
we find the terminal value perpetuity we must forecast another year of abnormal
earnings growth. To find an adequate abnormal earnings growth value we calculated
the percent change of AEG over the forecasted ten years. For our as-stated AEG model
we found a relatively stable AEG percent change around 15 percent. We then multiplied
our number for 2018 abnormal earnings growth by the 15 percent growth to find our
2019 AEG figure. Our growth percentage of AEG was very volatile for our restated
financials so we found another method to find our 2019 figure. We found our annual
change in residual income in our restated residual income model for 2019 and used that
figure for our 2019 value in our restated AEG model. We can perform this method due
to the fact that the annual change in residual income is the exact same number as our
abnormal earnings growth for each respective year. After we found our 2019 figure we
must divide that number by the difference in our cost of equity and the growth rate.
The result is the perpetuity but we need to find the present value of this perpetuity. To
get our perpetuity in a current dollar figure we then multiply our perpetuity by the 2018
present value factor. The result is our terminal value perpetuity for our AEG model.
223
After we found our terminal value perpetuity we must find the total average net
income of the perpetuity. To find this figure we have to add our core net income or
2009’s forecasted net income by the sum of year-by-year present value of AEG and the
present value of our terminal value perpetuity. Our next step is to find our intrinsic
value per share, or model price. To find our model price we divide our total average net
income of the perpetuity by HNI’s 2008 number of shares outstanding. We then take
that number and divide by our cost of equity to find the intrinsic value per share. This
gives us a model price at the end of HNI’s 2008 fiscal year. In order to find a time
consistent price we multiply our model price by one plus our cost of equity raised to the
three twelfths, or (1+Ke)3/12. This time consistent price gives us a benchmark for
comparison with observed April 1st share price of $10.50. Our last step is to perform a
sensitivity analysis so we can compare our time consistent AEG model price with our
observed share price. We used a 15 percent margin of acceptance when trying to find
the value of HNI. This means that HNI is fairly valued if any model price falls between
$8.93 and $12.08. HNI is overvalued if our AEG model price is below $8.93 and
undervalued if we find a model price above $12.08. Below is our restated and as-stated
sensitivity analysis for HNI.
-10% -20% -30% -40% -50%11.21% $17.10 $16.98 $16.92 $16.88 $16.8512.67% $14.02 $14.04 $14.05 $14.06 $14.0614.12% $11.78 $11.86 $11.91 $11.94 $11.9615.57% $10.08 $10.19 $10.26 $10.30 $10.3317.03% $8.75 $8.88 $8.95 $9.00 $9.0418.48% $7.71 $7.84 $7.91 $7.96 $8.0019.93% $6.87 $7.00 $7.07 $7.12 $7.15
overvalued < $8.93 undervalued > $12.08
Growth Rate
Cost of Equity
HNI's As-stated AEG Sensitivity Analysis
$8.93 < fairly valued < $12.08
224
-10% -20% -30% -40% -50%11.21% $14.42 $14.45 $14.46 $14.47 $14.4812.67% $12.27 $12.29 $12.30 $12.31 $12.3114.12% $10.62 $10.64 $10.65 $10.65 $10.6615.57% $9.32 $9.33 $9.34 $9.34 $9.3517.03% $8.28 $8.28 $8.28 $8.28 $8.2918.48% $7.41 $7.42 $7.42 $7.42 $7.4319.93% $6.70 $6.70 $6.71 $6.71 $6.71
overvalued < $8.93 undervalued > $12.08
Cost of Equity
Growth RateHNI's Restated AEG Sensitivity Analysis
$8.93 < fairly valued < $12.08
The AEG model is very similar to the residual income model due to the fact that
changes in the cost of equity and the growth rates result in small changes to the model
price. For both as-stated and restated sensitivity analysis we can see that by using
HNI’s actual cost of equity of 15.57% results in HNI being fairly valued. Also, for both
analyses a slightly lower cost of equity results in HNI being fairly valued. The AEG
model is an important model when it comes to our final conclusion of HNI’s value
because of its high explanatory power. This high explanatory power is why we are
confident in determining HNI is a fairly valued company.
Long Run Residual Income
The long run residual income and the residual income model both find their stock
estimations on finding the market value of equity of a company. However, the long run
residual income model uses a different way to find market value of equity compared to
the residual income model. Instead of finding market value of equity through a
company’s annual residual income and terminal value perpetuity; the long run residual
income model utilizes an equation based on return on equity. The long run residual
income equation used to find the market value of equity is as follows:
MVE = BVE2008 (1+(ROE-Ke)/(Ke-G))
225
Before we start the long run residual income model we must find HNI’s return on
equity using our ten years of forecasted numbers. To find HNI’s return on equity we
divide HNI’s net income by last year’s book value of equity. Below is our return on
equity using our as-stated and restated financials.
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018ROE 21.36% 17.60% 15.51% 15.34% 15.18% 15.02% 14.87% 14.71% 14.56% 14.39%
2009 2010 2011 2012 2013 2014 2015 2016 2017 201834.59% 27.40% 23.57% 22.99% 22.47% 21.98% 21.51% 21.05% 20.60% 20.16%
ROE Restated
The return on equity we used as a constant for our restated and as-stated
sensitivity analysis equals our 2018 return on equity. Since we already know HNI’s cost
of equity, 15.57%, and we have our return on equity figures; we know must find an
adequate growth rate. To find our growth rates we have to subtract our return on
equity from our cost of equity for our ten forecasted years. Once we have these
numbers we conducted a growth percentage over the ten years to find that when cost
of equity is equal to 15.57% our growth rate ends up being 15%. Now we can plug in
our variables to find our market value of equity. Our as-stated market value of equity
for HNI ends up being negative $480,330,000. We ended up with a negative number
due to the fact that the numerator of our equation turns out to be a negative number.
We then take our market value of equity and divide by our number of shares
outstanding to find our model price. Once we found our model price we need to present
a time consistent price so we can compare with our observed April 1st share price. To
find our time consistent price we take our model price and multiply one plus our cost of
equity rose to the three twelfths, or (1+Ke)3/12. This gave us a time consistent price of
negative $11.24 to compare with our observed share price of $10.50.
226
Our next step is to perform a sensitivity analysis using both restated and as-
stated financials. We need to perform three separate sensitivity analysis for both
restated and as-stated to show what happens to the stock estimation when one variable
stays constant. The three variables we are working with are our return on equity, cost
of equity and growth rate. Below is our as-stated and restated sensitivity analysis for
HNI.
-0.14 -0.05 0.03 0.05 0.1511.21% $11.71 $12.44 $14.43 $15.72 $1.6713.39% $10.83 $11.02 $11.46 $11.69 $3.9615.57% $10.08 $9.90 $9.51 $9.33 N/A17.75% $9.43 $8.99 $8.15 $7.77 N/A19.93% $8.87 $8.24 $7.13 $6.66 N/A
As-Stated Sensitivity Analysis
ROE held constant at 14.39%$8.93 < fairly valued < $12.03overvalued < $8.93 undervalued > $12.03
Growth rate
Cost of Equity
0.1118 0.1279 0.1439 0.1600 0.176011.21% $10.65 $6.16 $1.70 N/A N/A13.39% $24.79 $14.34 $3.96 N/A N/A15.57% N/A N/A N/A $18.42 $47.8917.75% N/A N/A N/A $3.84 $9.9719.93% N/A N/A N/A $2.15 $5.59
As-Stated Sensitivity Analysis
Growth Rate held constant at 15%overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03
ROE
Cost of Equity
227
0.1118 0.1279 0.1439 0.16 0.176-0.14 $8.94 $9.51 $10.08 $10.65 $11.22-0.05 $8.26 $9.08 $9.90 $10.72 $11.540.03 $6.83 $8.18 $9.51 $10.86 $12.190.05 $6.14 $7.74 $9.33 $10.93 $12.520.15 N/A N/A N/A $18.42 $47.89
As-Stated Sensitivity Analysis
overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03Cost of Equity held constant at 15.57%
Growth Rate
ROE
-0.65 -0.16 -0.09 -0.062 -0.0480.1121 $5.74 $6.83 $7.41 $7.78 $8.010.1339 $5.61 $6.35 $6.72 $6.95 $7.090.1557 $5.48 $5.94 $6.16 $6.28 $6.360.1775 $5.36 $5.58 $5.68 $5.74 $5.770.1993 $5.25 $5.27 $5.28 $5.28 $5.28
Growth Rate
Cost of Equity
ROE held constant at 20.16%
Restated Sensitivity Analysis
overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03
0.1675 0.1846 0.2016 0.2187 0.23570.1121 $6.55 $6.98 $7.41 $7.85 $8.280.1339 $5.94 $6.33 $6.72 $7.12 $7.510.1557 $5.44 $5.80 $6.16 $6.52 $6.880.1775 $5.02 $5.35 $5.68 $6.02 $6.350.1993 $4.66 $4.97 $5.28 $5.59 $5.90
Restated Sensitivity AnalysisROE
Cost of Equity
Growth Rate held constant -9%overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03
228
0.1675 0.1846 0.2016 0.2187 0.2357-0.65 $5.26 $5.37 $5.48 $5.59 $5.70-0.16 $5.38 $5.66 $5.94 $6.22 $6.50-0.09 $5.44 $5.80 $6.16 $6.52 $6.88
-0.062 $5.47 $5.88 $6.28 $6.69 $7.09-0.048 $5.49 $5.92 $6.36 $6.79 $7.23
ROERestated Sensitivity Analysis
Cost of Equity held constant at 15.57%overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03
Growth Rate
Our tables show how HNI is valued when we keep one of the three variables
constant. As you can see for our as-stated analysis many of our numbers end up
negative. This is due to the fact that the figures we found for our growth rates, cost of
equity and return on equity are all volatile numbers that when put in our equation allow
for fluctuations in model prices. For example, when we held our return on equity
constant at 14.39% and plugged in our higher cost of equity numbers are market value
of equity will turn negative due to the negative numerator in the equation.
