Generating Returns in an Industry in a Deep Freeze - Long Herman Miller (MLHR)/Short HNI Corporation (HNI)

8/14/2019 Generating Returns in an Industry in a Deep Freeze - Long Herman Miller (MLHR)/Short HNI Corporation (HNI)

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PAA Resea rc h LLC PAA@plea sea c tac c ordingly.c omwww.pleaseactaccordingly.com 7/20/09

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INVESTMENT THESIS

LONG: Herma n Miller Inc. (MLHR: $15.33)

SHORT: HNI Corporation (HNI, $18.92)

Company HNI Corporation FY1 PE (Consensus) 99.6 YTD % Change 19.4%Ticker HNI FY2 PE (Consensus) 28.2 52 Week High 34.37Stock Price $18.92 FY1 EV/EBITDA (PAA) 15.0x 52 Week Low 7.70Mkt Cap 848 FY2 EV/EBITDA (PAA) 9.1x 200-Day 14.96Enterprise Value 1,132 FCF Yield FY1 (PAA) 1.6% 50-Day 17.35Net Debt 284 ROE 6.8% RSI 46.40

Credit Ratings N/A Price/Book 1.9x Avg. Daily Vol. (000s) 358.6

Cash/Share $0.49 Dividend Yield 4.7%

Company Herman Miller, Inc. FY1 PE (Consensus) 18.3 YTD % Change 17.7%Ticker MLHR FY2 PE (Consensus) 15.5 52 Week High 30.54Stock Price $15.33 FY1 EV/EBITDA (PAA) 6.7x 52 Week Low 7.91

Mkt Cap 823 FY2 EV/EBITDA (PAA) 5.9x 200-Day 14.60Enterprise Value 998 FCF Yield FY1 (PAA) 10.3% 50-Day 14.42

Net Debt 173 ROE 394.1% RSI 55.14

Credit Ratings N/A Price/Book 16.0x Avg. Daily Vol. (000s) 455.4Cash/Share $3.45 Dividend Yield 0.6%

Investment Thesis Overview:In the de ba te ove r “ green shoo ts” we have d irec ted our attention in large p art to thestate of the ho using m arket a s an indica tor as to w hen the ec onom y ac tually mightimprove (a s op posed to getting worse a t a slower ra te). From that pe rspec tive, atbe st the re are som e enc ourag ing signs and at wo rst som e very mixed signals forec onomic grow th ove r the next seve ral years. How eve r, we w ould b e remiss if we

d id n’t a c knowled ge the true d evastation ongo ing in the lab or ma rket. Simp ly stated :this is the worst lab or market in the past 70-yea rs. The US is on pac e to hem orrha gec lose to 7 m illion jobs this yea r. Unem ployment is likely to rem ain eleva ted for seve ralyea rs to c ome, whic h will signific antly dam pen the m ag nitude of any ec onom icrec ove ry. In this type of environm ent w e think it is rea sona ble to b id up ea rly c yclic alsba sed on “ green shoots” or “ sec ond derivative” im proveme nts, but we find ourselveshard pressed to b elieve how late c yclica ls (those stoc ks are typ ic ally moredep end ent on job ga ins) should rally.

Outsid e o f staffing, we c anno t think of ano ther group of c ompa nies that a re m oredep end ent on emp loyment trend s than o ffic e furniture m anufac turers. We ha vebe en watc hing the p ric e a c tion o f a lead ing o ffic e furniture m anufac turer, HNICorporation (HNI), of la te w ith co nsid erable c onsterna tion. The stoc k is on a roll, up19% YTD and an am azing 89% since 3/31/09. Even though we a re no t bullish on theoffice furniture manufacturers we think investors can generate strong returns througha pa ir trad e – long Herma n Miller, Inc . (MLHR) and short HNI Co rpora tion (HNI). Ourthesis is based on the following :

1. This is the worst labor market in the past 70 years, don’t forget it. We recog nizethat a pe ak in weekly job less cla ims m ight ha ve formed and that the rate of




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dec line in non-farm payrolls ha s lessened . However, even the m ost op tim isticec onomic forecaster is not looking for mea ningful job grow th until next yea r a tthe e arliest. The p layb oo k on the o ffic e furniture m anufac turers has alwa ysbe en to buy these na mes in the e arly stag es of an ec onom ic rec overy (notnec essarily a t the bo ttom of a rec ession), afte r which ga ins were to ugher to

