Leggett & Platt: The Specialty Foam Potential
Feb. 22, 2021 Leggett & Platt, Incorporated (LEG)
Summary
Leggett & Platt Inc. may be more appropriately analyzed as comprising a Specialty Foam division and the rest of the LEG business units (Classic LEG division).
The Classic LEG division is a "steady" business with a 2.2 % CAGR in revenue and a 4.9% CAGR in EBIT from 2010 to 2019.
The Specialty Foam division is a growth business with double-digit growth in 2019. In 2019, it contributed an additional 17% to the group average EBIT (5 years average).
I valued LEG at USD 50 per share based on a sum of part valuation model. There is a sufficient margin of safety at the current market price.
Investment thesis
The past two years' performance of Leggett & Platt (LEG) does not present an accurate picture of the long-term prospects of the business. Not only has the 2020 performance been distorted by the Covid-19 pandemic but the potential of the Specialty Foam business that was acquired in 2019 has yet to be seen.
While the Classic LEG division is a 'steady" business, the Specialty Foam is a growth one.
To assess the fundamental value of LEG you have to look at the pre-Covid-19 performance. At the same time, the valuation of LEG should be based on a sum of parts value as the Specialty Foam business prospects are different from those of the Classic LEG division.
LEG is currently under-priced based on a sum of parts value of USD 50 per share. There is a buying opportunity with a sufficient margin of safety.
Rationale
1. LEG can be considered as a USD 4.8 billion Total Assets group comprising 2 divisions:
The Specialty Foam division employing about USD 1.3 billion of total assets.
The Classic LEG division employing about USD 3.5 billion of total assets.
2. The Specialty Foam division achieved double-digit growth in 2019 and added 17 % to the group's past 5 years average annual EBIT. This division provides LEG with another growth path into the polyfoam sector.
3. From 2010 to 2019, the revenue and EBIT of the Classic LEG division grew at 2.2 % CAGR and 4.9 % CAGR respectively. While not exciting, it provides "steady" earnings.
4. I valued LEG at USD 50 per share based on a sum of part valuation with the Specialty Foam division modeled as a growth business and the Classic LEG division modeled as a "steady" business.
LEG Total Assets Profile
As of the end of 2020, LEG had USD 4.8 billion of Total Assets. I estimated that USD 1.3 billion of these was deployed in the Specialty Foam division with the balance in the Classic LEG division. About 64 % of LEG 2020 Total Assets comprises goodwill and intangibles. The breakdown of the Total Assets into the Specialty Foam and Classic LEG divisions are shown in the chart below.
You will note that a very significant portion of the Specialty Foam division's Total Assets comprises goodwill and intangibles. In its 2019 SEC Filings, Note S, LEG stated that of the USD 1.24 billion purchase price of the Specialty Foam division:
USD 0.59 billion was for goodwill.
USD 0.37 billion was for customer relationships.
USD 0.17 billion was for technology.
LEG Total Assets ProfileSource: Author(A) The Specialty Foam tangible assets were derived from the 2018 SEC Filing for the ECS Performa financials after deducting 2 years of depreciation and amortization as per the said Performa. The Specialty Foam goodwill/intangibles were assumed to be the same as that in the 2018 Performa(B) The Classic LEG data were based on the unaudited FY 2020 financials after deducting the relevant amount for the Specialty Foam division
This high level of goodwill and intangibles mean that the actual reinvestment to fund its growth is relatively low as compared to the situation where the majority of the Total Assets are tangible assets. This low reinvestment rate "boosts" the free cash flow and hence the value of the business.
Specialty Foam division
In Jan 2019, LEG acquired Elite Comfort Solutions Inc (ECS) for USD 1.24 billion. This became the Specialty Foam business unit under the LEG organization structure.
Using the very best in custom design polyurethane foam technology, ECS is a leader in the proprietary specialized foam technology for the bedding and furniture industries. Its products included finished mattresses sold through both traditional and online channels, mattress components, mattress toppers, pillows, and furniture foam.
In 2018, about 65 % of ECS sales were to the bedding sector with 25 % to the furniture sector.
ECS sales profile
Source: LEG Nov 2018 Investors Presentation
What is the Specialty Foam division's potential contribution to LEG? I estimated this based on the information provided by LEG in its SEC Filings and summarized it as shown in the table below.
ESC parametersSource: Author from LEG SEC Filings on ESC Performa financial statements
In its Nov 2018 presentation to investors, LEG represented that ECS is expected to generate double digits revenue growth.