We can now come to some conclusions of HNI’s value using our long run residual
income model. Our as-stated sensitivity analysis tells us that our growth rates and
return on equity are volatile and that in many cases leads to negative model prices. In
regards to our as-stated sensitivity analysis, when we held ROE constant at 14.39%
HNI becomes fairly valued the majority of the time. When we hold our growth rate
constant at 15% we are deemed extremely overvalued. This is partly due to the fact
that in almost half of the sensitivity analysis our numerator will be negative because our
return on equity is smaller than our cost of equity. When we hold our cost of equity
constant at 15.57%; HNI shows to be mostly fairly valued when computing with our
lower growth rates. Our restated sensitivity analysis tables show that HNI is extremely
overvalued. Our restatement of goodwill caused our book value of equity and net
income to change which in turn has affected our return on equity. This restatement
caused for new growth rates as well. These new return on equity and growth rate
229
figures along with our restated book value of equity caused our equation to find that
HNI is an overvalued company.
The long run residual income model is similar to the residual income model by
trying to find the market value of equity but it does not have the same explanatory
power. The long run residual income model has a lower explanatory power than the
residual income but still had a higher power than the discounted free cash flows and
dividend models. We can now assume that HNI is fairly valued to slightly overvalued
after computing our long run residual income sensitivity analysis. We believe that our
assumptions will be fairly similar to our final recommendation due to the adequate level
of explanatory power.
Analyst Recommendation
After reviewing our extensive research and intrinsic valuations we have
concluded that HNI is fairly valued to slightly overvalued. We were able to come up
with our conclusion by reviewing the data we have on the office furniture and hearth
industry as well as HNI and its competitor’s key accounting policies and financial
statements. Our industry analysis helped in understanding the factors that allows for
companies within the office furniture and hearth industry to achieve success. By
analyzing HNI and its competitor’s financial statements and significant accounting
policies; we were able to determine an accurate financial picture of HNI and
competitors with their industry. After determining the accuracy of HNI’s financial
statements we performed a ten year forecast that allowed for us to build a better
picture of how HNI could perform in the future. We used these forecasted financials to
develop valuation models that allowed for further insight into the value of HNI.
It is important to understand the office furniture and hearth industry so we can
determine what factors allow for success. After extensive research into the hearth
industry we were not able to find any public companies that compete in the hearth
industry. Since we could not find any competitors to HNI in the hearth industry, we
230
were lacking important financial information to conduct any accounting, financial, or
valuation analysis. The basis of our accounting, financial, and valuation analysis is from
the office furniture industry in which HNI conducts nearly 85% of their business. By
looking deeper into the accounting strategy behind HNI’s financials we were able to
conclude that the impairment of goodwill would be needed to understand a more
accurate financial picture. We believe our restated balance sheet and income statement
provide a more accurate picture of HNI’s financials.
Our forecast analysis was important to understand so we can gain an idea of
what HNI will look like in the future. Many factors like the current recession came into
mind when determining our most important forecastable line item, sales growth. We
believe by analyzing the industries and HNI’s performance during the last recession we
came up with an accurate sales growth percentage. Our sales growth percentage
represented a base for almost all other forecastable line items. We believe our as-stated
and restated forecasted financials provide an in depth look into HNI’s future financial
performance.
The intrinsic valuation models provided the most accurate display of HNI’s value.
Our discounted dividends model showed HNI to be mostly overvalued, while being fairly
valued using a very low cost of equity. The discounted free cash flows model was
similar to the discounted dividends model due to the fact that our sensitivity analysis
was mostly overvalued but fairly valued when using a very low cost of equity. These
two valuation models came into consideration when determining our final conclusion
but due to their low explanatory power we believe our other valuation models provide a
better picture of HNI’s value. The residual income has the highest explanatory power
and showed that HNI was fairly valued for our as-stated model. The residual income
model using our restated financials showed HNI to be slightly overvalued but also fairly
valued when using a low cost of equity. The restated and as-stated abnormal earnings
growth model showed HNI as being fairly valued. The long run residual income models
show two different views of HNI. Our long run residual income model using our restated
forecasts shows HNI as being completely overvalued. Our as-stated model shows HNI
231
as fairly valued in two of our sensitivity analysis; when return on equity is held constant
at 14.39% and when the cost of equity is held constant at 15.57%.
HNI’s observed share price on April 1st, 2009 was $10.50; which served as a
benchmark in how to value HNI. We conducted each valuation model using a 15%
margin of safety; which means HNI is fairly valued anywhere between $8.93 and
$12.03. When deciding upon our conclusion of HNI’s value, we believe that our
restatement of goodwill was necessary to decipher HNI’s current financial picture. As a
result, we took into greater consideration our restated intrinsic valuations rather than
our as-stated. Consequently, we believe HNI is fairly-valued to slightly overvalued. We
recommend investors to hold onto HNI’s stock, but carefully watch the stock price over
the next few months. Due to the current volatile market and recession we believe that
investors should sell their stock if the price starts to exceed our 15% margin of safety
number of $12.03.
232
Appendices
Liquidity Ratios
Current Ratio Days Sales Outstanding
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
HNI 1.88 1.41 1.36 1.41 1.27 HNI 37.72 40.93 41.48 43.12 41.01
Herman Miller 1.81 1.52 1.30 1.35 1.59 Herman Miller 38.84 40.89 36.39 35.78 37.91
Steelcase 1.73 1.73 1.35 1.91 1.37 Steelcase 55.66 52.80 48.59 41.55 42.36
Knoll Inc. 0.85 1.59 1.48 1.45 1.49 Knoll Inc. 47.78 47.77 51.29 49.42 47.36
Industry Average 1.57 1.56 1.37 1.53 1.43 Industry Average 45.00 45.60 44.44 42.47 42.16
Quick Asset Ratio Inventory Turnover
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
HNI 1.57 1.02 1.01 0.99 0.86 HNI 12.83 9.68 9.75 8.76 8.35
Herman Miller 1.44 1.19 0.99 0.99 1.22 Herman Miller 24.22 21.97 24.68 22.73 23.84
Steelcase 1.14 1.19 0.96 1.42 0.97 Steelcase 14.76 13.99 13.45 14.78 15.65
Knoll Inc. 0.57 1.01 0.99 0.93 0.92 Knoll Inc. 12.02 9.39 9.49 8.73 7.50
Industry Average 1.18 1.10 0.99 1.08 0.99 Industry Average 15.95 13.76 14.34 13.75 13.83
Working Capital Turnover Days’ Supply Inventory
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
HNI 8.12 19.32 19.08 18.40 24.57 HNI 28.45 37.69 37.45 41.65 43.74
Herman Miller 6.92 10.15 19.13 19.15 11.01 Herman Miller 15.07 16.62 14.79 16.06 15.31