c om e by. How ever if this ec onomic d ow nturn has prove n anything it’s thatpo rtfolio m ana geme nt playb ooks c ompiled in the p ast 25-yea rs are no t nea rlyas effec tive. We are conc erned tha t the stoc ks of the lea d ing o ffic e furnituremanufac turers and HNI in particula r have had a fa lse d awn. The Business andInstitutiona l Furniture Ma nufa c turer’ s Assoc iation (BIFMA) c urrently forec asts apea k to d ec line troug h of ap proxim ate ly 30%, which we think is too low giventhe m agnitude of job losses. Ad d itionally, BIFMA c urrently forec asts a m odestrec overy in o ffic e furniture p rod uc tion in 2010, which we think might beop timistic. It is important to rem em be r tha t me aningful job G ROWTH is anec essary c ond ition in o rder for reve nues and ea rnings to rec over for thisgroup . We anticipa te it co uld take a few yea rs before there is any rea l job

growth which is currently not reflected in the sell-side outlook.2. We think HNI will violate their total leverage covenant within the next quarter ortwo, which could cause the compa ny to drastica lly reduce its dividend. Wethink HNI sha res have b ee n supported in la rge part by the c om pany’sd ividend. HNI currently pays out $0.88/sha re in d ivid end s annua lly, implying ayield o f ap proxim ate ly 4.7%. The d ividend has bec om e a n inc rea singlyunwieldy use o f ca sh for the c om pa ny. The p ayout ratio exce ed s 125% andba sed on our projec tions the c ompa ny will not likely co ver the d ivide ndpayment with free c ash flow g eneration. Based on our EBITDA forec asts overthe next two quarters, we think HNI will viola te its tota l leve rage c ovenant (tota ldeb t EBITDA) of 3.0x in the third quarter. Given that the c om pany now spend s$38-$39 million on its d ividend and free c ash flow ge neration p rospec ts are

likely to be lim ited for the ne xt 2-3 yea rs, we think the c om pany’ s lend ers willask for a la rge d ividend red uc tion a s pa rt of a ny am end ment to HNI’s cred itagreement.

3. In a tale of the tape between Herma n Miller and HNI, MLHR wins by a knockoutThere is no rational reason as to why HNI commands a valuation premiumrelative to MLHR. Even tho ugh there a re slight d ifferenc es in the e nd-m arketsthey ad dress, MLHR and HNI sha res have b ee n highly correla ted ove r the p ast15-yea rs. Ove r the past 12-months and 15 yea rs, HNI and MLHR have had ac orrela tion of 0.874 and 0.809. However, since M arc h 31st of this year, HNI hasoutperforme d M LHR by approximately 44%, whic h we find truly aston ishing.There have o nly be en two o ther pe riod s this dec ade d uring w hich HNI

outperforme d M LHR shares by mo re than 30% on a 3-month basis. In themonth follow ing those tw o period s, MLHR shares outperformed HNI by 20% and30%. HNI trad es a t a lmost twice the multiple of MLHR on a forwa rd P/ E basisand EV/ EBITDA even thoug h MLHR’s as a c om pany is financ ially sup erior inalmo st eve ry way. We think the rec ent o utperformanc e in HNI sha res hasc rea ted an op portunity to hed ge a short po sition w ith a long position in MLHR,a c om pany which ha s superior revenue g row th, ope ra ting m arg ins, FCFge neration and return on eq uity. We expec t a divide nd red uc tion and




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pote ntia l neg ative revisions to e stim ates for HNI to c rea te m ea n reversion in itsva luation relative to M LHR.

RISKS:

The risks to our investment thesis are the follow ing:

1. HNI’s “Cup a nd Handle” technica l forma tion. In a market with suc h ec onomicuncertainty and c harac terized by the ong oing d eb ate a bo ut the form ation ofgreen shoots, we have found that investors increasingly rely on technicals togovern their investment de c isions. Ca usality in the stoc k m arket is alw aysd iffic ult to p eg in an a bsenc e of c ompa ny spe c ific news, but we think HNIshares have be en rallying o f late ba sed on tec hnic al trad ers buying a “ cupand hand le” forma tion. What is a c up and hand le formation? In general ac up a nd handle is a b ullish trad ing p attern that m arks a c onsolid a tion p eriodfollowed by a b rea kout. There are two p arts of the pa ttern, the “ c up” and the“ hand le”. The c up should be “ U” shap ed (as op po sed to “ V” shap ed ), withhighs tha t are eq ual (or close) on b oth sid es. In the c ha rt be low, you c an see

a solid “ c up” pa ttern form ed for HNI from Janua ry to May. A pull ba c kfollowing the form ation of the “ c up” is typically viewe d as the “ hand le” . As youc an see the “ handle” in this c ase looks like it might ha ve b ee n formed in thepa st mo nth.