Then in its 2019 Highlights of its SEC Filings, LEG reported that ECS added 14 % to its 2019 revenue. This is equivalent to about USD 665 million. Considering that the acquisition of ECS was in Jan 2019, I estimated that a full year Specialty Foam division revenue to be 725 million i.e. about 19 % growth compared to the 2018 Performa revenue.
Assuming the ECS 2018 gross profit margin and SGA, this works out to be about USD 79 million EBIT. This is equivalent to about 17 % of LEG group 2015 to 2019 average annual EBIT of USD 471 million.
To give you a sense of the contribution of the Specialty Foam division from an enterprise perspective, this 17 % EBIT contribution was generated from 27 % (USD 1.3 billion) of the group Total Assets in 2020.
While LEG has focussed on ECS's contribution to its bedding business in announcing the acquisition, I believe that the Specialty Foam division opens up a new growth possibility for LEG i.e. into the polyfoam market.
According to Grand View Research, the global polymer foam market size was valued at USD 113.89 billion in 2019 and is projected to expand at a CAGR of 3.8% from 2020 to 2027. Growing applications in various industries, such as packaging, furniture and bedding, and automotive industries, are expected to drive the type demand.
I believe that the Specialty Foam division can provide benefits to the Classic LEG business units beyond the bedding business.
US Foam industrySource: Grand View Research
Classic LEG division
Excluding the Specialty Foam division, I estimated that the Classic LEG division generated revenue of USD 4.1 billion in 2019. Over the period from 2010 to 2019, the Classic LEG division revenue grew at 2.2 % CAGR.
The Classic LEG business model appears to be one where there is annual closure or sale of business units as well as new acquisitions. The revenue growth is the net effect of these acquisitions and business closure. From 2010 to 2019
13 business units were discontinued or sold
There were 28 (excluding ECS) acquisitions. Except for ECS, all these were within the existing Classic LEG businesses and/or products.
Due to the discontinuation and acquisition program, the Classic LEG division EBIT has an uptrend with a CAGR of 4.9 % from 2010 to 2019 as illustrated by the Performance Index chart.
Nevertheless, its EBIT dipped in 2013 and 2014 due to the following:
The results in 2013 were due to a USD 63 million impairment of goodwill and intangibles for assets related to the Commercial Vehicle Products.
In 2014, there was a loss of USD 124 million following the sale and discontinuation of the Store Fixtures unit
Gross profitability which had some improvement from 2014 to 2016 has declined since then. You should not be surprised to see the link between EBIT and gross profitability.
Classic LEG division Performance IndexSource: Author(a) The 2019 metrics were estimated by deducting the portion attributable to the Specialty Foam division. The Specialty Foam division parameters were based on USD 665 million of revenue with the 2018 Performa margins
The Classic LEG division is organized into three segments as of Jan 2020. The chart below shows how the three segments have performed over the past 10 years.
The Bedding segment accounted for 39 % of the 2019 group revenue. But it only achieved 0.5 % CAGR between 2010 and 2019
The Furniture, Flooring & Textile segment is the next biggest revenue contributor. It achieved a 1.3 % CAGR.
The Speciality Foam segment accounted for about 26 % of the 2019 group revenue. However, this is the fastest-growing segment with a 7.4 % CAGR. This is despite the complete closure of the Commercial Vehicle Business in 2017. In the first half of the decade, the Commercial Vehicle Business contributed about USD 120 million annual revenue.
Classic LEG division segment revenueSource: Author from SEC Filings. Note that the 2010 to 2016 segment figures were estimated based on the business unit's revenue and may not be the same as those if they were recast by LEG. However, it should provide a picture of the trend over the years.
Even without taking into account any synergy from the Specialty Foam division, you can see that the Classic LEG division is a "steady" business.
While LEG has extolled the benefits to the Classic LEG division in its announcement about the ECS acquisition, there is not enough information at this stage to understand the scale of this contribution. Thus, in my valuation of the Classic LEG division, I will not cover any synergy impact.
Valuation
I value LEG based on a sum of part valuation with:
Classic LEG division valued based on a single-stage low growth model.
Specialty Foam division valued as a high growth business. I use a 2-stage growth model for this.
The equity value of LEG based on the sum of parts model is USD 50 per share computed as per the table below.
LEG Sum of Parts valuationSource: Author
The Classic LEG division accounted for slightly more than ¾ of the value with the balance from the Specialty Foam division. This appears to be in line with the Total Assets deployment where the Classic LEG division accounted for slightly less than ¾ of the Total Assets.
Single-stage growth model for the Classic LEG division
The enterprise value was derived based on a Free Cash Flow to the Firm (FCFF) model as per Damodaran.