Steelcase 5.88 5.84 9.83 5.29 13.59 Steelcase 24.74 26.08 27.14 24.70 23.33
Knoll Inc. ‐24.69 11.27 12.63 12.73 12.21 Knoll Inc. 30.37 38.89 38.48 41.79 48.66
Industry Average ‐0.94 11.65 15.17 13.89 15.35 Industry Average 24.66 29.82 29.46 31.05 32.76
Accounts Receivable Turnover Cash to Cash Cycle
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
HNI 9.68 8.92 8.80 8.47 8.90 HNI 66.18 78.62 78.94 84.77 84.74
Herman Miller 9.40 8.93 10.03 10.20 9.63 Herman Miller 53.91 57.51 51.18 51.84 53.23
Steelcase 6.56 6.91 7.51 8.78 8.62 Steelcase 80.40 78.88 75.72 66.25 65.69
Knoll Inc. 7.64 7.64 7.12 7.39 7.71 Knoll Inc. 78.15 86.66 89.77 91.21 96.03
Industry Average 8.32 8.10 8.36 8.71 8.71 Industry Average 69.66 75.42 73.90 73.51 74.92
233
Profitability Ratios
Gross Profit Margin Asset Turnover
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
HNI 36.4% 35.9% 36.2% 34.6% 35.2% HNI 1.72 2.05 2.15 2.19 2.13
Herman Miller 31.1% 32.3% 33.1% 33.7% 34.7% HNI (Restated) 1.79 2.23 2.43 2.55 2.62
Steelcase Inc. 26.2% 28.5% 29.5% 30.6% 32.9% Herman Miller 1.74 2.12 2.46 2.87 3.02
Knoll Inc. 33.9% 34.1% 33.7% 32.5% 34.6% Steelcase Inc. 1.00 1.11 1.21 1.32 1.43
Industry Average 31.9% 32.7% 33.1% 32.8% 34.4% Knoll Inc. 1.18 1.26 1.43 1.69 1.67
Industry Average 1.86 2.19 2.42 2.65 2.72
Operating Expense Ratio Return on Assets
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
HNI 0.2738 0.2732 0.2730 0.2678 0.2732 HNI 9.6% 11.1% 12.1% 10.1% 10.0%
HNI (Restated) 0.2683 0.2738 0.2732 0.2730 0.2678 HNI (Restated) N/A 7.2% 8.9% 11.6% 9.6%
Herman Miller 0.2272 0.2156 0.2151 0.2063 0.1967 Herman Miller 5.5% 9.5% 14.1% 19.3% 22.9%
Steelcase Inc. 0.2889 0.2763 0.2642 0.2685 0.2698 Steelcase Inc. ‐1.0% 0.5% 2.1% 4.6% 5.6%
Knoll Inc. 0.2148 0.2402 0.2218 0.2058 0.2112 Knoll Inc. 6.2% 4.8% 6.3% 10.1% 11.3%
Industry Average 0.3183 0.3198 0.3118 0.3053 0.3047 Industry Average 5.1% 8.3% 10.9% 13.9% 14.8%
Operating Profit Margin Return on Equity
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
HNI 8.5% 8.5% 8.8% 7.7% 7.5% HNI 13.8% 17.0% 23.1% 24.9% 26.2%
HNI (Restated) 6.4% 6.4% 6.8% 6.0% 5.6% HNI (Restated) N/A 11.4% 13.1% 18.6% 20.9%
Herman Miller 4.6% 8.0% 9.1% 10.3% 12.3% Herman Miller 22.1% 34.9% 58.2% 93.3% 98.1%
Steelcase Inc. ‐3.1% 0.7% 2.9% 3.7% 5.9% Steelcase Inc. ‐1.8% 1.1% 4.1% 8.9% 10.8%
Knoll Inc. 12.4% 10.1% 11.5% 11.9% 13.5% Industry Average 11.4% 21.5% 32.8% 48.5% 52.0%
Industry Average 7.2% 8.4% 9.8% 9.9% 11.2%
Net Profit Margin
2003 2004 2005 2006 2007
HNI 5.6% 5.4% 5.6% 4.6% 4.7%
HNI (Restated) 4.2% 4.2% 4.4% 3.6% 3.2%
Herman Miller 3.2% 4.5% 5.7% 6.7% 7.6%
Steelcase Inc. ‐1.0% 0.5% 1.7% 3.5% 3.9%
Knoll Inc. 5.2% 3.8% 4.4% 6.0% 6.8%
Industry Average 4.3% 4.6% 5.5% 6.1% 6.5%
234
Capital Structure Ratios
Debt to Equity Ratio Debt Service Margin
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
HNI 0.44 0.53 0.92 1.47 1.63 HNI 3.42 7.29 311.16 3.96 11.14
HNI (Restated) 0.46 0.6 1.18 2.29 3.23 HNI (Restated) N/A 7.29 311.16 3.96 11.14
Herman Miller 2.67 3.14 3.83 3.29 32.47 Herman Miller 6.08 8.41 11.57 45.9 71.2
Steelcase 0.95 0.98 0.95 0.94 1.33 Steelcase 2.93 3.33 2.6 1.07 48.96
Industry Average 1.51 1.75 2.29 2.66 12.89 Knoll Inc 1.24 0.74 717.05 29.83 34.1
Knoll Inc N/A N/A N/A N/A N/A Industry Average 3.42 6.76 338.38 21.18 44.14
Industry Average 3.42 6.63 345.19 25.48 52.38
Times Interest Earned Altman Z‐Score
2003 2004 2005 2006 2007 2004 2005 2006 2007 2008
HNI 50.49 201.37 91.53 14.41 10.66 HNI 7.65 6.69 5.11 4.45 3.83
HNI (Restated) 37.56 150.68 70.95 11.24 7.92 HNI (Restated 9.67 3.61 4.98 4.38 3.43
Herman Miller 4.34 8.71 11.26 14.46 13.12 Herman Miller 5.2 5.58 6.62 6.8 4.53
Steelcase ‐3.97 0.87 4.56 6.15 12 Steelcase 2.03 2.41 2.74 2.98 2.79
Knoll Inc 4.28 3.67 3.92 4.93 5.78 Knoll 2.71 3.08 3.47 3.09 2.93
Industry Average 23.17 91.32 45.56 12.8 12.37 Industry Average 5.45 4.27 4.58 4.34 3.5
235
Goodwill Restated Financial Statements
2002 2003 2004 2005 2006 2007 2008Total Current Asset 405,054 462,122 374,579 486,598 504,174 489,072 417,841Long Term Assets:
Property, Plant, Equipment 353,270 312,368 311,344 294,660 309,952 305,431 315,606Goodwill 192,395 153669 141226 110467 74498 29792 41340Other Assets 69,833 55,250 111,180 116,769 160,472 155,639 163,790
Total Assets $1,020,552 983409 938329 1008494 1049096 979934 938577
Liabilities:Total Current Liabilities 298,680 245,816 266,250 358,174 358,542 384,461 373,625Long term Liabilities 74979 66121 86244 188153 371898 363607 343,171Total Liabilities 373659 311,937 352,494 546,327 730,440 748,068 716,796
Stockholder's EquityTotal Common Stock 58,374 58,239 55,303 51,849 47,906 44,835 44,324Additional paid-in capital 549 10,324 6,879 941 2,807 3,152 6,037Retained Earnings 587,731 603315 523304 409045 271005 183033 173327Accum. other comprehensive income 239 (406) 349 332 (3,062) 846 (1,907)
Total Stockholder's Equity 646,893 671,472 585,835 462,167 318,656 231,866 221,781
Total Liabilities and Stockholder's Equity $1,020,552 983,409 938,329 1,008,494 1,049,096 979,934 938,577
HNI's Restated Balance Sheet (in thousands)
236
2002 2003 2004 2005 2006 2007 2008Net Sales $1,692,622 $1,755,728 $2,093,447 $2,450,572 $2,679,803 $2,570,472 $2,477,587Cost of products sold 1,092,743 1,116,513 1,342,143 1,562,654 1,752,882 1,664,697 1,648,975Gross Profit 599,879 639,215 751,304 887,918 926,921 905,775 828,612Selling and Administrative Expenses 454,189 480,744 572,006 668,910 717,676 702,329 717,870Restructuring related and Impairment charges 3,000 8,510 886 3,462 2,829 9,788 25,859Goodwill Impairment 0 38417 44911 48,449 45,486 49,780 10Operating Income 142,690 111,544 133,501 167,097 160,930 143,878 84,873Interest Income 2,578 3,940 1,343 1,518 1,139 1,229 1,172Interest Expense 4,714 2,970 886 2,355 14,323 18,161 16,865Income Before Taxes 140,554 112514 133,958 166,260 147,746 126,946 69,180Income Taxes at 34.5% 48,491 38817 46,216 57,360 50,972 43,796 23,867Net Income $92,063 73697 87,742 108,900 96,774 83,150 45,313
HNI's Restated Income Statement (in thousands)
Three Month Regression
Sl ice BETA ADJUSTED R SQUARED LOWER 95% UPPER 95% RISK PREMIUM RISK FREE RATE ESTIMATED Ke LOW Ke HIGH Ke
72 1.374815096 0.250771555 0.823813468 1.925816723 6.8 2.87 12.21874265 8.471931581 15.96555372
60 1.470372441 0.253908999 0.829300262 2.11144462 6.8 2.87 12.8685326 8.509241781 17.22782342
48 1.444744894 0.231014771 0.696844846 2.192644941 6.8 2.87 12.69426528 7.608544956 17.7799856
36 1.373285012 0.216241275 0.518361422 2.228208602 6.8 2.87 12.20833808 6.39485767 18.0218185
24 1.405998183 0.208357113 0.308093944 2.503902422 6.8 2.87 12.43078764 4.965038819 19.89653647
237
24 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.492723421R Square 0.242776369Adjusted R Square 0.208357113Standard Error 0.137888712Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.13411037 0.13411037 7.053504284 0.014436979Residual 22 0.418292529 0.019013297Total 23 0.5524029
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.00728008 0.03162641 ‐0.230189909 0.82007114 ‐0.07286924 0.058309079 ‐0.07286924 0.058309079X Variable 1 1.405998183 0.529397995 2.655843422 0.014436979 0.308093944 2.503902422 0.308093944 2.503902422
36 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.488502182R Square 0.238634382Adjusted R Square 0.216241275Standard Error 0.118405828Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.149404896 0.149404896 10.65660017 0.00250409Residual 34 0.476677962 0.01401994Total 35 0.626082858
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.009274819 0.02097164 ‐0.44225531 0.661105065 ‐0.05189432 0.033344681 ‐0.05189432 0.033344681X Variable 1 1.373285012 0.420679496 3.264444849 0.00250409 0.518361422 2.228208602 0.518361422 2.228208602