A true c up a nd ha ndle formation will be c harac terized by a b rea kout on

signific ant volum e. Last week, HNI broke to new highs for the yea r, but on ve rywe ak volume. Overall trad ing volume s in the past mo nth have b ee n 50% ofnorma l in the pa st month. Our expec tation is tha t Wed nesd ay’s ea rningsrelease w ill be the test that e ither confirms a “ c up and hand le’ formation orc rea tes a d ifferent tec hnica l picture for HNI shares. We’re in the la tter ca m p.

2. HNI is heavily shorted. Clearly we’re not the only ones who think that HNI shareshave signific ant d ow nside. There were ap proxim ately 6.7 m illion sha res short as




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of last month, rep resenting a short interest ratio o f 22.5 days. We think thefund am entals are likely to rem ain poo r for HNI for several yea rs. How ever thatdoe sn’t m ea n that shares won’t rally on the most mod est of “ sec ondderivative” imp rovem ents. We still think the stoc k will be ha rd pressed to findinc rem enta l buyers given the relative valua tion g ap to its pee rs who in ma ny

c ases have b ette r balanc e shee ts and strong er brand s.

BRIEF INDUSTRY AND COMPANY DESCRIPTION AND A LOOK AT THE TRADING HISTORY

Ac c ord ing to the Business and Institutiona l Furniture M anufa c turer’s Assoc iation(BIFMA), the to ta l am ount of o ffic e furniture p rod uc ed in the U.S. dec lined 3.2% in2008 to $11.2 b illion. The ind ustry is highly cyc lic al a nd la rgely dep end ent onem ployment t rends. 2000 wa s the strong est yea r for the industry in its history both froma p rod uc tion a nd c onsump tion p erspe c tive due to the extrao rd inarily tight lab orma rkets. As the c hart be low ind ic a tes, it is not unc ommon for the industry to have a

pe ak to troug h d ec line o f 25-30% over the c ourse of a rec ession.

U.S. Office Furniture Production and YOY Change($ in Billions)

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

1 9 9 0

1 9 9 1

1 9 9 2

1 9 9 3

1 9 9 4

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9 E

2 0 1 0 E

-35.0%

-30.0%

-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

Production

% YOY Change

Source: The Business a nd Institutiona l Furniture Ma nufa c turer’ s Assoc iatio n (BIFM A)

BIFMA d ivid es the ind ustry into 6-ma jor p rod uc t c a teg ories: sea ting , caseg oo ds(storag e p rod uc ts, d esk sets), storag e, files, ta bles, and system s. Over the past 15-20yea rs the perce ntage of industry revenues derived from systems has dec lined whilethat g enerate d from the sale of sea ting a nd c aseg ood s has inc rea sed . We a ttributethe d ec line in system s related revenue to a d esire among c orpo ra tions to red uce the




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presenc e of “ ind ustrial” c ub ic les in the work plac e. Manufac turers have respond edwith mo re eleg ant desk solutions and c aseg ood s. Sea ting has inc rea sed as ape rc entage of revenue d ue to the a dve nt of ergo nom ic cha irs such a s Herma nMiller’s Aeron c hair. The tables be low c ompa re the p ercenta ge of prod uc tionc om ing from e ac h prod uc t line in 1990 to tha t in 2008.

1990 U.S. Office Furniture Production Product Mix

Tables

7%

Casegoods

10%

Systems

36%

Seating

25%

Files

16%Storage

6%

2008 U.S. Office Furniture Production Product Mix

Tables

10%

Storage

6%Files

15%

Seating

29%

Systems

28%

Casegoods

12%

Sourc e: BIFMA

A Quick Look a t Herman Miller

Herma n Miller Inc . wa s found ed as Star Furniture Com pa ny in 1905 and has bec om eone of the largest m anufac turer’s of o ffic e furniture in the wo rld throug h a series ofac qu isitions and orga nic g row th. The c om pany is prob ably be st know n for its Aeronc ha ir, but Herman Miller also ha s a full produc t suite of a wa rd winning sea ting ,c aseg oo d , furniture system s and storage solutions. In 2008, the c om pany wa s named

to Fortune ’s “ 100 Best Companies to Work For” , Fortune ’s “ Mo st Admired ” , and FastCom pany’ s “ Fast 50” m ost innova tive lists. The c om pany has 157 ac tive patents in theU.S. and 52 more design p atents pend ing. The c om pany sells 70% of its p rod uc tthroug h indep end ent dea lers.

Over the p ast five to te n yea rs, Herma n Miller has mad e a c onc erted effort to d iversifyits revenues into ne w end markets internat ionally as well as new vertica ls in the U.S. Asa result, the p ercenta ge of revenue s the c omp any g enerates from the trad itiona loffice furniture c ha nnel has d ec lined from 75% in 2001 to 58% in 2008.




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MLHR Revenues by End Market

International

22%

US Off ice

Including

Government

58%

Healthcare,

Home,

Education

20%

Source : Com pa ny repo rts.