FCFF = EBIT X (1-tax rate) X (1-Reinvestment rate)
Value = [ FCFF X (1+growth rate) ] / [ WACC - growth rate ]
The key inputs and assumptions used in the valuation are shown below.
Classic LEG valuation imputsSource: Author(a) The EBIT was derived by adding net interests to the PBT. Thus, it included all the impairments and gain from the sale of businesses. This is appropriate as business closures and acquisitions (except for ECS) are not a one-off event.(b) The actual reinvestment rate over the past 5 years was about 5.4 %
2-stage valuation model for the Specialty Foam division
I adopted a 2-stage valuation model for the Speciality Foam division with the following additional assumptions.
Specialty Foam valuation
The challenge with valuing the Specialty Foam division is that there is not sufficient historical data. As such, I have referred to other sources for the 2 key parameters in the 2-stage model - the high growth rate and the reinvestment rates.
Can growth be justified?
The high growth rate of 9.1 % that I have assumed would increase the Specialty Foam division revenue in 10 years by 2.4 times to about USD 1.9 billion. To give you a sense of scale, the 2019 revenue of a number of the Classic LEG furniture businesses (Bedding, Adjustable Beds, Home Furniture, Work Furniture) was USD 1.9 billion.
My assumed high revenue growth rate is realistic as:
The US bedding industry had grown at a 9.1 % CAGR for the past 10 years. An online retailer like Amazon doubled its revenue from 2018 to 2019. If you want more background on the US bedding industry and its potential, refer to my Seeking Alpha article "Tempur-Sealy: Time to exit" (TPX)
In 2019, the Specialty Foam division revenue grew by 19 %.
Note that at the assumed growth rate, the Specialty Foam division would just maintain its market share of the US bedding sector. At the same time, this growth rate is looking at just the bedding industry without taking into account the other poly foam sectors.
Can the reinvestment rates be justified?
The 26.4 % reinvestment rate was based on the average of
The Specialty Foam division 2018 Performa reinvestment rate of 47.3 %.
The Classic LEG division past 5 years average reinvestment rate of 5.4 %
It is obvious that with a lower reinvestment rate, you would get a higher valuation. My view is that the Specialty Foam division rate is not sustainable whereas the Classic LEG division rate looks very low. I cite the following to support my reinvestment assumption.
In my TPX article, I estimated that the TPX reinvestment rate to be about 17%.
The Furniture/Furnishing sector had a [ Net Capex / EBIT (1-t) ] of 20.8%. (Source: Damodaran Jan 2021). This is a reinvestment rate before accounting for the increase in working capital related to the growth.
In LEG 2021 Guidance, capital expenditure for the group was estimated at USD 150 million. This is similar to the past 5 years' capital expenditure. There did not seem to any significant change to the historical capital expenditure even with the Specialty Foam division.
I have earlier mentioned that the tangible assets employed by the Specialty Foam division are actually very small relative to the Total Assets. I estimated it to be currently under USD 200 million. A 26.4 % reinvestment rate would result in about USD 15 million reinvestment compared to the USD 200 million tangible assets.
Are there other boosters to the margin of safety?
My valuation has resulted in a 20 % margin of safety. I believe this is conservative for the following reasons.
Firstly, I have assumed a 1% growth rate for the Classic LEG division compared to its past 10 years growth rate of 2.2 %. A valuation based on a 2 % growth rate would add another USD 8.84 per share to the value of LEG and increase the margin of safety to 41 %.
Secondly, over the past 10 years, LEG has spent about USD 1.5 billion to repurchase about 45 million shares. LEG currently has USD 349 million of cash. If I assumed that it spends part of the cash eg USD 150 million to buy back shares at the current price, it would reduce the average number of shares by 3.6 million. This would boost the value by USD 0.23 per share. This is the impact of a buyback for one year.
Valuation risk
It is clear that the margin of safety comes from modeling the Specialty Foam division as a high-growth business. Over the 10 years' high revenue growth period, the cumulative EBIT for the Specialty Foam division amounted to USD 1.2 billion. Assuming a 25 % tax rate, this is equivalent to an after-tax payback period of about 13 years based on the USD 1.24 billion acquisition price. They may those who would argue that the payback period is too long and that my assumptions were "conservative".
While LEG has not shared the financial projections for the acquisition, I would think that LEG would have to assume that it was a high growth business for the acquisition to make financial sense. Therein lies the risk. If the Specialty Foam division does not deliver double-digit growth over the coming decade, it would have been an expensive acquisition. And of course, the sum of part valuation would not make sens
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