238
48 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.497369238R Square 0.247376159Adjusted R Square 0.231014771Standard Error 0.10991802Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.182673478 0.182673 15.11951 0.000322534Residual 46 0.555770675 0.012082Total 47 0.738444154
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.000776667 0.016484198 0.047116 0.962625 ‐0.032404302 0.033957636 ‐0.032404302 0.033957636X Variable 1 1.444744894 0.371554322 3.888381 0.000323 0.696844846 2.192644941 0.696844846 2.192644941
60 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.516289269R Square 0.266554609Adjusted R Square 0.253908999Standard Error 0.098917953Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.206251276 0.206251276 21.07882539 2.41571E‐05Residual 58 0.567516158 0.009784761Total 59 0.773767434
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.00330719 0.013093408 0.252584362 0.801482438 ‐0.022902114 0.029516494 ‐0.022902114 0.029516494X Variable 1 1.470372441 0.320261071 4.591168194 2.41571E‐05 0.829300262 2.11144462 0.829300262 2.11144462
239
72 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.511198659R Square 0.261324069Adjusted R Square 0.250771555Standard Error 0.093756456Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.21768368 0.21768368 24.76415437 4.46139E‐06Residual 70 0.615319117 0.008790273Total 71 0.833002797
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.001931743 0.011086149 0.174248367 0.862173244 ‐0.020178882 0.024042369 ‐0.020178882 0.024042369X Variable 1 1.374815096 0.276269245 4.97635955 4.46139E‐06 0.823813468 1.925816723 0.823813468 1.925816723
One Year Regression Slice BETA ADJUSTED R SQUARED LOWER 95% UPPER 95% RISK PREMIUM RISK FREE RATE ESTIMATED Ke LOW Ke HIGH Ke
72 1.37 0.25 0.82 1.92 6.80 2.87 12.20 8.45 15.9460 1.47 0.25 0.83 2.11 6.80 2.87 12.84 8.49 17.2048 1.44 0.23 0.69 2.19 6.80 2.87 12.66 7.59 17.7436 1.37 0.22 0.52 2.22 6.80 2.87 12.18 6.38 17.9824 1.40 0.21 0.31 2.50 6.80 2.87 12.40 4.95 19.85
24 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.492147117R Square 0.242208785Adjusted R Square 0.207763729Standard Error 0.13794038Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.133796835 0.133796835 7.031743247 0.014569639Residual 22 0.418606065 0.019027548Total 23 0.5524029
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.007083521 0.031679872 ‐0.223596886 0.825134247 ‐0.072783553 0.058616512 ‐0.072783553 0.058616512X Variable 1 1.401495424 0.528518485 2.651743435 0.014569639 0.305415177 2.497575672 0.305415177 2.497575672
240
36 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.488232981R Square 0.238371444Adjusted R Square 0.215970604Standard Error 0.118426272Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.149240275 0.149240275 10.64118333 0.002519985Residual 34 0.476842583 0.014024782Total 35 0.626082858
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.009115819 0.020993139 ‐0.434228502 0.666865813 ‐0.05177901 0.033547371 ‐0.05177901 0.033547371X Variable 1 1.3692577 0.41974954 3.262082667 0.002519985 0.516224006 2.222291393 0.516224006 2.222291393
48 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.496864657R Square 0.246874488Adjusted R Square 0.230502194Standard Error 0.109954648Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.182303022 0.182303022 15.07879663 0.000327804Residual 46 0.556141132 0.012090025Total 47 0.738444154
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.001007595 0.016507182 0.061039824 0.951591932 ‐0.032219638 0.034234829 ‐0.032219638 0.034234829X Variable 1 1.440393769 0.370935067 3.883142622 0.000327804 0.693740217 2.187047321 0.693740217 2.187047321
241
60 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.515637357R Square 0.265881884Adjusted R Square 0.253224676Standard Error 0.098963307Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.205730743 0.205730743 21.00635984 2.4836E‐05Residual 58 0.56803669 0.009793736Total 59 0.773767434
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.003627373 0.01311584 0.276564278 0.783097885 ‐0.022626833 0.029881578 ‐0.02262683 0.029881578X Variable 1 1.466293685 0.319923074 4.583269557 2.4836E‐05 0.82589808 2.10668929 0.82589808 2.10668929
72 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.510667163R Square 0.260780952Adjusted R Square 0.25022068Standard Error 0.093790918Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.217231262 0.217231262 24.69452953 4.58198E‐06Residual 70 0.615771535 0.008796736Total 71 0.833002797
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.002245486 0.011095627 0.202375737 0.840210034 ‐0.019884044 0.024375015 ‐0.019884044 0.024375015X Variable 1 1.371442985 0.275979853 4.969359066 4.58198E‐06 0.821018531 1.921867439 0.821018531 1.921867439
Two Year Regression Slice BETA ADJUSTED R SQUARED LOWER 95% UPPER 95% RISK PREMIUM RISK FREE RATE ESTIMATED Ke LOW Ke HIGH Ke72.000 1.370 0.250 0.819 1.921 6.800 2.870 12.185 8.440 15.93060.000 1.463 0.252 0.823 2.103 6.800 2.870 12.818 8.464 17.17248.000 1.437 0.230 0.691 2.183 6.800 2.870 12.640 7.567 17.71336.000 1.366 0.216 0.514 2.218 6.800 2.870 12.160 6.368 17.95224.000 1.398 0.207 0.303 2.494 6.800 2.870 12.379 4.933 19.826
242
24 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.491661322R Square 0.241730855Adjusted R Square 0.207264076Standard Error 0.137983872Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.133532826 0.133532826 7.013444842 0.014682239Residual 22 0.418870074 0.019039549Total 23 0.5524029
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.007103838 0.031692921 ‐0.224145902 0.824712329 ‐0.072830934 0.058623257 ‐0.072830934 0.058623257X Variable 1 1.398422653 0.528047216 2.648290928 0.014682239 0.303319757 2.493525549 0.303319757 2.493525549
36 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.487925629R Square 0.238071419Adjusted R Square 0.215661755Standard Error 0.118449595Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.149052435 0.149052435 10.62360498 0.00253824Residual 34 0.477030423 0.014030307Total 35 0.626082858
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.009181573 0.020991941 ‐0.437385616 0.664597515 ‐0.05184233 0.033479184 ‐0.05184233 0.033479184X Variable 1 1.366159076 0.419145989 3.259387209 0.00253824 0.514351945 2.217966206 0.514351945 2.217966206
243
48 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.496248682R Square 0.246262755Adjusted R Square 0.229877162Standard Error 0.109999295Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.181851291 0.181851291 15.02922509 0.000334343Residual 46 0.556592862 0.012099845Total 47 0.738444154
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.001003524 0.016515147 0.060763849 0.95181052 ‐0.032239743 0.03424679 ‐0.032239743 0.03424679X Variable 1 1.436779878 0.370614104 3.876754453 0.000334343 0.690772391 2.182787365 0.690772391 2.182787365
244
60 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.51481729R Square 0.265036842Adjusted R Square 0.252365063Standard Error 0.099020248Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.205076877 0.205076877 20.91552028 2.57153E‐05Residual 58 0.568690557 0.00980501Total 59 0.773767434
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.003742916 0.013130201 0.285061572 0.776612423 ‐0.022540037 0.030025868 ‐0.022540037 0.030025868X Variable 1 1.462932852 0.319882187 4.573348913 2.57153E‐05 0.822619091 2.103246614 0.822619091 2.103246614
72 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.509991089R Square 0.260090911Adjusted R Square 0.249520781Standard Error 0.093834683Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.216656456 0.216656456 24.60621719 4.73979E‐06Residual 70 0.616346341 0.008804948Total 71 0.833002797