HNI Corporation at a Glance

HNI c orpo ra tion w as found ed in 1944 and is now the sec ond largest ma nufac turer ofoffic e furniture in the world . The c om pany has two m ajor operating g roup s: offic efurniture and hearth produc ts. Throug h its office furniture g roup, HNI ha s 9 majorop erating d ivision a nd brand s: Allstee l, Gunloc ke, HBF, Paoli, Omni Workspac eCom pany, HON, Ma xon, ba syx, and Lam ex. The c ompany d ivides its end markets foroffic e furniture into two broa d c ate gories: the supplies d riven c hannel and thec ontrac t c hannel. The end buyer in the supplies driven c hannel is p rima rily ac onsumer or small business. The selling mod el for this c hanne l is a c om bination o find ep end ent d ea lers, and large offic e supply stores (Stap les, Offic e Depot, andOffic eMax). The c ompa ny has a g rea ter perc entage of its revenues c oming from thesup plies d riven c ha nnel than do m ost of its public ly traded c om pet itors (KNL, SCS, andMLHR etc .) The c ontrac t channe l is where HNI has the m ost ove rlap with thetrad itiona l offic e furniture ma nufa c turer. Reve nue p rospec ts in HNI’s supplies drivenc hannel and its c ontrac t c hannel are highly correlated , even though the e nd-buyer isslightly different.

HNI is North Ame ric a ’s largest ma nufac turer of p refa bric a ted firep lac es and relate dprod uc ts. The c om pany’s hea rth prod uc ts inc lude a full suite o f gas, elec tric andwo od burning firep lac es. Sales for this d ivision are highly c orrela ted to ne w homesales.




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HNI Revenues by Product

Hearth

Products

17%

Office

Furniture

83%

Source : Comp an y Rep orts

Trading Background: MLHR shares pea ked in Feb ruary 2007 in c on junct ion with a pea k in non-farm p ayrollsfor the p revious ec onomic c ycle. At its pe ak, MLHR shares traded a t $40, whichrep resente d 15.6x wha t turned out to b e p ea k earnings for the c ycle. MLHR hastaken a num be r of steps to red uce ma nufac turing c ap ac ity and c ut co sts in order topreserve profitab ility. In Dec em ber, the c ompany announc ed plans to lay off 1,000em ployees. On May 14th, MLHR anno unced that it planned to c lose a ma nufac turingfac ility in Spring Lake, MI and wo uld red uc e its d ividend by 75% from $0.088 quarterly

to $0.022. These c ost red uc tions ena bled the c om pany to exce ed stree t estimates for4Q09 (Ma y 31st FYE) and the stoc k rallied more tha n 10% on the day ea rnings wereannounced.




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HNI sha res pea ked a t $58 in the first q ua rter of 2006, a full yea r prior to those forMLHR. We attribute this to the d ec line in revenues and o pe ra ting inc om e for thec om pa ny’s hea rth prod uc ts d ivision w hich trac ked the p ea k in housing . To p ut this inpe rspec tive, the hea rth p rod uc ts d ivision ge nerated $600 million in sales and $58

million of o perating inc om e in 2006, co mpared to our forec ast for 2009 for $300 millionin revenues and an operating loss. As we ment ioned prev iously, HNI sha res havec losely trac ked tho se o f the o ther lea d ing offic e furniture m anufac turer’s up until thelast three to four months.

Short Dynamics

As of the end of June there w ere a pproximately 2.6 m illion sha res short for MLHR,which represents 4.9 da ys to c ove r. We d o not th ink the short inte rest in MLHR will pla ya m aterial role in its stoc k price p erformanc e.

HNI is heav ily shorted and investors should a lways be m indful of a pote ntial shortsquee ze eve n on a mod estly po sitive d ata p oint. As of the e nd of June there wereapproxim ately 6.7 million sha res short, which rep resents 15.3% of the floa t a nd 22.5days to c ove r. We think MLHR represents a superior wa y to p lay any rec ove ry in theoffic e furniture sec tor (which we view a s d oub tful) and c ontinue to see rota tion out ofHNI g iven its huge valuation prem ium.

INVESTMENT THESIS IN DETAIL

Our investment thesis is predicated on the following:

1. Employment is the single most important factor that drives demand for office

furniture - we’re in for a deep free ze. As investors we c onstantly sea rc h fo r




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pa rallels when evaluating c om pa nies and ana lyzing the b roa d er ec onom y.Ove r the p ast 12-18 months how often have we he ard p eo ple d isc uss whe theror not this ec onomic dow nturn resem bles tha t o f the e arly 1980’s, the m id1970’s, the p ost wa r period , or eve n the Great Depression. One thing is forc erta in, this is the wo rst lab or ma rket in the past 70 yea rs. As the c ha rt below

dem onstrates, the overall YOY dec line in non-farm p ayrolls in the past yea r ismore than twice tha t of any rec ession the U.S. ec onomy has expe rienc edsince 1940. The m agnitude of job losses is truly staggering a nd almost certa inlywill be a m ajor im ped ime nt to co nsumer spe nding and b roa d er ec onom icgrow th for the next several yea rs. Not only has this rec ession bee n the w orstfrom a lab or market pe rspec tive in the past 70 yea rs, but it wa s prec ed ed byan ec onomic rec ove ry that wa s m ost nota ble for its lac k of job ga ins. Investorsshould no t forge t how “ d eep in the hole” this c ould leave ma ny industries thatare p artic ularly sensitive to employment g row th.

YOY Change in Total Non-Farm Payrolls(in thousands)

(8,000)

(6,000)

(4,000)

(2,000)

-

2,000

4,000

6,000

1 9 4 0

1 9 4 4

1 9 4 8

1 9 5 2

1 9 5 6

1 9 6 0

1 9 6 4

1 9 6 8

1 9 7 2

1 9 7 6

1 9 8 0

1 9 8 4

1 9 8 8

1 9 9 2

1 9 9 6

2 0 0 0

2 0 0 4

2 0 0 8

Sourc e: Burea u o f La bo r Sta tistics

The U.S. offic e furniture m arket is highly correlated to la bor market t rend s. Asthe c hart be low d em onstra tes, the YOY c hange in offic e furniture p rod uc tionhas c losely trac ked the 12-m onth c hange in non-farm p ayrolls.




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YOY Change in U.S. Office Furniture Production vs. 12-month

Change in Non-farm Payrolls

-30.0%

-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1 9 9 1

1 9 9 2

1 9 9 3

1 9 9 4

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9 E

-8,000

-6,000

-4,000

-2,000

0

2,000

4,000

6,000

% YOY Change in U.S.Office Furniture Production

12-month change in non-farmpayrolls (in millions)

Sourc e: BIFMA a nd Burea u of La bo r Sta tistics

In its base c ase p rojec tions for 2009 and 2010, BIFMA ha s forec ast a 28%dec line in industry-wide prod uc tion in 2009 and then a sligh t recove ry inprod uc tion in 2010. Overall this wo uld im ply a 30% pea k to troug h d ec line inprod uc tion a nd c onsump tion for the c urrent ec onom ic d ownturn. This wo uldbe less than the 36% dec line in p rod uc tion witnessed from the pea k in 2000 tothe eventua l troug h in 2003. We rec og nize tha t 2000 rep resented the end o fan unusual pe riod of ec onom ic growth c harac terized in pa rt by incred iblelab or market tightness. However, the shee r ma gnitude o f job losses thus far inthis rec ession would sugge st tha t the d ow nturn from pea k to troug h will beeven greater this tim e a round . We a ntic ipa te it could e xc eed 40% and takemore than three yea rs. It ap pea rs tha t consensus estimates for the public lytrad ed furniture ma nufa c turers are more c losely trac king BIFMA forec asts rathe rthan our more sanguine view.

Peak to Trough

Consumption Production

Current Recesion Forecast -30.0% -29.9%2001 Recession -32.4% -36.0%

Sourc e: BIFMA

2. HNI Corporation will likely violate its total leverage covenant within the nextquarter or two, which we think will result in a substantial reduction in thecompany’s dividend. In our view, HNI’s seeming ly a ttrac tive d ividend yield(4.7%) has bee n one of the key fac tors supporting the c om pany’s valua tion




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prem ium rela tive to its pee rs. We anticipa te the a ttrac tivene ss of HNI sha resfrom a d ivid end yield p erspec tive a re likely to change w ithin the next 3-6months. As part of its c red it agreem ent, HNI must ma inta in tota l leve rage nogrea ter tha n 3.0x as mea sured by tota l d eb t to LTM EBITDA. Based on ourforec ast, we think HNI c ould v iola te its tota l leve rage c ovenant as soo n as the

third q uarter of this yea r. Currently the c om pa ny’s d ividend p ayout ra tioexceed s 125% on a TRAILING b asis and overall the d ivid end is a $38-$39 millionuse o f ca sh annua lly. Historica lly, HNI ha s gene ra ted a m ple free c ash flow(150%+ of net inc ome). How ever, given the ma gnitude o f the do wnturn we d onot think HNI will gene rate enough FCF to p ay its d ividend for the ne xt 12-18months. As a result, we think lend ers will ask for the c om pany to red uce itsd ivide nd m ea ningfully as pa rt of a ny am end me nt to HNI’s c red it ag reem ent.