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.002437149 0.011104356 0.219476802 0.82691739 ‐0.019709792 0.024584089 ‐0.019709792 0.024584089X Variable 1 1.369853956 0.27615432 4.960465421 4.73979E‐06 0.819081538 1.920626373 0.819081538 1.920626373
Seven Year Regression Slice BETA ADJUSTED R SQUARED LOWER 95% UPPER 95% RISK PREMIUM RISK FREE RATE ESTIMATED Ke LOW Ke HIGH Ke
72 1.367 0.249 0.817 1.917 6.800 2.870 12.165 8.423 15.90760 1.454 0.252 0.816 2.091 6.800 2.870 12.754 8.420 17.08848 1.427 0.230 0.686 2.168 6.800 2.870 12.574 7.533 17.61536 1.357 0.215 0.511 2.204 6.800 2.870 12.098 6.342 17.85424 1.391 0.207 0.301 2.481 6.800 2.870 12.330 4.917 19.742
245
24 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.4914291R Square 0.241502561Adjusted R Square 0.207025404Standard Error 0.138004642Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.133406715 0.133406715 7.004712289 0.014736315Residual 22 0.418996185 0.019045281Total 23 0.5524029
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.006410154 0.031821903 ‐0.201438421 0.842206664 ‐0.07240474 0.059584433 ‐0.07240474 0.059584433X Variable 1 1.3911394 0.525624379 2.6466417 0.014736315 0.301061162 2.481217639 0.301061162 2.481217639
36 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.487760436R Square 0.237910243Adjusted R Square 0.215495838Standard Error 0.118462123Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.148951525 0.148951525 10.61416741 0.002548099Residual 34 0.477131333 0.014033275Total 35 0.626082858
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.008781454 0.021037066 ‐0.417427692 0.678989859 ‐0.051533914 0.033971007 ‐0.051533914 0.033971007X Variable 1 1.357076269 0.41654439 3.257939135 0.002548099 0.510556225 2.203596313 0.510556225 2.203596313
246
48 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.496083831R Square 0.246099167Adjusted R Square 0.229710018Standard Error 0.110011231Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.181730491 0.181730491 15.01598246 0.000336112Residual 46 0.556713663 0.012102471Total 47 0.738444154
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.001375233 0.016544027 0.083125655 0.934112312 ‐0.031926166 0.034676632 ‐0.031926166 0.034676632X Variable 1 1.427110867 0.368282292 3.875046123 0.000336112 0.685797075 2.16842466 0.685797075 2.16842466
60 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.514156357R Square 0.26435676Adjusted R Square 0.251673256Standard Error 0.099066051Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.204550652 0.204550652 20.84256501 2.64447E‐05Residual 58 0.569216782 0.009814082Total 59 0.773767434
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.004366258 0.013169034 0.331554944 0.741420413 ‐0.021994428 0.030726945 ‐0.021994428 0.030726945X Variable 1 1.453512873 0.318378183 4.565365813 2.64447E‐05 0.816209702 2.090816044 0.816209702 2.090816044
247
72 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.509503379R Square 0.259593693Adjusted R Square 0.24901646Standard Error 0.093866206Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.216242273 0.216242273 24.54268467 4.85678E‐06Residual 70 0.616760525 0.008810865Total 71 0.833002797
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.003339719 0.011126206 0.300166941 0.764939434 ‐0.018850798 0.025530236 ‐0.018850798 0.025530236X Variable 1 1.366869845 0.275909166 4.954057395 4.85678E‐06 0.816586371 1.917153318 0.816586371 1.917153318
Ten Year Regression Slice BETA ADJUSTED R SQUARED LOWER 95% UPPER 95% RISK PREMIUM RISK FREE RATE ESTIMATED Ke LOW Ke HIGH Ke
72 1.365 0.249 0.816 1.915 6.800 2.870 12.155 8.417 15.89360 1.450 0.252 0.814 2.086 6.800 2.870 12.733 8.408 17.05848 1.424 0.230 0.684 2.164 6.800 2.870 12.553 7.524 17.58236 1.354 0.215 0.509 2.199 6.800 2.870 12.077 6.334 17.82024 1.389 0.207 0.301 2.477 6.800 2.870 12.314 4.914 19.714
24 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.491434117R Square 0.241507491Adjusted R Square 0.207030559Standard Error 0.138004193Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.133409439 0.133409439 7.004900842 0.014735145Residual 22 0.418993461 0.019045157Total 23 0.5524029
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.006062382 0.031883059 ‐0.190144304 0.850939626 ‐0.072183798 0.060059034 ‐0.072183798 0.060059034X Variable 1 1.388847382 0.524751306 2.646677321 0.014735145 0.300579785 2.477114978 0.300579785 2.477114978
248
36 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.487754625R Square 0.237904574Adjusted R Square 0.215490003Standard Error 0.118462563Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.148947976 0.148947976 10.61383555 0.002548446Residual 34 0.477134882 0.014033379Total 35 0.626082858
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.008555138 0.021061257 ‐0.406202632 0.687139128 ‐0.051356761 0.034246485 ‐0.051356761 0.034246485X Variable 1 1.353967988 0.415596823 3.257888204 0.002548446 0.509373631 2.198562345 0.509373631 2.198562345
48 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.49613379R Square 0.246148737Adjusted R Square 0.229760666Standard Error 0.110007614Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.181767096 0.181767096 15.01999462 0.000335575Residual 46 0.556677058 0.012101675Total 47 0.738444154
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.001588108 0.016558854 0.095906901 0.924011124 ‐0.031743135 0.034919352 ‐0.031743135 0.034919352X Variable 1 1.423956591 0.367419212 3.875563781 0.000335575 0.684380087 2.163533094 0.684380087 2.163533094
249
60 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.514116965R Square 0.264316254Adjusted R Square 0.251632052Standard Error 0.099068778Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.20451931 0.20451931 20.83822406 2.64888E‐05Residual 58 0.569248124 0.009814623Total 59 0.773767434
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.004629096 0.0131833 0.351133354 0.726760616 ‐0.021760145 0.031018338 ‐0.021760145 0.031018338X Variable 1 1.450442764 0.317738795 4.564890366 2.64888E‐05 0.814419468 2.086466059 0.814419468 2.086466059
72 Slice
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.509518179R Square 0.259608775Adjusted R Square 0.249031758Standard Error 0.09386525Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.216254836 0.216254836 24.54461054 4.85319E‐06Residual 70 0.616747961 0.008810685Total 71 0.833002797
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.003658196 0.011133155 0.328585743 0.743449796 ‐0.018546181 0.025862573 ‐0.018546181 0.025862573X Variable 1 1.365414714 0.275604628 4.954251764 4.85319E‐06 0.815738623 1.915090805 0.815738623 1.915090805
250
Methods of Comparables
Price/Earnings Trailing
P/E Trailing Comparables
Company PPS EPS P/E Trailing Industry Ave. HNI PPS
HNI 10.50 1.02 10.29 5.21 5.32
HNI Restated 10.50 1.63 6.44 5.21 8.49
Herman Miller 12.28 1.82 6.75
Steelcase 4.13 ‐0.09 N/A
Knoll Inc. 6.69 1.82 3.68
Price/Earnings Forecast
Forecasted P/E Comparables
Company PPS EPS 1 Year Out P/E Forecast Industry Ave. HNI PPS
HNI 10.50 2.16 4.86 8.01 17.30
HNI Restated 10.50 1.73 6.07 8.01 13.86
Herman Miller 12.28 0.93 13.21 outlier
Steelcase 4.13 N/A N/A
Knoll Inc. 6.69 0.84 8.01
251
Price/Book
Price/Book Comparables
Company PPS BPS P/B Industry Ave. HNI PPS
HNI 10.50 10.13 1.04 2.58 26.09
HNI Restated 10.50 5.00 2.10 2.58 12.89
Herman Miller 12.28 0.91 13.56 outlier
Steelcase 4.13 5.29 0.78
Knoll Inc. 6.69 0.96 6.95
Dividends/Price
Dividends/Price Comparables
Company PPS DPS D/P Industry Ave HNI PPS
HNI 10.50 0.88 0.0838 0.0595 14.79
HNI Restated 10.50 0.88 0.0838 0.0595 14.79
Herman Miller 12.28 0.36 0.0293
Steelcase 4.13 0.32 0.0775
Knoll Inc. 6.69 0.48 0.0717
252
Price Earnings Growth (P.E.G.)