In this environm ent the stigm a surround ing a d ividend red uc tion has bee nred uced . Add itiona lly, we think HNI managem ent and its lend ing group willlook closely at MLHR’s dec ision to red uc e its d ividend by 75%. Although MLHR

neve r pa id out a s much as MLHR, the d ivid end red uc tion in pa rt has ena bledthe c om pany to pursue d rastic red uc tions to its leverag e levels. We think ad ividend red uc tion w ould remo ve the last supp ort that long investors have inHNI. The ta b le below outlines HNI’s historic al com plianc e w ith its tota l leverag ec ovenant a nd our foreca sts.

HNI Covenant Compliance - Total Leverage

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

4.5x

1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09E 3Q09E 4Q09E

HNI Total Debt/LTM EBITDA

HNI Leverage Covenant

Sourc e: Com p a ny repo rts, PAA Resea rch

3. MLHR and HNI are highly correlated, but in a tale of the tape between Herman

Miller and HNI, MLHR wins in a knockout. HNI and MLHR sha res ha ve b ee nhighly co rrelate d for 15-yea rs. On a 12-month basis, the tw o stoc ks have had a




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c orrela tion o f 0.874.

HNI/MLHR

Correlation

1-year 0.87442

2-year 0.835843-year 0.909345-year 0.7682110-year 0.7095715-year 0.80916

Source: Yahoo finance, PAA Research

Since 3/ 31/09, HNI sha res have increased 89.2%, while MLHR sha res are up amore mo dest 45.1%. Tha t’s 44% outp erformanc e for two c om panies tha t havehistoric ally bee n highly c orrelated . To p ut this in p erspec tive, this dec ade the rehave only been two othe r period s during which HNI shares outp erformed MLHRshares by more than 30% on a three month basis. There w as a 20-da y pe riod in

the fourth quarter of 2008 and a 10-d ay pe riod in the third q ua rter of 2002 andthat’ s it. In 2008, the p erform ance g ap w as narrow ed by 30% within a m onthand in 2002 the relative performa nc e o f MLHR shares increa sed by 20%.

We find little fund am enta l justific a tion for the rela tive outperformanc e. Wethink the long M LHR/ short HNI pa ir trad e is particula rly compelling bec auseMLHR is c learly a fund am enta lly superior comp any and a b ette r wa y to pla yany rec ove ry in the o ffic e furniture ma rket, in our view. To top if off, MLHRtrades a t a stee p d isc ount to HNI shares. Let’ s take a look at the twoc om panies side -by-side ac ross a va riety of fundam ental barome ters. First froma P&L perspective:

HNI MLHR

LTM Revs $2,320 $1,630YOY Change -8.0% -19.0%

Growth Most Recent Q -28.0% -38.4%5-yr CAGR 7.1% 8.5%FY1 Revs $1,770 $1,330

FY1 Growth Est. -28.6% -18.4%LTM Gross Margin 32.9% 32.4%

LTM EBIT $87 $151Margin 3.8% 9.3%

LTM EBITDA $159.44 $192.30

Margin 6.9% 11.8%

LTM EPS $0.99 $1.59FY1 EPS $0.19 $0.84

FY 2 EPS $0.67 $0.995-yr EPS growth rate -9.4% 52.2%

Source : Co mp an y repo rts, Yaho o Financ e, PAA Resea rch

Loo king a t the tab le above , one c an q uic kly see tha t MLHR had strong erreve nue g row th ove r the past 5-yea rs, has supe rior margins and genera tedhighe r EPS growth in the most rec ent cyc le. One thing tha t skews the ana lysis a




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little b it is the d ifferenc e in the fisc al yea r end fo r ea c h c om pany. HNI is astand ard Decem ber 31, FYE, while MLHR ha s a May 31 fisc al yea r end . Thisexpla ins why the LTM revenue d ec line for MLHR is highe r than tha t fo r HNI.Based on our forec asts the YOY revenue dec line on an LTM basis will jump to17% when HNI reports 2Q09 results.

From a wo rking c ap ital and CAPEX pe rspec tive, both c om pa nies ap pe ar to b eve ry sim ilar. CAPEX typ ically approximates 2-3% of tota l revenue s, DSO’ s arevery rea sonable a t 38-42 da ys, and invento ry turnove r is very high. Structurallyspea king, bo th c om pa nies have strong free cash flow m od els. MLHR is bette rpositione d rela tive to HNI in our view bec ause the c om pany has less leverag e(on a net-de bt b asis) and does not have a huge d ividend pa yout. It should b enoted that MLHR’s de bt to c ap has be en skewed by the hug e a mo unt of sharebuyb ac ks the compa ny c om pleted over the pa st 2-3 yea rs. The c ompa nynow plans to use its excess free c ash flow to repay d eb t and c urrently has a$75 million tend er offer out for its 7.125% no tes expiring in 2011.