Price Earnings Growth (P.E.G.) Comparables
Company P/E Growth P.E.G. Industry Ave HNI PPS
HNI 12.75 3.28 3.89 2.45 9.50
HNI Restated 12.78 3.28 3.90 2.45 9.53
Herman Miller 13.17 3.2279 4.08
Steelcase N/A N/A N/A
Knoll Inc. 8.02 9.90 0.81 *Based on five year P.E.G.'s
Price/EBITDA
Price/EBITDA Comparables
Company MKT Cap EBITDA P/EBITDA Industry Ave HNI PPS
HNI 465.4 156.10 2.98 2.97 10.46
HNI Restated 465.4 156.20 2.98 2.97 10.47
Herman Miller 650.27 240.90 2.70
Steelcase 552.02 126.20 4.37
Knoll Inc. 314.49 170.89 1.84 *MKT Cap and EBITDA in millions
253
Enterprise Value/EBITDA
Enterprise Value/EBITDA Comparables
Company EV EBITDA EV/EBITDA Industry Average HNI PPS
HNI 817.30 156.10 5.24 3.69 13.00
HNI Restated 817.30 156.20 5.23 3.69 13.00
Herman Miller 894.46 240.90 4.86
Steelcase 634.786 126.20 4.37
Knoll Inc. 645.45 170.89 1.84 *EV and EBITDA in millions
Price to Free Cash Flows (P/FCF)
P/FCF Comparables
Company MKT Cap FCF P/FCF Industry Ave HNI PPS
HNI 465.40 42.84 10.86 8.93 8.63
HNI Restated 465.4 42.71 10.90 8.93 8.61
Herman Miller 650.27 81.10 8.02
Steelcase 551.36 56.00 9.85
Knoll Inc. 314.49 3.82 82.33 outlier *MKT Cap and FCF in millions
254
Intrinsic Valuation Models
Discounted Dividends Approach WACC(BT) Kd KePerp
Relevant Valuation Item 0 1 2 3 4 5 6 7 8 9 10 112008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
DPS (Dividends Per Share) 0.86 0.86 0.92 0.98 1.04 1.10 1.16 1.22 1.28 1.34 1.41BPS (Book Value Equity per Share)DPS Growth Rate 0.00% 6.98% 6.52% 6.12% 5.77% 5.45% 5.17% 4.92% 4.69%
PV Factor 0.87 0.75 0.65 0.56 0.49 0.42 0.36 0.31 0.27 0.24PV Dividends 0.74 0.64 0.60 0.55 0.50 0.46 0.42 0.38 0.35 0.32
% ValuePV of YBY Dividends 4.97 70.03%Pv of Term Perp 2.13 29.97% 9.04Model Price (12/31/08) $7.09 100.00%Time Consistent Price (4/1/2009) $7.35
Observed Share Price (4/1/2009) $10.50 0.00 0.01 0.02 0.03 0.04 0.05 0.06Initial Cost of Equity (You Derive) 15.57% 11.21% $10.61 $11.05 $11.58 $12.24 $13.09 $14.20 $15.74Perpetuity Growth Rate (g) 0 12.67% $8.26 $9.56 $9.91 $10.34 $10.86 $11.52 $12.38
14.12% $8.20 $8.41 $8.66 $8.95 $9.29 $9.71 $10.2415.57% $7.35 $7.51 $7.68 $7.88 $8.12 $8.40 $8.7417.03% $6.65 $6.76 $6.89 $7.03 $7.20 $7.39 $7.6218.48% $6.07 $6.16 $6.25 $6.36 $6.48 $6.61 $6.7719.93% $5.58 $5.65 $5.72 $5.80 $5.88 $5.98 $6.10
HNI's Discounted Dividends Sensitivity AnalysisGrowth Rate
Cost of Equity
overvalued < $8.93 $8.93 < fairly valued < $12.08 undervalued > $12.08
255
Discounted Free Cash Flow(in thousands of dollars)
0 1 2 3 4 5 6 7 8 9 10 112008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Cash Flow From Operations 174,369 170,458 158,526 153,770 164,534 176,051 188,375 201,561 215,671 230,768 246,921 Cash Flow From Investing Activities (131,526) (123,582) (114,931) (111,483) (119,287) (127,637) (136,572) (146,132) (156,361) (167,306) (179,018)
FCF Firm's Assets 46,876 43,595 42,287 45,247 48,414 51,803 55,429 59,309 63,461 67,903 72,657 PV Factor (WACC) 0.92 0.85 0.79 0.73 0.67 0.62 0.57 0.53 0.49 0.45PV YBY Free Cash Flows 43,267 37,141 33,254 32,842 32,436 32,035 31,639 31,247 30,861 30,479 Growth Rate -7.00% -3.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00%
$ Value % ValueTotal PV YBY FCF 335,201 43.00%FCF Perp 444,315 57.00% 989,872 Market Value of Assets 779,516 100.00%Book Value Debt & Preferred Stock $716,796Market Value of Equity $62,720divide by Shares to Get PPS at 12/31 44,324 Model Price 12/31/08 $1.42Time consistent Price (4/1/09) $1.44 0.01 0.015 0.02 0.025 0.03 0.035 0.04
6.67% $7.32 $8.81 $10.61 $12.86 $15.71 $19.46 $24.627.23% $4.99 $6.15 $7.54 $9.22 $11.29 $13.92 $17.36
WACC(BT) 8.34% 7.79% $3.05 $3.98 $5.06 $6.35 $7.91 $9.83 $12.25Perp Growth Rate 0.01 8.34% $1.42 $2.19 $3.06 $4.07 $5.27 $6.73 $8.51Oberved Share Price (4/1/09) $10.50 8.90% $0.01 $0.62 $1.32 $2.12 $3.06 $4.18 $5.52
9.46% N/A N/A N/A $0.55 $1.30 $2.18 $3.2310.02% N/A N/A N/A N/A N/A $0.50 $1.32
Restated WACC 6.60% $7.64 $9.18 $11.05 $13.38 $16.36 $20.30 $25.75
HNI's Discounted Free Cash Flows Sensitivy Analysis
Weighted Average Cost of
Capital
Growth rate
overvalued < $8.93 $8.93 < fairly valued < $12.08 undervalued > $12.08
256
All Items in Thousands of DollarsResidual Income Perp
0 1 2 3 4 5 6 7 8 9 10 112008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Net Income 45,450 95,883 89,171 86,496 92,550 99,029 105,961 113,378 121,315 129,807 138,893Total Dividends 38,095 38,119 38,119 40,778 43,438 46,097 48,756 51,416 54,075 56,735 59,394Book Value Equity 448,833 506,597 557,649 603,367 652,480 705,412 762,616 824,579 891,818 964,890 1,044,389
Annual Normal Income (Benchmark) 69,883 78,877 86,826 93,944 101,591 109,833 118,739 128,387 138,856 150,233Annual Residual Income 25,999 10,294 -330 -1,394 -2,562 -3,872 -5,361 -7,072 -9,049 -11,340 -13,041pv factor 0.865 0.749 0.648 0.561 0.485 0.420 0.363 0.314 0.272 0.235YBY PV RI 22,497 7,707 -214 -781 -1,243 -1,625 -1,947 -2,222 -2,460 -2,668Growth Percentage RI -60.41% -103.21% 322.02% 83.82% 51.11% 38.47% 31.92% 27.96% 25.32%Annual Change in RI (15,706) (10,624) (1,064) (1,168) (1,309) (1,489) (1,711) (1,977) (2,291) (1,701)
$ Value % Value -32.36% -89.99% 9.86% 12.08% 13.75% 14.88% 15.55% 15.87%Book Value Equity 448,833 98.9%Total PV of YBY RI 17,043 3.8%Terminal Value Perpetuity -11,999 -2.6% (51,002) MVE 12/31/08 453,877 100.0%divide by shares -10% -20% -30% -40% -50%Model Price on 12/31/08 $10.24 11.21% $15.86 $15.43 $15.21 $15.08 $14.98Time consistent Price on 4/1/09 $10.62 12.67% $13.75 $13.57 $13.47 $13.41 $13.37
14.12% $12.03 $12.01 $12.00 $11.99 $11.99Observed Share Price (4/1/2009) $10.50 15.57% $10.62 $10.70 $10.74 $10.77 $10.79Initial Cost of Equity (You Derive) 15.57% 17.03% $9.43 $9.57 $9.65 $9.71 $9.74Perpetuity Growth Rate (g) -0.1 18.48% $8.44 $8.62 $8.72 $8.79 $8.84Number of shares outsanding 44324 19.93% $7.60 $7.80 $7.92 $8.00 $8.05
overvalued < $8.93 undervalued > $12.08
Growth RateHNI's As-Stated Residual Income Sensitivity Analysis
Cost of Equity
$8.93 < fairly valued < $12.08
257
Restated Residual Income(in thousands of dollars)
Perp0 1 2 3 4 5 6 7 8 9 10 11
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Restated Net Income 45,313 76,706 71,337 69,197 74,040 79,223 84,769 90,703 97,052 103,845 111,115Restated Total Dividends 38,095 38,119 38,119 40,778 43,438 46,097 48,756 51,416 54,075 56,735 59,394Restated Book Value Equity 221,781 260,368 293,586 322,005 352,608 385,734 421,746 461,033 504,010 551,120 602,841
Annual Normal Income (Benchmark) 34,531 40,539 45,711 50,136 54,901 60,059 65,666 71,783 78,474 85,809 Annual Residual Income 42,175 30,797 23,485 23,904 24,322 24,710 25,037 25,269 25,371 25,305 25,052 pv factor 0.87 0.75 0.65 0.56 0.49 0.42 0.36 0.31 0.27 0.24 0.20YBY PV RI 36,493 23,058 15,215 13,400 11,797 10,371 9,092 7,940 6,898 5,953 Annual Change in RI (11,378) (7,312) 419 418 388 327 232 102 (66) (253) Growth % of RI -26.98% -23.74% 1.78% 1.75% 1.59% 1.32% 0.93% 0.40% -0.26%