HNI MLHR

LTM CAPEX 58.5 40.5As a % of Revenue 2.5% 2.5%

Free Cash Flow $117.7 $173.1FCF/Net Income 225.0% 113.7%Annual dividends/share $0.88 $0.09

Dividend Payout Ratio 129.1% 5.5%

DSO 41.3x 33.3xInventory Turnover 27.2x 29.6xTotal Debt 316.11 377.4

Net Debt 284.11 173.2

Debt/Cap 39.5% 97.7%Interest Coverage Ratio 10.8x 8.0x

Leverage Ratio (Total Debt/EBITDA) 2.1x 2.0xCovenant 3.0x 3.5x

Sourc e: Com p a ny repo rts, PAA Resea rch

Based on the previous two tab les, one would be rationa le to a ssume that HNIand MLHR trad e a t sim ilar valua tion m ultiples, or perhap s MLHR trad es a t aprem ium. Of co urse we know tha t the op posite is true. From a return onc ap ital perspec tive, the re is no fundam enta l justific a tion fo r HNI sha res to trad eat a premium to those o f MLHR. MLHR c onsistently ha s ha d som e o f thestrong est returns on c ap ita l em ployed and e qu ity in the broa der market. It ishard to b elieve tha t HNI trad es a t almo st twice the m ultiple o f MLHR. Meanreve rsion in the relative valuation a ppea rs inev itab le and the d ow nside to HNIshares with a c ombination o f a d ivid end red uction a nd d ownwa rd revisions toestim ates c ould be c onsid erab le.




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HNI MLHR

Stock Price $18.92 $15.33Market Cap $847.62 $824.60

Enterprise Value $1,131.73 $997.80FY1 P/E 99.6x 18.3xFY2 P/E 28.2x 15.5x

P/E Peak EPS 7.4x 6.0xEV/FY1 EBITDA 15.0x 6.7xLTM FCF Yield 13.9% 21.0%

Price/Revenue (FY1) 0.5x 0.6xPrice/Book 2.0x 16.0xDividend Yield 4.65% 0.57%

ROIC 3.6% 22.4%

ROIC 5-yr. Avg. 13.6% 23.0%ROE 6.8% 394.1%ROE 5-yr. Avg. 19.6% 64.2% Source : Yahoo financ e, PAA Resea rch

CATALYSTS

We like pa ir trad es in uncerta in trad ing environm ents, the S&P 500 has bee n stuc k in arange for the past few m onths betwee n 880 and 950. We a ntic ipa te this c ouldc ontinue through the summ er until the d eb ate o ver “g reen shoo ts” is eventuallyresolved by the b ac k to sc hoo l and holiday sea sons. Even if the o ffic e furnituremarket is in an “ ice age” (i.e. it’ s frozen) we still think there a re signific ant returns to bema de. Here are the c a talysts we see fo r the trad e over the next seve ral months.

1. HNI 2Q09 Results (7/ 22/ 09,before market open). HNI will report 2Q09 results onWednesday, before the m arket opens. We think the c om pany will fall short ofc onsensus revenue and EPS estim ates and po tentially a nnounce a d ec ision tolowe r its d ividend . If the com pany does not ad d ress its d ivid end polic y inc onjunc tion with this ea rnings relea se, we almost c ertainly think a reduc tion willoc c ur on o r be fore its third quarter ea rnings relea se.

2. July Non-farm payrolls (8/ 7/ 09, 8:30AM). As we highlighted ab ove ,em ployment trend s are the single most impo rtant ma c ro-ec onom ic fac tor thatd rives revenue prospec ts for office furniture manufa c turers. In general thestoc k pric es will only move on the d ay of a non-farm p ayrolls relea se if theresult is substantially d ifferent from expec ta tions.

3. August non-farm payrolls (9/ 4/ 09, 8:30AM). See a bo ve. 4. MLHR 1Q10 (last September). We expec t MLHR to a nnounc e the results of itsdeb t tend er offer and prog ress on its c ost reduc tion efforts. Our call here is notpred ic ted on e arnings upside for MLHR as much as it is about the c om pany’sab ility to g enerate c ash and c ontinue to red uce leverag e in this environment.