$ Value % Value -35.73% -105.73% -0.25% -7.20% -15.78% -28.91% -55.99% -164.52%Book Value Equity 221,781 57.60%Total PV of YBY RI 140,216 36.42% 97,975 Terminal Value Perpetuity 23,050 5.99%MVE 12/31/08 385,047 Model Price on 12/31/08 8.69time consistent Price (4/1/2009) 9.01 -10% -20% -30% -40% -50%
11.21% $12.83 $12.24 $11.94 $11.75 $11.63Observed Share Price (4/1/2009) $10.50 12.67% $11.31 $10.92 $10.72 $10.59 $10.50Initial Cost of Equity (You Derive) 15.57% 14.12% $10.06 $9.81 $9.67 $9.59 $9.53Perpetuity Growth Rate (g) -0.1 15.57% $9.01 $8.86 $8.77 $8.72 $8.68Number of Shares Outstanding 44,324 17.03% $8.11 $8.03 $7.98 $7.95 $7.93
18.48% $7.36 $7.32 $7.30 $7.29 $7.2819.93% $6.71 $6.71 $6.70 $6.70 $6.70
overvalued < $8.93 undervalued > $12.08
Growth Rate
Cost of Equity
$8.93 < fairly valued < $12.08
HNI's Restated Residual Income Sensitivity Analysis
258
AEG Valuation(in thousands of dollars) Perp
0 1 2 3 4 5 6 7 8 9 102008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Net Income 45,450 95,883 89,171 86,496 92,550 99,029 105,961 113,378 121,315 129,807 138,893 Total Dividends 38,095 38,119 38,119 40,778 43,438 46,097 48,756 51,416 54,075 56,735 59,394 Dividends Reinvested at Ke (Drip) 5,935 5,935 6,349 6,763 7,177 7,591 8,005 8,420 8,834 9,248 Cum-Dividend Earnings 95,106 92,431 98,900 105,792 113,138 120,970 129,320 138,226 147,727 Normal Earnings 110,812 103,055 99,963 106,961 114,448 122,459 131,031 140,203 150,018 Abnormal Earning Growth (AEG) (15,706) (10,624) (1,064) (1,168) (1,309) (1,489) (1,711) (1,977) (2,291) (2,634)
PV Factor 0.87 0.75 0.65 0.56 0.49 0.42 0.36 0.31 0.27 0.24PV of AEG (13,590) (7,954) (689) (655) (635) (625) (621) (621) (623) Residual Income Check Figure (15,706) (10,624) (1,064) (1,168) (1,309) (1,489) (1,711) (1,977) (2,291) % change in AEG -32.36% -89.99% 9.86% 12.08% 13.75% 14.88% 15.55% 15.87% assume 80%
$ Value % ValueCore Net Income 95,883 142.96% 1.15Total PV of AEG (26,014) -38.79%PV of Terminal Value (2,801) -4.18% (10,303) Total Average Net Income Perp (t+1) 67,068 100.00%Number of Shares 44,324 15% analyst 8.93 12.08Divide by shares to Get Average EPS Perp 1.51Capitalization Rate (perpetuity) 15.57%
-10% -20% -30% -40% -50%Intrinsic Value Per Share (12/31/2008) 9.72 11.21% $17.10 $16.98 $16.92 $16.88 $16.85time consistent implied price 4/1/2009 10.08 12.67% $14.02 $14.04 $14.05 $14.06 $14.06April 1, 2009 observed price $10.50 14.12% $11.78 $11.86 $11.91 $11.94 $11.96Ke 15.57% 15.57% $10.08 $10.19 $10.26 $10.30 $10.33g -0.1 17.03% $8.75 $8.88 $8.95 $9.00 $9.04
18.48% $7.71 $7.84 $7.91 $7.96 $8.0019.93% $6.87 $7.00 $7.07 $7.12 $7.15
overvalued < $8.93 undervalued > $12.08
Growth Rate
Cost of Equity
HNI's As-stated AEG Sensitivity Analysis
$8.93 < fairly valued < $12.08
259
Restated AEG Valuation(in thousands of dollars)
Perp0 1 2 3 4 5 6 7 8 9 10
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Restated Net Income 45,313 76,706 71,337 69,197 74,040 79,223 84,769 90,703 97,052 103,845 111,115 RestatedTotal Dividends 38,095 38,119 38,119 40,778 43,438 46,097 48,756 51,416 54,075 56,735 59,394 Dividends Reinvested at 17% (Drip) 5,935 5,935 6,349 6,763 7,177 7,591 8,005 8,420 8,834 Cum-Dividend Earnings 77,272 75,132 80,389 85,986 91,946 98,294 105,057 112,265 119,948 Normal Earnings 88,649 82,444 79,970 85,568 91,558 97,967 104,825 112,163 120,014 Abnormal Earning Growth (AEG) (11,378) (7,312) 419 418 388 327 232 102 (66) (253)
PV Factor 0.87 0.75 0.65 0.56 0.49 0.42 0.36 0.31 0.27PV of AEG (9,845) (5,475) 271 234 188 137 84 32 (18) Residual Income Check Figure (11,378) (7,312) 419 418 388 327 232 102 (66) % change in RI -35.73% -105.73% -0.25% -7.20% -15.78% -28.91% -55.99% -164.52%
$ Value % Value -2.77% 7.00% 6.96% 6.93% 6.90% 6.88% 6.86% 6.84%Core Net Income 76,706 123.63% -990Total PV of AEG (14,390) -23.19%PV of Terminal Value (269) -0.43%Total PV of AEG 62,047 100.00% -10% -20% -30% -40% -50%
11.21% $14.42 $14.45 $14.46 $14.47 $14.48Divide by shares to Get Average EPS Perp 44,324 12.67% $12.27 $12.29 $12.30 $12.31 $12.31
14.12% $10.62 $10.64 $10.65 $10.65 $10.6615.57% $9.32 $9.33 $9.34 $9.34 $9.35
Intrinsic Value Per Share $8.99 17.03% $8.28 $8.28 $8.28 $8.28 $8.29time consistent implied price $9.32 18.48% $7.41 $7.42 $7.42 $7.42 $7.43April 1, 2009 observed price $10.50 19.93% $6.70 $6.70 $6.71 $6.71 $6.71Ke 15.57% overvalued < $8.93 undervalued > $12.08g -0.1
Cost of Equity
Growth RateHNI's Restated AEG Sensitivity Analysis
$8.93 < fairly valued < $12.08
260
As Stated ROEAs Stated ROE ‐ % Change‐0.1557
0.2136 0.0579 ‐1.37200.1760 0.0203 ‐0.64920.1551 ‐0.0006 ‐1.0291
Estimated Price per Share (end of 2008) 0.1534 ‐0.0023 2.90050.1518 ‐0.0039 0.6999
Observed Share Price $10.50 0.1502 ‐0.0055 0.3977 0.00800.1487 ‐0.0070 0.2808
ROE 0.1439 0.1471 ‐0.0086 0.2200Ke 0.1557 0.1456 ‐0.0101 0.1831G ‐0.14 0.1439 ‐0.0118 0.1582BVE 448833
MVE 430922 -0.14 -0.05 0.03 0.05 0.15divide by shares 44324 11.21% $11.71 $12.44 $14.43 $15.72 $1.67Model Price 9.72 ROE constant 13.39% $10.83 $11.02 $11.46 $11.69 $3.96Time Consistent Price 10.08 0.1439 15.57% $10.08 $9.90 $9.51 $9.33 N/A
17.75% $9.43 $8.99 $8.15 $7.77 N/A19.93% $8.87 $8.24 $7.13 $6.66 N/A
15% analyst 8.93 12.08green overvaluedyellow undervalued 0.1118 0.1279 0.1439 0.1600 0.1760red fairly valued 11.21% $10.65 $6.16 $1.70 N/A N/A
13.39% $24.79 $14.34 $3.96 N/A N/AGrowth constant 15.57% N/A N/A N/A $18.42 $47.89
0.15 17.75% N/A N/A N/A $3.84 $9.9719.93% N/A N/A N/A $2.15 $5.59
0.1118 0.1279 0.1439 0.16 0.176-0.14 $8.94 $9.51 $10.08 $10.65 $11.22
Ke Constant -0.05 $8.26 $9.08 $9.90 $10.72 $11.540.1557 0.03 $6.83 $8.18 $9.51 $10.86 $12.19
0.05 $6.14 $7.74 $9.33 $10.93 $12.520.15 N/A N/A N/A $18.42 $47.89
As-Stated Sensitivity Analysis
overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03Cost of Equity held constant at 15.57%
Growth Rate
ROE
As-Stated Sensitivity Analysis
Growth Rate held constant at 15%overvalued < $8.93 $8.93 < fairly valued < $12.03
As-Stated Sensitivity Analysis
ROE held constant at 14.39%$8.93 < fairly valued < $12.03overvalued < $8.93 undervalued > $12.03
Growth rate
Cost of Equity
undervalued > $12.03
ROE
Cost of Equity
261
As Stated ROEAs Stated ROE ‐ % ChangeAs‐stated Long Run Residual Income ‐0.1557
0.2136 0.0579 ‐1.37200.1760 0.0203 ‐0.64920.1551 ‐0.0006 ‐1.0291
Estimated Price per Share (end of 2008) 0.1534 ‐0.0023 2.90050.1518 ‐0.0039 0.6999
Observed Share Price $10.50 0.1502 ‐0.0055 0.3977 0.00800.1487 ‐0.0070 0.2808
ROE 0.1439 0.1471 ‐0.0086 0.2200Ke 0.1557 0.1456 ‐0.0101 0.1831G ‐0.14 0.1439 ‐0.0118 0.1582BVE 448833
MVE 430922 -0.14 -0.05 0.03 0.05 0.15divide by shares 44324 11.21% $11.71 $12.44 $14.43 $15.72 $1.67Model Price 9.72 13.39% $10.83 $11.02 $11.46 $11.69 $3.96Time Consistent Price 10.08 15.57% $10.08 $9.90 $9.51 $9.33 N/A
17.75% $9.43 $8.99 $8.15 $7.77 N/A19.93% $8.87 $8.24 $7.13 $6.66 N/A
15% analyst 8.93 12.08green overvaluedyellow undervalued 0.1118 0.1279 0.1439 0.1600 0.1760red fairly valued 11.21% $10.65 $6.16 $1.70 N/A N/A
13.39% $24.79 $14.34 $3.96 N/A N/A15.57% N/A N/A N/A $18.42 $47.8917.75% N/A N/A N/A $3.84 $9.9719.93% N/A N/A N/A $2.15 $5.59
0.1118 0.1279 0.1439 0.16 0.176-0.14 $8.94 $9.51 $10.08 $10.65 $11.22-0.05 $8.26 $9.08 $9.90 $10.72 $11.540.03 $6.83 $8.18 $9.51 $10.86 $12.190.05 $6.14 $7.74 $9.33 $10.93 $12.520.15 N/A N/A N/A $18.42 $47.89
As-Stated Sensitivity Analysis
overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03Cost of Equity held constant at 15.57%
Growth Rate
ROE
As-Stated Sensitivity Analysis
Growth Rate held constant at 15%overvalued < $8.93 $8.93 < fairly valued < $12.03
As-Stated Sensitivity Analysis
ROE held constant at 14.39%$8.93 < fairly valued < $12.03overvalued < $8.93 undervalued > $12.03
Growth rate
Cost of Equity
undervalued > $12.03
ROE
Cost of Equity
262
Restated ROE Restated ROE % Change‐0.1121
Restated Long Run Residual Income 0.3459 0.2338 ‐3.0853 ‐0.0900 0.15570.2740 0.1619 ‐0.3075 ‐0.0480 0.11210.2357 0.1236 ‐0.2365 ‐0.0620 0.1339
Estimated Price per Share (end of 2008) 0.2299 0.1178 ‐0.0466 ‐0.1600 0.17750.2247 0.1126 ‐0.0446 ‐0.6500 0.1993
Observed Share Price 10.50$ 0.2198 0.1077 ‐0.04370.2151 0.1030 ‐0.0436
ROE 0.1675 0.2105 0.0984 ‐0.0442Ke 0.1993 0.2060 0.0939 ‐0.0454G ‐0.09 0.2016 0.0895 ‐0.0471BVE 221781
MVE 197403 -0.65 -0.16 -0.09 -0.062 -0.048divide by shares 44324 0.1121 $5.74 $6.83 $7.41 $7.78 $8.01Model Price $4.45 0.1339 $5.61 $6.35 $6.72 $6.95 $7.09Time Consistent Price $4.66 0.1557 $5.48 $5.94 $6.16 $6.28 $6.36
0.1775 $5.36 $5.58 $5.68 $5.74 $5.770.1993 $5.25 $5.27 $5.28 $5.28 $5.28
15% analyst 8.93 12.08green overvaluedyellow undervaluedred fairly valued 0.1675 0.1846 0.2016 0.2187 0.2357
0.1121 $6.55 $6.98 $7.41 $7.85 $8.280.1339 $5.94 $6.33 $6.72 $7.12 $7.510.1557 $5.44 $5.80 $6.16 $6.52 $6.880.1775 $5.02 $5.35 $5.68 $6.02 $6.350.1993 $4.66 $4.97 $5.28 $5.59 $5.90
0.1675 0.1846 0.2016 0.2187 0.2357-0.65 $5.26 $5.37 $5.48 $5.59 $5.70-0.16 $5.38 $5.66 $5.94 $6.22 $6.50-0.09 $5.44 $5.80 $6.16 $6.52 $6.88
-0.062 $5.47 $5.88 $6.28 $6.69 $7.09-0.048 $5.49 $5.92 $6.36 $6.79 $7.23
ROERestated Sensitivity Analysis
Cost of Equity held constant at 15.57%overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03
Growth Rate
Growth Rate
Cost of Equity
ROE held constant at 20.16%
Restated Sensitivity Analysis
overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03Restated Sensitivity Analysis
ROE
Cost of Equity
Growth Rate held constant -9%overvalued < $8.93 $8.93 < fairly valued < $12.03 undervalued > $12.03
263
Work cited
Palepu, Krishna G., and Paul M. Healy. Business Analysis & Valuation. 4th ed. Mason,
OH:Thomson, 2008. 1-1+.
Dougherty, Conor. “Unemployment Rises in Every State.” 28 Jan. 2009. Wall Street
Journal. 4 Feb. 2009
<http://online.wsj.com/article/SB123307958229020395.html>
Dittmer, Jerald K. “10k.” HNI Corporation. 25 Feb. 2008. 4 Feb. 2009
Civigin, Don. “10k.” Office Max. 27 Feb. 2008. 4 Feb. 2009
<http://investor.officemax.com/phoenix.zhtml?c=85171&p=irol-sec>
Wheeler, Leslie . "Hearth Industry Backgrounder and Statistics." Hearth, Patio &
Barbecue Association. 31 Dec. 2002. 4 Feb 2009 <Hearth Industry Backgrounder
and Statistics>.
Johnson, Don . "State of the Hearth Industry Report." 31 Dec 2007. 4 Feb 2009
<http://mha-net.org/docs/temp/2008.08.02%20State_of_the_Hearth_Industry_F
act_Sheet_2008.pdf>.
“Statistics." wwww.bifma.org. 19 Jan 2009. BIFMA. 4 Feb 2009
<http://www.bifma.org/statistics/index.html>.
Heakal, Reem . "What Are Economies Of Scale?." investopedia.com. 4 Feb 2009
<http://www.investopedia.com/articles/03/012703.asp>.
264
"Center for Manufacturing Research and Innovation." www.nam.org. National
Association of Manufacturers. 4 Feb 2009
<http://www.nam.org/AboutUs/TheManufacturingInstitute/CenterforManufacturi
ngResearchandInnovation.aspx>.
"Finish a bright spot for office furniture maker." www.allbusiness.com. 1 March 1995. 4
Feb 2009 <http://www.allbusiness.com/furniture-related/office-furniture-
including/495954-1.html>.
Pullen, Curtis S. 10k. 29 July 2008. Herman Miller. 4 Feb 2009
<http://investor.shareholder.com/mlhr/secfiling.cfm?filingID=926044-08-379>
Sylvester, David C. 10k. 29 Feb 2008. Steelcase. 4 Feb 2009
<http://www.steelcase.com/na/files/07ce19f8d07446fab9bc214432a773af/SECFil
ings3.pdf>.
McCabe, Barry L. 10k. Knoll Inc. 4 Feb 2009 <http://phx.corporate-
ir.net/phoenix.zhtml?c=66169&p=irol-sec>.
"HMI Warranty." www.hermanmiller.com. 25 Aug 2008. Herman Miller. 4 Feb 2009
<http://www.hermanmiller.com/hm/content/category/persistent_nav/HMI_Warra
nty.pdf>
www.forbes.com
Gaffen, David . "Oil's Price Volatility Got You Down? Some Seek Stability in Energy
Firms." Jan 7 2009. Wall Street Journal. 4 Feb 2009
<http://online.wsj.com/article/SB123130480373760361.html?mod=relevancy>.
265
Curran, Rob. "Commodities Inspire Bold Bets, Hedges." 21 Aug 2008. Wall Street
Journal. 4 Feb 2009
<http://online.wsj.com/article/SB121928489084759129.html?mod=relevancy>.
Derby, Michael S . "U.S. Factories Slumped in December." 2 Jan 2009. Wall Street
Journal. 4 Feb 2009
<http://online.wsj.com/article/SB123090812392149093.html>.
Derby, Michael S. "U.S. Factories Slumped in December." 2 Jan 2009. Wall Street
Journal. 4 Feb 2009
<http://online.wsj.com/article/SB123090812392149093.html>.
Tejada, Carlos. "Business Savvy Propels Ma in China Market." 13 Jan 2009. Wall Street
Journal. 4 Feb 2009
<http://online.wsj.com/article/SB123187470105578101.html>.
Wotapka, Dawn. “Builders Offer Delayed Payments, Low Rates, Delayed Insurance.” 28
Jan 2009. Wall Street Journal. 4 Feb 2009
<http://online.wsj.com/article/SB123316179463224803.html>
Matthews, Robert. “Miners Stall on Iron-Ore Price Talks.” 27 Jan 2009. Wall Street
Journal. 4 Feb 2009
<http://online.wsj.com/article/SB123308798204120981.html>
Beijing AP. “Chinese Steelmakers Plan Merger.” 30 December 2008. Wall Street
Journal. 4 Feb 2009
<http://online.wsj.com/article/SB123064271568642271.html>
Vaughan, Martin. “Taking Credit For Energy Efficiency.” 31 December 2008. Wall Street
Journal. 4 Feb 2009
266
<http://online.wsj.com/article/SB123067614629543737.html>
Covel, Simona. “Alternative-Energy Companies Grow Even as Others Falter.” 13 Jan
2009. Wall Street Journal. 4 Feb 2009
<http://online.wsj.com/article/SB123181075624775965.html>
"BIFMA News." BIFMA. 22 Apr 2009 http://www.bifma.org/news/newsrelease.pdfs/Q1_2009NewsRelease.pdf.
"Standards." BIFMA.org. BIFMA. 22 Apr 2009 <http://www.bifma.org/standards/index.html>.