A Look at Our Estimates vs. Consensus




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We see signific ant d ow nside to estimates for HNI. We think the KNL 2Q09 earnings c allprovided a p review o f what is to c om e. Ma nag em ent d isc ussed the p ossib ility for aseq uential d ec line in revenues from 2Q to 3Q, whic h is not fac tored into HNI

estim ates. Add itiona lly, KNL managem ent was som ew ha t tep id a bout the prospec tsfor a strong seq uential improvem ent in revenue s in 4Q. Lastly they highlighted howthe low level o f revenues will ma ke it d iffic ult to susta in gross margin levels eve nthoug h input costs have d ec lined a sizea ble am ount o n a YOY basis. Here are ourkey a ssumptions for our HNI estima tes:

From a b roa d er perspec tive, we think the p ea k to troug h dow nturn in industry-wid e U.S. offic e furniture p roduc tion will exc eed 40%

A 35% YOY dec line in 2Q09 for both o ffic e furniture a nd hea rth prod uc trevenues

2Q09 gross margins of 32% (130 bps improvement from 1Q09) as a result of

ma nufac turing c ap ac ity rationalization a nd lower ma terial c osts. Overall gross margins of 31.5% for 2009 A 6.5% YOY dec line in reve nues for 2010. It is important to note tha t the d ec line

in revenue s for the first ha lf of 2009 wa s som ewhat m itiga ted by ba c klogc rea ted in 2008.

Tota l FCF of $25 million in 2009 and $40 million in 2010, assum ing CAPEX of $30million a nd $44 million in those yea rs respec tively.

PAA Research for HNI vs. Consensus and Guidance

Mgmt.

Consensus PAA Research Guidance

2Q09E FY09E FY10E 2Q09E FY09E FY10E 2Q09

Revenues $401.2 $1,770.0 $1,700.0 $392.4 $1,728.6 $1,615.5% Change -34.6% -28.6% -4.0% -36.0% -30.2% -6.5% (-32%)-(-38%)

EPS -$0.08 $0.19 $0.67 -$0.18 -$0.23 $0.52 Operating Loss

EBITDA $5.4 $74.6 $120.2FCF ($3.0) $11.6 $20.6

Source : Yaho o financ e, PAA Resea rch

PROBABILITY WEIGHTED RETURN

Looking at t he return on investment ba sed not o nly on c urrent va luation, but the

prob ab ility we ighted return given our conviction level

Upside Convic tion Leve l: 70% MLHR Long , 80% HNI sho rt

We think MLHR shares could trade as high as $20 and MLHR shares south of $12: Ourc all here is not ab out M LHR shares being hug ely unde rvalued . The stoc k ap pea rsrea sona bly valued g iven the unce rtain nature a nd ma gnitude of a ny stab ilization orrec ove ry in the labor m arket. In an environment where non-farm pa yrolls appea r tosta b ilize w e think MLHR sha res c ould trad e as high a s 20x FY11 estimates based on




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investors buying in antic ipa tion of a return to p ea k earnings, whic h in the most rec entc ycle were $2.56. HNI, on the othe r hand should trad e a t a valua tion c onsistent w iththat of MLHR. A 16x multiple o n c onsensus FY10 EPS would put HNI sha res $10.50. If thec om pa ny cuts its d ivide nd a nd employment trend s d o not show any mea ningfulimproveme nt w e think it’ s possible tha t shares c ould trad e to those levels.

Total Probability Weighted Return: In ord er to b etter alloc ate c ap ital from a timing a ndsizing perspec tive, we think it is im portant to look a t ea c h p osition on a prob ab ilitywe ighted return ba sis. In the c ase o f a p air trad e w e w ant to eva luate the relativeupside a nd dow nsid e in ea c h stoc k. We are targe ting a 25% net return from this pa irtrad e. We think there’ s a 70% c hanc e MLHR shares will trad e highe r in the next 6-9mo nths. Overall our prob ab ility we ighted return is a mod est 9.9%. In the c ase of g oingshort HNI, we think the stoc k could trad e a s high a s $20.00 in a short squeeze sc enario.Outside of tha t, we see d ow nside b elow $11 as previously mentioned. Tha t yield s atota l prob ability we ighted return of 23.6%.

Total

MLHR - LONG Probability

Current Target Conviction Absolute Holding Annualized Weighted

Return Matrix Price Price Level Return Period Return Return

Upside $15.33 $20.00 30.0% 30.5% 0.5x 60.9% 9.9%

Base $15.33 $17.00 40.0% 10.9% 0.5x 21.8%Downside $15.33 $13.50 30.0% -11.9% 0.5x -23.9%

Source: PAA Research LLC

Total

HNI - SHORT Probability

Current Target Conviction Absolute Holding Annualized Weighted

Return Matrix Price Price Level Return Period Return Return

Upside $18.92 $11.00 25.0% 41.9% 0.5x 83.7% 23.6%

Base $18.92 $14.00 55.0% 26.0% 0.5x 52.0%Downside $18.92 $20.00 20.0% -5.7% 0.5x -11.4%

Source: PAA Research LLC

Documents

Generating Returns in an Industry in a Deep Freeze - Long Herman Miller (MLHR)/Short HNI Corporation (HNI)